Frank Fabozzi, Carmel de Nahlik Project Financing 8th Edition

Project Financing
Eighth Edition
ProjectFinancing.indb 1 18/06/2012 07:49

Project Financing
Eighth Edition
Frank J Fabozzi and Carmel F de Nahlik
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Published by
Euromoney Institutional Investor PLC
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Copyright 2012 Euromoney Institutional Investor PLC
ISBN 978 1 78137 070 4

Seventh edition 2000
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Contents
Preface xxiii
List of case studies xxv
Case study cross-reference table xxvii
About the authors xxix
1 An overview of project finance 1

1 Checklist for a successful project financing 2
2 Causes of project failures 4
3 Credit impact objective 4
4 Accounting considerations 5
5 Meeting internal project appraisal objectives 6
6 Other benefits 7
7 Tax considerations 7
8 Disincentives to project financing 8
9 Principles apply regardless of project size or context 8
10 Building blocks of project financing 8
11 Reconsidering decision-making 9
Case study: Eurotunnel a disaster for lenders 10
2 Criteria for a successful project financing 13

1 Risk phases 13
Engineering and/or construction phase 13
Start-up phase 14
Operations according to specification 14
2 Different lenders for different risk periods 15
3 Review of criteria for a successful project financing 16
Credit risk rather than equity risk is involved 16
Feasibility study and financial projections 17
Assuring the cost of supplies and raw materials 19
Energy supplies assured at a reasonable cost 21
A market exists for the product, commodity or service 21
Take-or-pay contracts 21
Take-and-pay contracts 22
Transportation of product to market 22
Adequate communications 23
Availability of building materials 23
Experienced and reliable contractor 23
Experienced and reliable operator 24
Management personnel 24
No new technology 25

Contents
Contractual agreements among joint venture partners 25

Political environment, licences and permits 26
No risk of expropriation 26
Country and sovereign risk 27
Currency and foreign exchange risk 28
Adequate equity contribution 29
The project as collateral for asset lending 29
Satisfactory appraisals 29
Adequate insurance coverage 30
Force majeure risk 30
Delay and cost overrun risks 32
Adequate ROE, ROI and ROA 34
Realistic inflation and interest rate assumptions 34
Environmental risks 34
Foreign Corrupt Practices Act and other similar legislation 35
Protection systems against kidnapping and extortion 36
Commercial legal system to protect property and rights 36
3 Use of a financial adviser 37

1 Developing a relationship with the sponsors 38
2 Designing and contracting for the preliminary feasibility study 38
3 Planning and selecting the optimal financing structure and key providers 39
The sponsors and promoters of the project are identified 39
Other interested parties to the project are identified 39
Location and design of the project 40
Estimated construction costs 40
The financial plan 40
The proposed terms for financing 40
4 Monitoring and administering the financing 40
Construction 41
Start-up 41
Operations 41
5 Selection of an outside adviser 42
6 Engagement letter 42
4 The offering memorandum 44

1 Proposed financing and summary of terms 44
2 The project company 46
3 Capitalisation 46
4 Products/markets 48
5 Marketing 49
6 Competition 49
7 Manufacturing and production 50
8 Management/personnel 50
vi

Contents
9 Business risks 50
10 Historical and other financial information 50
11 Plans and forecasts 56
12 Each case is different 57
13 Potential future liabilities 57
5 Risks that a lender may assume 58

1 Country risk 58
2 Sovereign risk 59
3 Political risk 59
4 Foreign exchange risk 60
5 Inflation risk 60
6 Interest rate risk 60
7 Appraisals 61
8 Availability of permits and licences 61
9 Operating performance risk 61
10 Price of product 62
11 Enforceability of contracts for product 62
12 Price of raw materials and energy 62
13 Enforceability of contracts for raw materials 63
14 Refinancing risk 63
15 Force majeure risk 63
16 Legal risk 64
6 Choosing a lead bank 65

1 Factors to consider in selecting a bank 65
Size 65
Experience 65
Support 66
Documentation 66
Working relationships 66
Leaving management decisions to management 66
Country exposure 67
2 Choice of a sponsor by a bank 67
7 Contacting lenders and investors 69

1 Following the first contact 69
2 Structuring the transaction and contact points 70
3 Preparing the documentation 70
4 Syndication 70
8 Credit risk appraisal 73

1 Stakeholder interests 73
2 Credit analysis from the standpoint of a term lender 73
vii

Contents
3 General considerations in credit decisions 74

Management 74
Level and stability of earnings 74
The industry 75
Financial resources 75
Asset protection 75
Indenture provisions 75
Guarantees and securities 75
Cash trap 75
4 Financial ratios 76
Liquidity ratios 76
Debt/leverage ratios 77
Profitability ratios 77
Coverage ratios 78
5 Commercial debt ratings 79
9 Risk analysis of a project loan 81

1 Credit risk in a project loan 81
2 Purpose of a risk classification system 82
3 Risk classification criteria 83
Criteria 83
Industry 83
Company or project 84
Modifiers 85
4 Description of risk classification grid 86
Highest quality 1 96
Highest quality 2 96
Good quality 1 96
Good quality 2 97
Good quality 3 97
Fair quality 97
Other categories 98
10 Types of capital and debt 99

1 Equity 99
2 Subordinated loans 100
Equity kickers 102
Financial covenants 103
Interest rate and term 103
Unsecured loans by sponsors 103
3 Senior debt 104
Unsecured loans 105
Secured loans 106
Nature of security for senior debt 108
viii

Contents
Security agent for senior debt 109

Secured loans other than senior debt 109
4 Concerns of senior lenders 110
5 Inter-creditor agreement 110
11 Sources of equity and debt 112

1 Multilateral development agencies 115
2 International Finance Corporation (IFC) 115
3 Government export financing and national interest lenders 116
Insurance products 116
Loans and guarantees 117
Supplier credit 117
Buyer credit 117
The Berne Union 117
4 Host governments 117
5 Commercial banks 117
6 Institutional lenders 118
7 Money market funds 118
8 Commercial finance companies 118
9 Leasing companies 118
10 Private equity providers 118
11 Buy-outs, buy-ins and buy-in management buy-outs funds 119
12 Bond markets 119
13 Wealthy individual investors 119
14 Suppliers of a product or raw materials 120
15 New product buyers or service users 120
16 Contractors 120
17 Trade creditors 121
18 Vendor financing of equipment 121
19 Sponsor loans and advances 121
20 Project collateralised bond and loan obligation pools 122
21 Insurance provided by private insurance companies 122
22 Islamic finance 122
23 General guidelines when selecting sources of finance 124
12 Use of captive insurance and finance companies 125

1 Captive insurance companies 125
Different forms of insurance captives 126
Why project companies may consider forming a captive 127
Internal control 127
External control 127
Disadvantages of captive insurance companies 128
2 Captive finance companies 128
The US case as an historic example 128
ix

Contents
13 Instruments used in project financing 132

1 Commercial bank loans 133
2 Supplier financing and captive finance companies 134
3 Export credit financing 134
4 Buyer credits supported by an export credit agency 135
5 National and international development bank loans 135
6 Co-financing and complementary financing 135
7 Syndicated credit facility 136
8 Production payment loans and advances 137
9 Short-term financing vehicles 137
10 Bond financing 138
Eurobond market 138
US bond market 139
Rule 415 140
Form S-3 140
Yankee bonds 141
Private placement debt 141
Rule 144A 142
Industrial development revenue bonds 142
Bond structures 143
Floating-rate notes 143
Zero-coupon bonds 143
Deferred coupon bonds 144
Convertible bonds 144
Bonds with warrants 145
Dual-currency bonds 146
Commodity-linked notes 146
Credit-linked notes 146
Inflation-indexed bonds 147
11 Medium-term notes 147
12 Asset-backed securities 149
13 Leases 150
14 Preferred stock 150
15 Master limited partnerships 151
16 Research and development limited partnership 152
17 Equity funding via depositary receipts 152
18 Islamic lending 152
19 Credit enhancement 153
14 Construction financing 154

1 Estimation of funding needs 154
Special purpose entity project financing 156
Direct construction financing 157
2 Construction financing using leveraged leasing 159

Contents
Construction supervision agreement 161

Construction contract assignment 162
15 Term loans and private placements 163

1 Commercial bank loans 163
Term bank loans 164
Revolving bank loans 165
Syndicated credits, including Eurocurrency loans 167
2 Private placements 170
Investment criteria of investors 172
The use of agents or advisers 173
3 Description of a typical term loan or debt private placement
agreement 174
Loan terms and closing the loan 174
The notes(s) 174
Making the loan 174
Conditions of closing 175
Financial covenants 176
Required payments 176
Optional prepayments without penalty (doubling-up) 177
Restriction on refinancing 177
Optional prepayment under certain circumstances 177
Optional prepayments with penalty 178
Affirmative covenants 179
Financial statements and information 179
Books of record and account 179
Right to inspect properties and books 179
Payment of taxes 180
Maintenance of properties 180
Compliance with laws 180
Insurance 180
Permitted business (character of business) 180
Covenant to secure note equally with other lenders 180
Protective covenants 180
Minimum working capital requirement 181
Limitation on short-term debt 181
Limitation on long-term debt 182
Restriction on lease obligations 183
Restricted dividend payments, other stock payments and the
repurchase of stock 183
Restrictions on supply and purchase contracts (take-or-pay
agreements) 184
Limitation on guarantees and contingent liabilities 184
Limitation on sale and lease-back transactions 185
xi

Contents
Limitations on mortgages, liens and other

encumbrances 185
Other protective covenants 185
Default and remedies 186
Boilerplate 187
Modification of the agreement 187
Definitions 188
Expenses of the financing 188
16 Industrial development revenue bonds 189

1 Municipal revenue bonds 190
2 Qualification for the issuance of a tax-exempt bond 192
Qualifying private activities 193
Annual cap limitation on issuance 193
Other general rules 194
3 Structure for IDR financing 195
Loan agreement 196
Lease 196
Lease/lease-back 196
Instalment sale 198
4 The process for issuing IDR bonds 198
17 Commercial paper and back-up credit facilities 202

1 Advantages of commercial paper financing 202
2 Concerns with using CP funding 203
3 Maturity characteristics of CP 203
4 Selecting a CP agent 204
5 Governmental approvals by non-US issuers 204
6 Jurisdiction for non-US issuers 204
7 Commercial paper ratings 205
8 Credit support facilities 206
9 Credit enhancement facilities 208
10 Asset-backed commercial paper 210
18 General principles of leasing and types of leases 211

1 What is a lease? 212
2 Different forms of leases 213
3 Different types of lessors 214
4 The conditional sale lease or non-tax oriented lease 214
5 The true lease or lease as part of the financing of a sales
package 215
How true leasing works 216
Principal advantage is low cost 217
Rationalisation of the loss of residual value 217
xii

Contents
6 Leveraged lease 217

Parties to a leveraged lease 218
The lessee 218
Equity participants 219
Loan participants or lenders 219
Owner trustee 219
Indenture trustee 220
Single trustee acting as both an indenture trustee and an
owner trustee 221
Manufacturer or contractor 221
Packager or broker 222
Guarantor 222
Structure of a leveraged lease 222
Closing a leveraged lease transaction 223
Participation agreement 223
Key documents 225
Indemnities 225
Closing the lease 226
Cash flows during the lease 227
Debt for leveraged leases 227
Commercial paper investors 228
Public debt markets 228
Government financing 228
Industrial revenue bonds 228
Supplier financing 228
Multicurrency financing 229
International currency and bond markets 229
Bridge financing 229
Facility leases 229
Facility support agreements 229
Credit exposure of equity participants 232
Points of contention between lenders and equity participants 232
Indenture defaults which are not lease defaults 232
Control of sale of leased property in the event of default 232
Cure default rights of equity participants 233
Fish or cut bait provisions 233
Tax indemnity payments 233
Indemnification for future changes in tax law 234
Definition of the tax to be covered by the tax rate change indemnity 235
The risk of tax rate change to be covered by an indemnity 235
Dimensions of the problem: the triggers 235
Time limits on tax indemnity 236
Basic remedies for an indemnified party 236
xiii

Contents
Computation of the loss or benefit 236

Specific remedies of the indemnified party 237
Leveraged debt provisions should contemplate possible tax
indemnity 238
Risk of future rate change is significant 238
Leveraged leases with individual investors 238
Example of a leveraged lease of an electric generating facility by
a utility 238
Participation agreement 239
Partnership and agency agreement 239
Support facilities agreement 239
Trust indenture and mortgage 240
Lease agreement 240
Construction supervision agreement 240
Coal supply agreement 240
Non-tax oriented leveraged leases 242
7 TRAC leases 243
Equipment eligible for TRAC leases 243
Terminal rental adjustment clause defined 243
How a TRAC lease works 244
Except for TRAC clause, a TRAC lease must qualify as a true lease 244
Advantages of TRAC leases 244
8 Synthetic leases 244
19 International leasing 246

1 Cross-boundary leasing or cross-border leasing 246
Double dip leasing 247
2 Examples of leasing in different national contexts 250
Regulation of leasing activity 250
Initial costs of the transaction 250
Ownership of the asset 250
Tax issues 251
End-of-lease issues 251
3 Some examples of different leasing approaches 252
France 252
Ireland 253
Japan 253
China 254
Australia 255
Africa 255
Americas 255
Middle East 255
5 Islamic leases 255
xiv

Contents
20 Financial models 257

1 Project finance versus public-private partnership financing
models 257
2 Characteristics of a project finance/PPP model 257
3 Models in different phases of a project 258
4 Model best practice 258
5 Model flexibility 259
6 Modules within a model 259
7 Functional currency 261
8 Inflation and exchange rates 261
9 Currency adjustments 261
10 Interest rates 262
11 Revenues 262
12 Operating costs 263
13 Working capital 263
14 Discount rate 263
15 Weighted average cost of debt 264
16 Weighted average cost of capital 264
17 Key project selection criteria 265
18 Controlling the project during its life span 265
19 Funding 266
20 Taxation 266
21 Sinking funds 267
22 Bank accounts 267
23 Waterfall of accounts 267
24 Additional equity 268
25 Dividend cash trap 272
26 Loan prepayment 272
27 Loan repayments 273
28 The accounting statements 273
29 Break-even analyses 274
30 Foreign exchange savings 274
31 Scenario analysis 274
32 Sensitivity analyses 276
33 Risk analysis 276
34 Tornado diagrams 276
35 Cross checks 277
36 Testing the model 278
37 Modellers review of the legal documentation 279
38 Version control 279
39 Audit trails 279
40 Complex models 279
Multiple countries 279
Multiple points of view 280
xv

Contents
41 Using VBA 280

User defined functions 280
Test code 281
Analyses 281
Iterative calculations 281
42 Alternatives to spreadsheets 281
21 Financial modelling for different industries 282

1 Oil and gas development projects 282
2 Downstream petrochemical 282
3 Oil refineries 285
4 Pipelines 285
5 Railways 286
6 Toll roads 287
7 Telecommunication submarine cables 290
8 Power projects 292
9 Ships 293
10 Buildings 294
11 Airports 295
22 Overview of risk management 298

1 Types of risk 298
Risk retention 298
Neutralising risk 298
Risk transfer 299
2 Traditional insurance policies 300
Political risk insurance 300
OPIC insurance program as an exemplar 301
Private sector coverage 303
3 Trade credit insurance 303
4 Financial guarantees 304
5 Structured finance 304
Securitisation 305
Structured notes 306
6 Derivatives instruments 307
Risk-sharing versus insurance type derivatives 308
Credit derivatives 308
Credit default swaps 308
Use of CDS by banks 309
7 Alternative risk transfer 310
Insurance-linked notes 310
Contingent insurance 310
Captive insurance companies 310
xvi

Contents
23 Guarantees 312
1 Guarantors 313
Owner guarantors 313
Third-party guarantors 313
Candidates for third-party guarantors 313
Objectives of third-party guarantors 315
Typical third-party guarantors 315
Commercial guarantors 316
Banks letters of credit 316
Insurance companies 318
Investment companies 318
2 The coverage of guarantees 318
Commercial risk 318
Completion 318
Cost overrun 318
Delay 319
Cost of raw material and energy 319
Market for product 319
Political risk 320
Casualty risk 320
War risk 320
Acts of God 321
3 Types of guarantees 321
Limited guarantees 321
Guarantees limited in amount 321
Guarantees limited in time 322
Indirect guarantees 322
Contingent guarantees 323
Implied guarantees 323
Example of a project financing support by a user sponsors
guarantee 324
Completion guarantees 325
Guarantees and bonds under construction contracts 327
Bid bond 327
Performance bond 327
Advance payment guarantee 329
Retention money bonds 329
Maintenance bonds 329
Guarantee to support an off-balance sheet construction loan 329
Deficiency guarantees 330
Undertakings which provide comfort to lenders but are not really
guarantees 330
Loan to a corporate joint venture supported by the implied
guarantee of a cross-default clause 332
xvii

Contents
Project financing supported by third-party guarantor 334

Direct and indirect guarantees against nationalisation,
expropriation and political risk 336
US Eximbank financing and loan guarantee programs 339
Shipping company financing the purchase of a foreign flag ship
by a non-recourse loan 339
Take-or-pay, through-put and put-or-pay contracts 340
Take-or-pay contracts 340
Through-put contracts, tolling agreements and cost-of-service
tariffs 341
Put-or-pay contracts 342
Take-and-pay contracts 342
Take-if-needed 342
Comparison with ship charters 343
Take-or-pay contract obligations of utilities subject to special
scrutiny 343
Take-or-pay obligations of pipeline companies 343
Example of a project financing supported by a take-or-pay
contract 343
Pipeline project financing supported by through-put agreement
of users 345
Terms of a long-term take-or-pay, or put-or-pay, contract 347
Build own and transfer or build own and operate transactions 347
Puts and call as support mechanisms 347
24 Controlling risk via risk-sharing derivatives contracts: futures and

forward contracts 353
1 Futures contracts 354
Mechanics of futures trading 355
Interest-rate futures contracts 356
Eurodollar futures 356
Treasury bond and note futures 356
Currency futures 359
Commodity futures 359
Weather futures 359
2 Forward contracts 359
Long-term forward foreign exchange agreements 360
Long-term contracts 360
Cost of foreign funds 361
Forward rate agreement 361
3 Off-take agreements 361
4 Contract for differences 362
5 General principles of hedging with futures and forward contracts 362
Risks associated with hedging 363
xviii

Contents
Short hedge and long hedge 363

Hedging illustrations 364
Perfect hedge 364
Basis risk 366
Cross hedging 369
25 Controlling risk via risk-sharing derivatives contracts: swaps 374

1 Generic interest-rate swaps 375
Application 376
Calculation of the swap rate 377
Valuing a swap 380
2 Non-generic interest-rate swaps 381
Amortising, accreting and roller coaster swaps 381
Zero-coupon swaps 382
Basis rate swap 382
Forward-rate swaps 382
3 Currency swaps 382
4 Cross-currency interest-rate swaps 383
5 Commodity swaps 385
26 Controlling risk via insurance-type derivative contracts: options,

caps and floors 387
1 Options 388
Differences between options and futures contracts 389
Exchange-traded versus OTC options 389
Exchange-traded futures options 390
Mechanics of trading futures options 390
Variants of standard options 391
Compound options 391
Forward-start options 392
Barrier options 392
Lookback options 392
Average options 392
2 Caps and floors 393
3 Collars 394
4 Swaptions 394
27 Entities for jointly owned or sponsored projects 396

1 Accounting for joint ventures 397
2 Corporations 397
True lease from third-party leasing company to a corporation 398
True lease from sponsors 399
Example of a corporation jointly owned by sponsors which
borrows to finance a project 399
xix

Contents
Example of a joint venture corporation with tax benefits

claimed by one party 400
3 Partnerships 400
General partnership to operate a project 406
A general partnership with limited recourse secured debt
supported by a take-or-pay from the sponsor partners 407
4 Limited partnerships 409
Leveraged limited partnerships 412
R&D limited partnerships 412
The structure of an R&D partnership 413
Rewards for investors 413
5 Contractual joint ventures 417
Joint venture supplier financed by advances of each joint venturer 419
Exploration, development and/or operation of a mine under
a joint venture operating agreement 421
Lease by a utility of an undivided interest in a co-generation
facility to be operated as a joint venture 424
Sponsor-owned joint venture supplier financed by sponsors
severable lease 425
Sponsor-owned joint venture supplier with one or more weak
sponsors financed by loan or lease 428
Sale of appreciated equipment to a joint venture which
finances the purchase with non-recourse debt 429
28 Reserves-oriented financing and drilling funds 432

1 Production loans 432
2 Non-recourse production loans 433
3 Production payments as collateral to obtain financing 433
Example of a reserved production payment to finance a
purchase of an oil or mineral property 435
Reserved production payment in a lease transaction 436
Carved-out production payment (non-development) to
raise capital 436
Development carve-outs: pledged production payments
dedicated to development of a property 439
Wrap-around carve-out 440
Use of income from stable country production to finance
development of unstable country production 440
The ABC deal: purchase of mineral-producing property by
off-balance sheet financing 441
The ACB deal: purchase of mineral-producing property by
off-balance sheet financing 443
4 Advance payments for oil, gas or coal payments 445
Example of an advance payment for gas and oil 445
xx

Contents
Oil and gas development funding outside the US 446

Comparison of advance gas payment contract with
carved-out development production payments 450
Supplier project facility financing supported by user-sponsors
advances 450
Using financial support from other group members in a
consortium to assist in financing through carried interests
and farm-in/farm-out approaches 451
A carried interest 452
A farm in/farm out 452
Net profits interest 452
5 Limited partnership drilling funds 453
Example of a limited partnership drilling fund 454
Discussion of special tax problems in oil and gas limited partnership
drilling funds 456
6 POGO type plans: financing offshore exploration through a newly
formed controlled subsidiary 457
7 Combination of POGO-controlled subsidiary and limited partnership 459
29 Restructuring 462
1 Asset sales, acquisitions and mergers 462
2 Leveraged buyouts of companies 463
Cash is king 464
Debt structures 464
Senior debt 465
Junior and subordinated debt 466
Equity 466
Collateralised loan obligations 467
Project finance structures used in LBOs 467
Leveraged buyout housed in a subsidiary 467
Leveraged buyout in which the acquired subsidiary or
division is merged into the acquiring corporation 467
Retention of key personnel 469
Valuation of an acquisition 469
Due diligence in the analysis of a proposed acquisition 469
Industry reports and analyses 470
Corporate documents 470
Insurance 473
Group insurance and welfare benefits 473
Environmental/OSHA compliance 474
Product development 474
Manufacturing inputs and costs 474
Financial information 474
Tax matters 476
xxi

Contents
Projections 476
Miscellaneous 476
3 Employee stock ownership plans 477
Securitised ESOP loans 478
Use of an ESOP to cash out a shareholder sponsor from
a project company 478
Use of an ESOP to divest a profitable division 479
Use of an ESOP to acquire a project company or to increase
stockholdings in a project company with pre-tax dollars 481
Use of an ESOP to permit repayment of a bank loan by the
ESOPs sponsor company using pre-tax dollars 481
Converting debt to equity in a leveraged buyout 483
Downsides of ESOPS 483
30 Public-private partnerships and the private finance initiative 485

1 Background and rationale for public-private partnering 486
2 Key requirements for a PPP transaction 487
Value for money 487
Reallocation of risk and risk management 489
Innovation 490
Enhanced performance and more transparent performance
management 490
Lower cost than an equivalent public sector comparator 490
3 Key components for a PPP/PFI 492
4 Classic form of a PPP/PFI 492
5 Different forms of PPPs and PFIs 492
Pure concession agreements 495
LIFT as a special case 495
Design-build-operate-transfer and build-operate-transfer projects 495
Design-build-finance-operate 496
Build-own-operate 497
6 Accounting issues for PPPs and PFIs 497
7 Different forms of PFI projects 498
The freestanding or commercial partnership 498
Joint ventures 498
Services sold to the public sector 498
8 PFI financing lifecycles: evidence and challenges 499
Case studies 503

Glossary 637
xxii

Preface
In the first edition of this book, the term project financing was used to identify and describe
certain kinds of instruments and certain types of transactions with unique characteristics which
enabled promoters of a project financing transaction to look at three characteristics of project
financing cash flow, assets and risks and to use an understanding of the dynamics of their
interactions to design financial structures that could allocate certain risks to third parties, while
at the same time retaining significant benefits of the project. In the ensuing editions of the book,
the term project financing was used to describe financing packages not included on balance
sheets and with shifted liability characteristics.
In a project financing, the project and its cash flow, supported by its assets, its contracts and
its fundamental economics are examined as a separate credit appraisal for loan or investments in
the project, independent of the sponsors creditworthiness. Lending to a project requires a strong
cash flow, possibly backed by strong credit support from some source; sometimes this support can
be accomplished in an indirect or contingent manner which may have little or no impact upon
the sponsors debt capacity as compared with a direct loan. In some circumstances, the credit of
third parties unrelated to the sponsor can be used to support the credit standing of the project.
Since the first edition was published, the financial markets have undergone tremendous
upheavals and many new structures and instruments have been created to meet the financing
needs of businesses. Traditional commercial banking may have been displaced by new financial
instruments and products but this is not universally true. Whilst new products have a role,
more efficient dissemination of information, sharing ideas and better project management as a
result of improved and more rapid communication have also changed the landscape of projects.
Techniques for financial analysis that were restricted to a few so-called experts are now avail-
able to anyone with a laptop through readily accessible data information services, the internet
and off-the-shelf software, but analysts still need to query and understand the basic assump-
tions and not be bedazzled by spreadsheets. The information age and new technologies can pro-
mote novel and useful financing techniques, but the credit basics should also not be forgotten.
We also have reformulated the ways we look at decision-making and this particularly applies
to areas of project finance. Whilst in the past, the model of rational decision-making under-
pinned the creation of large revenue generating projects and their associated financial structures,
nowadays we admit the importance of behavioural drivers. Thus we can sometimes see, with
hindsight, that certain projects were doomed to problematic existence because the underlying
decisions were not rational, but were overlaid by drivers resulting from the personal needs of the
decision makers. So, a theoretical example of this might be a vanity project conceived by a chief
executive officer wanting to leave a legacy or create a lasting monument. Another theoretical
example might be complex structures inserted into project financing by bankers who might be
considering personal bonus-related performance targets, rather than the overall financial logic
of the transaction.
As we look at the governance of organisations and the turnover of staff in key roles, we
can observe the possibility of a mismatch between long-term project timescales and short-term
involvement by individual stakeholders. Consequently, as we look forward to the next decades
xxiii

Preface
of successful projects that will reshape the world we live in, we should recall that decisions are
made by individuals who have personal decision-making frames and as we assess and approve
such long-term projects as a financial community, we should always interrogate those decisions
to ensure that we are contributing to a positive future, and not one with sovereign debt crises,
increased taxes and so on, to pay for poor decision-making.
This edition considers the wider world of project finance, applicable to such diverse situ-
ations as venture capital and leveraged buyouts, and using new approaches such as Islamic
finance techniques. Whilst this book has never been an intellectual treatise, it provides a con-
ceptual starting point for the further development of the readers own creative ideas on project
financing through an examination of alternative approaches seen in a compendium of concepts
and structures that can be applied at any stage in the analysis of an anticipated or proposed
project financing and offering a useful road map as to how to marshal those resources for
an effective and profitable result. We have included several historic structuring approaches to
spark the imagination of newer generations of project finance specialists.
Each project financing requires careful planning at its early stages in order to achieve the
maximum desired result of a segregated financing at as low a cost as possible. The entity to house
the project must be carefully chosen; financial instruments to be used to evidence debt obligations
and equity must be reviewed; joint venture partners or investors and lenders must be carefully se-
lected; borrowing options must be preserved. Supply contracts or sales contracts must be carefully
drafted. The operating climate and political stability of the environment for the project must be
satisfactory and a stable and predictable system of laws protecting property rights of creditors and
owners must be in place as a crucial ingredient for project financing. However, above all this stands
the projects estimated cash flow the source of debt service and repayment and equity rewards.
The ultimate design of any project financing is only limited by the imagination and care of all its
stakeholders in optimising the resources and environment of the transaction and the tools at hand.
A major contribution to this edition was provided by John Macgillivray (Managing Direc-
tor of Project Planning and Management Ltd) who authored Chapter 20 (Financial models) and
Chapter 21 (Financial modelling for different industries).
A new feature of this book is the 12 case studies. These appear at the end of the book prior
to the glossary and are reprinted from the Journal of Structured Finance published by Institu-
tional Investor. We thank Allison Adams of Institutional Investor for granting us permission
to use these articles and we have endeavoured to contact all the authors also. The table below
shows how the case relates to the material in the chapters.
We thank Hal Davis, editor of the Journal of Structured Finance, for assistance he provided
in various phases of this project.
The first edition was written by Peter K Nevitt, with subsequent editions co-authored with
Frank Fabozzi. Peter, who gained prominence as one of the pioneers of tax-driven leasing of
equipment and is regarded as the inventor of leveraged and synthetic leases, died of cancer in No-
vember 2002 at the age of 75. This book reflects many of his ideas regarding project financing and
we hope that it will inspire new generations of those associated with project finance to continue in
the creative structuring traditions that characterise this area of finance that touches so many lives.
Frank J Fabozzi, Professor of Finance, EDHEC Business School
Carmel F de Nahlik, Finance Teaching Fellow, Aston Business School
March 2012
xxiv

List of case studies
All cases reprinted with permission from Journal of Structured Finance.
Baker, CA, and Forrester, JP, Home run! A case study of financing the new stadium for the
St Louis Cardinals, Journal of Structured Finance, Summer 2004, pp. 6974.
Chu, Y, and Merna, T, Quantitative evaluation of the relationship between supply and
off-take contracts in petroleum refinery projects utilizing project finance, Journal of
Structured Finance, Spring 2011, pp. 7695.
Crozer, GK, Pertaminas Blue Sky Project heralds return of innovative project financing in
Indonesia, Journal of Structured Finance, Spring 2004, pp. 811.
Dong, F, and Chiara, N, Improving economic efficiency of public-private partnerships for
infrastructure development by contractual flexibility analysis in a highly uncertain context,
Journal of Structured Finance, Spring 2010, pp. 8799.
Esty, BC, The Equate Project: an introduction to Islamic project finance, Journal of Structured
Finance, Winter 2000, pp. 720.
Henderson, WC, Case studies of project finance in Latin America, Journal of Structured
Finance, Winter 1999, pp. 2534.
Joshi, P, Dabhol: a case study of restructuring infrastructure projects, Journal of Structured
Finance, Summer 2002, pp. 2734.
Jackson, CM, Accessing local currency through credit-enhanced bond structures in Africa:
a case study of Safaricoms medium-term floating-rate secured note issue, Journal of
Structured Finance, Summer 2002, pp. 2631.
Lake, TE, and Davis, HA, TermoEmcali, Journal of Structured Finance, Winter 1999,
pp. 3750.
Norris, S, and Ogunbiyi, C, Letting the crown jewels fall into private hands. A case study
of the Maputo Port Project, Journal of Structured Finance, Summer 2003, pp. 4752.
(Simon Norris at Trinity International LLP.)
Stern, S, International project finance: the Ilisu Dam Project in 2004 and the development
of common guidelines and standards for export credit agencies, Journal of Structured
Finance, Spring 2004, pp. 4654.
Strong, JS, Azito: opening a new era of power in Africa, Journal of Structured Finance,
Fall 2000, pp. 3653.
Every attempt has been made to contact individual authors of these case studies. The authors and their publisher
will be glad to make good in future editions any omissions brought to their attention.
xxv

Case study cross-reference table
Case title Most useful for chapters

Quantitative evaluation of the relationship between supply and off-take contracts in 8, 20, 21
petroleum refinery projects utilizing project finance
Improving economic efficiency of public-private partnerships for infrastructure 26, 30
development by contractual flexibility analysis in a highly uncertain context
Pertaminas Blue Sky Project heralds return of innovative project financing 13, 28
in Indonesia
International project finance: the Ilisu Dam Project in 2004 and the development of 7
common guidelines and standards for export credit agencies
Home run! A case study of financing the new stadium for the St. Louis Cardinals 1, 17, 18
Letting the crown jewels fall into private hands. A case study of the 2, 27
Maputo Port Project
Dabhol: a case study of restructuring infrastructure projects 23, 29
Accessing local currency through credit-enhanced bond structures in Africa: a case 3, 11
study of Safaricoms medium-term floating-rate secured note issue
The Equate Project: an introduction to Islamic project finance 10, 19
Azito: opening a new era of power in Africa 14, 22
Case studies of project finance in Latin America 9
TermoEmcali 12, 15
xxvii

About the authors
Frank J Fabozzi is Professor of Finance at EDHEC Business School and a member of the
EDHEC-Risk Institute. He held various professorial positions in finance at Yale Universitys
School of Management from 1994 to 2011 and from 1986 to 1992 was a visiting professor
of finance and accounting at MITs Sloan School of Management. In the 20112012 academic
year, he was a visiting fellow in the Department of Operations Research and Financial
Engineering at Princeton University where he also served for eight years on that depart-
ments Advisory Council. From 2008 to 2011, Professor Fabozzi was an affiliated professor
at the Institute of Statistics, Econometrics and Mathematical Finance at Karlsruhe Institute
of Technology (KIT) in Germany. Editor of the Journal of Portfolio Management and an
associate editor for the Journal of Structured Finance, Review of Futures Market, and Journal
of Fixed Income, he has authored numerous books and research papers.
Professor Fabozzi is a trustee for the BlackRock family of closed-end funds and previ-
ously a trustee for the Guardian family of open-end funds and variable annuities. In 2002,
he was inducted into the Fixed Income Analysts Societys Hall of Fame and is the 2007
recipient of the C Stewart Sheppard Award given by the CFA Institute. He earned a Ph.D. in
economics from the City University of New York in 1972, both a BA and MA in economics
and statistics degree in economics (magna cum laude and honors in economics) from the City
College of New York in 1970, and awarded an honorary doctorate from Nova Southeastern
University in June 1994. In 1969, he was elected to Phi Beta Kappa. He earned the designa-
tion of Chartered Financial Analyst and Certified Public Accountant.
Carmel F de Nahlik is a Teaching Fellow in Finance and Accounting at Aston Business

School. She has delivered executive programs focusing on project finance and project manage-
ment and taught at a number of universities in the UK including Imperial, Cranfield and
the Open University and in Ireland at the University of Limerick. Prior to joining Aston
Business School, she was the Head of Ethics and Governance for the Faculty of Business,
Environment and Society at Coventry University.
Dr de Nahliks background is in project finance and prior to her academic career, she
worked for a number of financial institutions as a commercial lender, investment banker/
adviser and as an equity/debt provider with experience in finding creative solutions for
problem projects. She received her undergraduate degree in chemistry from UMIST, an MBA
from Manchester Business School where she received the Conoco Oil Scholarship and a PhD
from Cranfield University School of Management where she studied the survival of small
oil firms in the UK. She also holds an MA in Online and Distance Learning from the Open
University. Dr de Nahlik is a former Council member of the Institute of Petroleum, and a
member of the Association for Project Management. Her research interests include project
finance and attitudes towards risk in financial decision-making.
xxix

Chapter 1
An overview of project finance
The origins of project financing may be seen in such examples as merchant adventurers in
the Middle Ages who invested in voyages, both in ships and cargo, in the expectation they
would be repaid from the liquidation of the voyage proceeds. We can see the same approach
today in conventional project financing and also in Islamic financing techniques where risks
are shared by investors and funders in a project. The principles of project financing are also
those that underpin other financial activities such as venture capital, leveraged buyouts and
other restructuring or financial engineering activities. Indeed project finance can be consid-
ered a type of structured finance. So, although the term project financing has been used to
describe all types and kinds of financing of projects, the term now tends to be more precise,
as our definition shows:
A financing of a specific 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
a loan will be repaid and equity serviced and to the assets of the economic unit as
collateral for the loan within a specified risk framework.
A key word in the definition is initially. While a lender may be willing to look initially to
the cash flows of a project as the source of funds for repayment of the loan, the lender
must also feel comfortable that the loan will in fact be paid on a worst case basis. This may
involve undertakings or direct or indirect guarantees by third parties who are motivated in
some way to provide such guarantees.
Mission-critical to any project is its promoter or sponsor, and a project may have one
or several sponsors. Construction companies act as sponsors to generate profits from the
construction or operation of the project; operating companies sponsor projects to generate
profits from fees for operating a facility and/or selling the product produced by the project.
Some companies may do both with different entities set up as sponsors for each phase.
Projects may also be set up to provide access to key resources or the processing or distribu-
tion of a basic product or service for a sponsor, or to ensure a source of supply vital to
the sponsors business.
The ultimate goal in project financing is to arrange a borrowing for a project that will
benefit the sponsor and at the same time be completely non-recourse to the sponsor, so
that there will be no impact on its financial statements, and in no way affects its credit
standing. Indeed, project financing is sometimes called non-recourse or off-balance sheet
financing. However, in todays world, regulators and accountants are taking an interest in
the information asymmetries that may exist for stakeholders, including investors, in organisa-
tions when liabilities may appear to disappear, so the off-balance sheet nature of project
finance may well be subject to change in future years.

Project Financing
There is considerable room for disagreement and debate between lenders and borrowers
as to what constitutes each feasible project financing. Borrowers prefer their projects to be
financed independently and off-balance sheet. Lenders, on the other hand, are not in the
venture capital business and are not equity risk takers. Lenders want to feel secure that they
are going to be repaid either by the project, the sponsor, or an interested third party. In
this difference of views lies the challenge of designing successful project financing to meet all
stakeholder needs. A successful project financing will include sufficient credit support through
guarantees or undertakings of a sponsor or third party, so that lenders will be satisfied with
the credit risk, while at the same time minimising the recourse to the sponsor.
In practice, few projects are financed independently on their own merits without some
form of credit support from sponsors. There is a popular misconception that project financing
means off-balance sheet financing to the point that the project is completely self-supporting
without guarantees or undertakings by financially responsible parties. This leads to misun-
derstandings by prospective sponsors who are under the impression that certain kinds of
projects may be routinely financed as stand-alone self-supporting project financings. Such
sponsors negotiate on the assumption that similar projects in which they have interests can
also be financed without recourse to the sponsor, be off-balance sheet to the sponsor and
be without any additional credit support from a financially responsible third party. Each
project is different. Sadly, 100% loans to support a project (non-recourse to sponsors) that
looks as though it would surely be successful on the basis of optimistic financial projections
are becoming very rare.
From its modern origins in the oil and gas industry and sophisticated leasing techniques
(where this book had its own origins), project finance has evolved into a number of different
approaches and techniques that are widely used in sophisticated economies and in emerging
economies by large companies and small, by governments and by tiny growing firms. This
book discusses the methods, structures and instruments that can be used to accomplish a
successful project financing by addressing the three key elements of risk, cash flow and
collateral/support structures.
1 Checklist for a successful project financing

An independent economic unit that qualifies as a viable credit for project financing must
usually meet the criteria, and have the characteristics, contained in the checklist shown in
Exhibit 1.1. However, not all of the items listed are applicable to all project financings. Also,
some of the criteria may be satisfied if the project has a guarantor willing to assume the
financial exposure and the costs associated with some of the noted risks. On the other hand,
if a project financing fails to satisfy any of the applicable criteria, both lenders and sponsors
will be apprehensive and should address the problem to resolve the risk exposure before
proceeding. (Each item contained in the checklist is discussed in more detail in Chapter 2.)

Exhibit 1.1
Checklist for a successful project financing
Risk Yes document No N/A

reference that Reason why?
addresses it?
1 A credit risk rather than an equity risk isinvolved.
2 A satisfactory feasibility study and financial plan have beenprepared.
3 The cost of supplies of product or raw material to be used by the
project isassured.
4 A supply of energy at reasonable cost has beenassured.
5 A market exists for the product, commodity, or service to beproduced.
6 Transportation is available at a reasonable cost to move the product
to themarket.
7 Adequate communications areavailable.
8 Building materials are available at the costscontemplated.
9 The contractor is experienced andreliable.
10 The operator is experienced andreliable.
11 The projects management personnel are experienced andreliable.
12 New technology is notinvolved.
13 The contractual agreement among joint venture partners, if any,
issatisfactory.
14 A stable and friendly political environment exists; licences and permits
are available; contracts can be enforced; legal remediesexist.
15 There is no risk ofexpropriation.
16 Country risk issatisfactory.
17 Sovereign risk issatisfactory.
18 Currency and foreign exchange risks have beenaddressed.
19 The key promoters have made an adequate equitycontribution.
20 The project has adequate value ascollateral.
21 Satisfactory appraisals of resources and assets have beenobtained.
22 Adequate insurance coverage iscontemplated.
23 Force majeure risk has beenaddressed.
24 Cost over-run risk has beenaddressed.
25 Delay risk has beenconsidered.
26 The project will have an adequate ROE, ROI and ROA for theinvestor.
27 Inflation rate projections arerealistic.
28 Interest rate projections arerealistic.
29 Environmental risks aremanageable.
Continued

Project Financing
Exhibit 1.1 continued

Risk Yes document No N/A
reference that Reason why?
addresses it?
30 Compliance with legislation such as US Foreign Corrupt Practice Act of
1977 (FCPA) and similarlegislation.
31 Protection systems are in place against criminal activities such as
kidnapping andextortion.
32 A commercial legal system is in place to protect property and
contractualrights.
Source: Frank J Fabozzi and Peter K Nevitt
2 Causes of project failures

The best way to appreciate the concerns of lenders about a project is to review and consider
some of the common causes for project failures, which include the following:
delay in completion of construction, with consequential increase in the interest expense

on the construction financing component and delay in the contemplated revenue flow;
capital cost overrun;
technical failure;
financial failure of the contractor;
government interference;
uninsured casualty losses;
increased price or shortages of raw materials;
technical obsolescence of the plant;
loss of competitive position in the marketplace;
expropriation;
poor management;
overly optimistic appraisals of the value of the collateral, such as oil and gas reserves; and
financial difficulties within the host or sponsor country government(s).
For a project financing to be successfully achieved, these risks must be properly considered,
monitored and avoided throughout the life of the project.
The Eurotunnel project and its financing presents an interesting case study that illustrates the
failure to address risks involved in project financing and a short discussion of the Eurotunnel
project appears at the end of this chapter. In the case studies at the end of the book, we
also include discussions of a number of other examples of project financing transactions.
3 Credit impact objective

Sponsors or beneficiaries of projects with more complex financing packages have been influ-
enced by a number of credit concerns including the following:

a wish to manage the effects of restrictive covenants in an indenture or loan agreement

which may preclude direct debt financing or leases for the project;
the need to avoid the impact on stakeholders of an open-ended first mortgage;
the requirement to treat any new financing for a project obtained by sponsors as a cash
obligation that would dilute interest coverage ratios, and affect the sponsors credit standing
with the rating services; and
the desire to restrict direct liability of sponsors or third party guarantors to a certain
period of time such as during construction and/or the start-up period, thereby avoiding
a liability for the projects remaining life.
These concerns expanded the use of project financing techniques from specialist domains, such
as oil and gas, into new areas, such as the creation of special purpose vehicles to hold sub-
prime mortgages, shares in which were sold in the secondary market. However, following the
failure of companies such as Enron, where liabilities were not transparent to stakeholders and
the recent global financial crisis wherein a number of financial institutions, such as Lehman
Brothers and many others, such as Citi and RBS, required rescue packages, regulators and
other stakeholders are re-emphasising simplicity and transparency and refocusing on cashflow.
The credit impact arises because whilst the project cash flow is the primary source of
repayment, sponsors may also be required to offer secondary support. If a sponsor cannot
initially arrange long-term non-recourse debt for its project which will not impact its balance
sheet, the project may still be feasible if the sponsor is willing to assume the credit risk
during the construction and start-up phase, provided lenders are willing to re-examine the
credit risk of the project after the project facility is completed and operating. Under such
an arrangement, most of the objectives of an off-balance sheet project financing and limited
credit impact can be achieved after the initial risk period of construction and start-up. In
some instances, the lenders may be satisfied to rely on revenue produced by unconditional
take-or-pay contracts from users of the product or services to be provided by the project to
repay debt. In other instances, the condition of the market for the product or service may
be such that sufficient revenues are assured after completion of construction and start-up so
that lenders may rely on such revenues for repayment of their debts.
4 Accounting considerations
Although historically the terms project financing and off-balance sheet financing may have
been used interchangeably, while the projects debt may not be on the sponsors balance sheet
(but be footnoted), the projects debt will appear on the face of the projects balance sheet.
In any event, the purpose of a project financing is to segregate the credit risk of the project
so that the credit risk of lending to either the sponsor or the project can be clearly and fairly
appraised on their respective merits. The purpose is not to hide or conceal a liability of the
sponsor from creditors, credit rating services, regulators or stockholders.
The governing financial reporting requirements are typically subject to IASB and FASB
rules under which sponsor entities and investors must report. Typically, significant under
takings of sponsor entities and investors must be shown in footnotes to their financial state-
ments if not in the statements themselves.

Project Financing
Since project financings are concerned with cash flows and balance sheet accounting
treatments, familiarity with accounting terms used to describe balance sheet reporting is
important. Terms such as contingent liability, indirect liability, deferred liability, deferred
expense, fixed charges, equity accounting and materiality are used to explain the appropriate
positioning of entries in a sponsors financial statements and footnotes. Two critical issues
that arise in the project finance context are relatedness and consolidation. The tests for
whether entities are related (and thus transactions between them may need to be disclosed)
may vary locally, but the worldwide move towards accounting standards convergence has
produced International Accounting Standard IAS 24, 27 and 28.
Consolidation and joint venture reporting are the subjects of a joint project between
the IAS and the US Financial Accounting Standards Board. This joint project led to three
new reporting standards that are expected to become effective January 2013. IFRS 10 is
completed and deals with consolidation, IFRS 11 with joint arrangements and IFRS 12
with disclosure relating to joint arrangements.1
These areas of relatedness and consolidation and disclosure are complex, interlinked with
many others within a project financing. Although the details are outside the scope of this
book, they should be addressed by advisers in order to ensure project revenue optimisation
and reporting compliance.
In general, accounting rules for reporting a project finances liabilities are under continual
review, as the accounting profession grapples with the problem of proper and fair disclosure
and presentation of objective information to stockholders, lenders, rating agencies, guaran-
tors, government agencies and other concerned parties.
5 Meeting internal project appraisal objectives

Most companies use one of three discounted cash flow methods net present value (NPV),
internal rate of return (IRR) or modified internal rate of return (MIRR) (discussed further
in Chapter 20 on financial modelling) to appraise the potential economic merits of proj-
ects. Therefore, project finance providers need to understand the nuances associated with
each of these methods, especially with regard to reinvestment and staged investments, and
how target rates of return are set by sponsors for new capital investments. If a proposed
capital expenditure will not generate a return greater than a companys target rate (often
its weighted average cost of capital (WACC) or risk adjusted WACC), it is not regarded as
a satisfactory use of capital resources. This is particularly true when a company can make
alternative capital expenditures which will produce a return on capital in excess of the
target rate. If the NPV is highly sensitive to changes in key input prices, this may also be
a marginal project.
Project financing has been used to improve the return on the capital invested in a
project by leveraging the investment to a greater extent than would be possible in a straight
commercial financing of the project, by using other interested stakeholders to support the
debt through direct or indirect guarantees. An example would be an oil company with a
promising coal property which it did not wish to develop because of better alternative uses
of its capital. By bringing in a company which required the coal, such as a public utility,
an indirect guarantee might be available in the form of a long-term take-or-pay contract

which would support long-term debt to finance the construction of the coal mine. This, in
turn, would permit the oil companys investment to be highly leveraged and consequently
to produce a much higher rate of return for its stockholders.
6 Other benefits
There are often other benefits resulting from segregating a financing as a project financing,
which may have a bearing on the motives of the company seeking such a structure:
dedicated credit sources may be available to the project that would not be available to
the sponsor;
guarantees may be available to the project that would not be available to the sponsor;
a project financing may enjoy better credit terms and interest costs in situations in which
a sponsors credit is weak;
higher leverage of debt to equity may be achieved;
legal requirements applicable to certain investing institutions may be met by the project
but not by the sponsor;
regulatory problems affecting the sponsor may be avoided;
for regulatory purposes, costs may be clearly segregated as a result of a project financing;
the project may enable a public utility sponsor to achieve certain objectives regarding its
rate base;
investment protection in foreign projects may be improved by joint venturing with
international parties, thus lessening the sovereign risk;
a more favourable labour contract or climate may be possible by separating the operation
from other activities of the sponsor; and/or
construction financing costs may not be reflected in the sponsors financial statements until
such time as the project begins producing revenue.
In some instances, any one of the reasons stated above may be the primary motivation for
structuring a new operation as a project financing.
7 Tax considerations
Specific tax benefits from any applicable tax credits, depreciation deductions, interest deduc-
tions, depletion deductions, research and development tax deductions, dividends-received
credits, foreign tax credits, capital gains and non-capital start-up expenses may be very signifi-
cant considerations in the investment, debt service and cash flow of most project financings.
Care must be used in structuring a project financing to make sure that these tax benefits are
both usable and used, if available. Projects have run into problems when the key driver is
tax-loss absorption or transfer and assumptions about the absorptive capacity of the project
to fully utilise the tax losses have been proved incorrect, so if a project financing is housed
in a new entity which does not have tax shelter benefits, it is important to structure the
project financing so that any tax benefits can be transferred in so that the new entity is in
a position currently to use such benefits.

Project Financing
8 Disincentives to project financing

Project financings are complex. The documentation tends to be complicated and thus add
to fees payable, and the cost of borrowing funds is higher than conventional financing. If
the undertakings of a number of parties are necessary to structure the project financing,
or if a joint venture is involved, the negotiation of the original financing agreements and
operating agreements will require patience, forbearing and an understanding of partnerships.
Decision-making in partnerships and joint ventures is never easy, since the friendliest of
partners may have diverse interests, problems and objectives. Problems can arise when the
project champions move on to new projects and working agreements are not documented,
so good project management practice must apply. However, the rewards and advantages
of a project financing will often justify the special problems which may arise in structuring
and operating the project.
9 Principles apply regardless of project size or context

Discussions of project financing sometimes tend to focus on large complex projects. This
might lead one to the conclusion that the project financing principles discussed in this book
have little application to smaller, more ordinary financings. This is not the case. The same
principles used to finance a major pipeline, copper mine, or Channel Tunnel can be used to
finance a cannery, a hotel, a ship or a processing plant.
Start-up companies in new and emerging business areas that are financed with risk
capital in the form of equity present a different emphasis on the traditional rules for project
financing that should be noted. One example is the rapid development of the internet and
electronic data transfer systems that have given rise to e-commerce business opportunities
that can result in a few cases of very large growth potential and future profits. Since the
risk for investors is very high, these are usually equity financed since the risk profile of the
project cash flows would not qualify these projects for debt finance.
Novel B2B (business to business) and B2C (business to consumer) commercial activities
have the potential to replace traditional distribution and sales channels. Venture capitalists
(VCs) and venture capital funds sometimes provide equity related securities to these proposed
projects that are often based merely upon the reputation of the sponsors and conjecture and
optimistic financial projections. Another type of venture capital support called an incubator
may provide small amounts of initial seed equity capital, advice and a community environ-
ment to support what are perceived promising start-ups in their early stages.
The time horizon of sponsors of many venture capitalists may be limited to the time
it takes to go to the public markets or to find a buyer, so key exit decision dates must be
clearly specified from the initial negotiations.
10 Building blocks of project financing

Before reviewing various specific project financings, it is necessary to discuss the building
blocks of project financing. First of all the project needs to generate a strong cash flow.
Then there needs to be an adequate equity cushion underpinning any project debt. Debt

instruments include notes, debentures, bonds, subordinated notes, term debt secured by a
particular asset, non-recourse debt, limited-recourse debt, warrants, options, tax-exempt
industrial revenue bonds, capital leases, operating leases, service leases, bank loans, short-
term notes and commercial paper. This debt may be unsecured or secured by a particular
asset, full recourse, limited recourse or non-recourse and may or may not have additional
featured such as warrants or options. This debt, in turn, may be restructured or combined
with derivatives, such as interest rate swaps and options, and currency swaps and options.
The debt is supported by the financial viability of the project, as well as the equity commit-
ment and any direct guarantees, contingent guarantees, indirect guarantees and implied
guarantees. Projects may be structured using subsidiaries, unrestricted subsidiaries, special
purpose corporations, nominee corporations, jointly owned corporations, general partnerships,
limited partnerships, joint ventures and trusts. These borrowings, guarantees and entities can
be combined in a variety of ways to produce a viable project financing package that services
its debt and equity.
When considering a project financing package, sponsors and advisers would normally
also review financial structuring methods used in other industries to generate ideas for new
structures transferable between industries or from one country to another country, recognising
differences in laws and tax consequences.
11 Reconsidering decision-making
Economists, psychologists and other social scientists have revisited the ways we look at decision-
making and this particularly applies to areas of project finance. Whilst in the past, the model
of rational decision-making underpinned the creation of large revenue generating projects and
their associated financing decisions and structures, even though Herbert Simon proposed the
concept of bounded rationality in a series of research papers starting in the late 1940s. Today,
we admit the importance of behavioural drivers and the increasing importance of behavioural
finance approaches. Thus we can sometimes see, with hindsight, that certain projects were
doomed to problematic existence because the underlying decisions were not rational, but were
overlaid by drivers resulting from the personal behavioural needs of the decisionmakers.
A theoretical example of this might be a vanity project conceived by a chief executive
wanting to leave a legacy or create a lasting monument. Another example might be complex
structures inserted into project financing by bankers who might be considering their own
personal remuneration and performance targets, rather than the overall financial logic of
the transaction.
As we look at the governance of organisations and the turnover of staff in key roles, we
can observe the mismatch between long-term project timescales and short-term involvement by
individual stakeholders. Consequently, as we look forward to the next decades of successful
projects that will reshape the world we live in, we should recall that decisions are made by
individuals who have decision-making frames influenced by the project and their personal
goals and as we assess and approve such long-term projects as a financial community, we
should always interrogate and audit those decisions to ensure that we are contributing to a
positive future, and not one with sovereign debt crises, increased taxes and so on, to pay
for poor decision-making.

Project Financing
Project finance and specifically the private finance initiative (PFI) implemented through
public-private partnerships (PPPs) (discussed in Chapter 30) has received bad press in
traditional heartland areas such as the UK when PFI projects to build new hospitals or
refurbish government buildings have resulted in hospital wards being closed and the mili-
tary charged 22.00 for 0.65 light bulbs under the operating and maintenance contracts.2
This detracts from the important contribution that the project finance community makes
to continue sustainable economic prosperity. In todays world of the instant sound bite,
decisions are more open to debate and public scrutiny. Corporate social responsibility
applies to financiers, meaning that all stakeholders in the project finance community need
to be ever more mindful of the basis for and the short and longer term consequences of
decisions made.
Case study: Eurotunnel3 a disaster for lenders

The 31-mile link under the English Channel between the UK and France is one of the most
expensive projects in the world. (See Exhibit 1.2.) It was the third attempt at a Chunnel
and came after the second had been cancelled by an incoming British government afraid of
a huge increase in the capital budget for the project a similar long-tunnel project in Japan
had just been completed with a cost overrun of 100%.4 Financed by a consortium of 225
banks it is a project in which the construction phase, overall cost and start-up revenues were
all underestimated. The proposed project financing failed the checklist (see Exhibit 1.1) on
a dozen grounds, any one of which should have caused rejection. In May 1987, construc-
tion was expected to be completed by May 1993. In 1990, construction was estimated to
be completed by May 1994. Actual completion occurred in December 1994. In the 1987
budget, total cost to build and open the tunnel was estimated to be 4.9 billion. In 1990
the estimate was raised to 7.5 billion. Actual cost was 9.7 billion.
Crucial to Eurotunnel is the fact that the project company was created by construc-
tion contractors to issue a construction contract5 to those contractors. Further, the project
financing became almost a matter of national pride (and pressure) even though the construc-
tion budget was not finalised and the rail equipment not finally specified at the time the
project was syndicated.
Bankers egos and old school ties apparently got in the way of responsibilities to bank
stockholders. Head bankers apparently approved the credit with its obvious many short
comings rather than experienced project finance loan officers.
The equipment specification aspect was revisited during the construction period, with a
cost increase to the project of 1 billion for fire safety on the rail shuttle cars. Yet, on 18
November 1996, the 21.42 train from Coquelles in France caught fire and the overall fire
systems failed (compounded by human error), shutting down the system for six months.
The traffic, already building slowly, was naturally put off by this disaster. In addition,
successive British governments failed to upgrade the rail connection from London to Folkestone
at the entry to the English side of the tunnel, whereas the French established their TGV
express trains from the Coquelles portal to Paris. The ferry companies thus competed with
Eurotunnel on many fronts, including price and convenience. The fast connection, known
as HS1, is now in place from London, having opened in 2003.
10

Exhibit 1.2
Eurotunnel
Eurotunnel
1 Partnership
agreement
Eurotunnel France
PLC Manche S.A.
79%
The Channel Eurotunnel

Tunnel Group Finance
Ltd
75% Eurotunnel 25% Construction

Services companies
Bouygues
LDED
Spie Batignolles
Eurotunnel SAE
trustees SGE
Construction
companies
Balfour Beatty
Taylor Woodrow
Costain
Tarmac Consortium Transmanche
Translink
Wimpey agreement Construction
2 Construction Transmanche
contracts link

Project Financing
A 2004 shareholder revolt changed the entire Board of Directors and in 2006 the company
formally moved to Paris and registered as a French company. Following these management
changes, in 2007, the new team addressed a radical restructuring of all of the Eurotunnel
entities including the massive debt that had almost brought the company to bankruptcy, as
it approached default and sought legal protection. Shareholders watched helplessly as more
of the bondholders debt was converted into equity, further diluting their interests with
bankruptcy offered as the alternative. The board was given three years to implement a plan
to reduce debt from 6.2 billion to 2.84 billion and some new debt injected to allow for
some further liquidity.
In 2009, the company paid its first small dividend and repeated this in 2010 with a
small increase in 2011.6
In 2012, the company tested the movement of air freight containers between a network
of European airports and the London terminal of Eurotunnel at St Pancras7 as another future
revenue source, adding to the truck freight service launched in 2005.
The very serious risk aspects of completion, traffic, infrastructure, force majeure and
operating aspects were either ignored or seriously misjudged in the various scenarios and
refinancings in evidence in this mega transaction, with its concomitant mega write-down.
This was a political project financed by the general public as shareholders and a large group
of banks including many who did not fully understand the risks involved and believed there
was an implicit government guarantee. (Read more about guarantees in Chapter 23.)
1
See the current state of progress on the IFRS website: www.ifrs.org/Current+Projects/IASB+Projects/Consolidation/
Consol+disclosure/Consol+dis.htm.
2
Andrew Hough, Ministry of Defence pays 22 for 65p light bulbs, Daily Telegraph, 4 March 2011: www.
telegraph.co.uk/news/uknews/defence/8360835/Ministry-of-Defence-pays-22-for-65p-light-bulbs.html.
3
Partnership of The Channel Tunnel Group Ltd. and France Manche SA formed to proceed with the tunnel on
behalf of five UK and five French contractors.
4
See Tinsley, CR, Advanced Project Financing: structuring risks, 1st edition, 2000, Euromoney Books.
5
Construction contracts established for the Target Works, Lump-Sum Works, and Procurement (Equipment).
6
Eurotunnel reference document 2010: www.eurotunnelgroup.com/uploadedFiles/assets-uk/Shareholders-Investors/
Regulated-Information/Access-To-Information/Annual-Financial-Reports/2010ReferenceDocumentUKGroupeEurot
unnelSA.pdf. 2011 Annual registration document (French version): www.eurotunnelgroup.com/uploadedFiles/assets-
fr/Actionnaires-Investisseurs/Publications/Doc-Reference/120301DocumentReference2011GroupeEurotunnelSA.pdf.
7
First major step for Eurocarex, Eurotunnel website press release: www.eurotunnelgroup.com/uploadedFiles/assets-
uk/Media/Press-Releases/2012-Press-Releases/120321First-major-step-for-Euro-Carex.pdf.
12

Chapter 2
Criteria for a successful project financing
In this chapter we begin by looking at the different risk phases of a project and the consid-
erations for providers of finance at each phase. Then we examine the key risk areas identified
in the checklist for a successful project financing in Exhibit 1.1 in the previous chapter.
If we think of a project as a stream of cash flows coming from a group of ring-fenced
assets owned by a group of sponsors who have divided and agreed to share all of the
projects risks, we can see the risk assessment is a key part of any decision to embark on
a project. We begin by looking at risks for common project phases and the implications of
those risks for providers of finance.
1 Risk phases
Project financing risks can be divided into three major groupings reflecting key time frames
for a project in which the elements of credit exposure assume different characteristics (see
Exhibit 2.1):
engineering and construction phase;

start-up, which may be classed as a pre-completion phase; and
operations according to planned specifications, which may generate project completion.
Different guarantees and undertakings of different partners may be used in each time frame
to provide the credit support necessary for structuring a project financing. The term project
completion is used to designate a certificated point at which the project is considered strong
enough to stand on its own feet, and guarantees and support mechanisms fall away so as to
leave the lenders and equity holders reliant solely on the project cash flows to generate loan
repayments and investor returns. In order to have a viable project, therefore, the sponsors need
to complete a thorough feasibility study. Organisations are often reluctant to invest a significant
amount of capital in feasibility studies because if the project is not eventually undertaken, then
the cost of the study must be written off. It is a balancing act on the one hand, a feasibility
study needs to be well researched and accurate to provide information to aid in decision-
making, but, on the other hand, organisational stakeholders and specifically shareholders can
object to an investment in what can be a significant write-off. A good feasibility study will
include a commentary on different risks to support a sound case for the investmentdecision.
Engineering and/or construction phase

Projects generally begin with a long period of planning and engineering. Equipment is ordered,
construction contracts are negotiated and actual construction begins. During this phase, it
13

Project Financing
is also important to remember that projects will require working capital, most likely in
the currency of the country in which the project is located. After construction begins, the
amount of financing at risk begins to increase sharply as funds are advanced to purchase
material, labour and equipment. Interest charges on loans to finance construction also begin
to accumulate, but at this point there is no certainty that the project will be completed and
thereby generate any cash flow. In the engineering/construction phase, lenders will be looking
for support from sponsors or other third parties to increase the likelihood that any funds
loaned are repaid.
Start-up phase
Project lenders do not regard a project as completed when construction has been completed.
They are concerned with whether or not the plant or facility will operate in line with the
costs and to the specifications which were planned when the financing was arranged. Similarly,
when project finance is applied to services, lenders need to be sure that the services can be
delivered in line with the specifications detailed in the original financing. A project that fails
to produce the product or service in the amounts and at the costs originally planned, or to
sell at the prices that were projected, may prove the feasibility study and the cash flows on
which it is based to be unsound and raise the prospect that there may be insufficient cash
to pay expenses, service debt and provide the projected return to equity.
Project lenders regard a project as acceptable only after the plant or facility has been
in operation for a sufficient period of time to ensure that the plant will in fact produce the
product or service at the price, in the amounts and to the standards assumed in the financial
plan that formed the basis for the financing. This start-up risk period may run from a few
months to several years.
Operations according to specification

Once the parties are satisfied that the plant is running to specification, the steady-state oper-
ating phase begins. Revenues from the sale of the product produced or service performed
should be sufficient to service debt, interest and principal, pay operating costs and provide a
return to sponsors and investors. Once the appropriate experts are satisfied that the project
is generating stable cash flows in line with projections, it is said to have met its comple-
tion test and a completion certificate is issued; at that point the project may move into the
non-recourse phase where guarantees from sponsors fall away and the servicing of debt and
payment to equity investors arises exclusively from the projects cash flows. Not all projects
switch to a non-recourse mode. Some sponsors may be prepared to pay a premium at the
beginning of a project for the possibility of subsequent non-recourse financing. However, as
the project progresses, they may choose to continue to guarantee debt service payments so
that even though the project could potentially meet a completion test, and shift to a limited
or non-recourse basis, that test is never requested. Why might this be? In order to shift to
a non-recourse financing basis, lenders need to receive a lot of sensitive information about
the specific project, and in a highly competitive industry context, sponsors may be reluctant
to release that information to third parties even under confidentiality agreements.
14

Exhibit 2.1
Risk phases in a project financing (cost in US$ million)
140
Engineering and
Start-up phase Operations phase
construction phase
120
Deb
t se
100 rvic
e
80
60
40
20
0
1 2 3 4 5 6 0 1 2 3 4 5 6 7 8 19 20
Engineering and
Start-up phase Operations phase
construction phase
2 Different lenders for different risk periods

Some projects are financed from beginning to end with a single lender or single group of
lenders, but in some cases different lenders or groups of lenders may provide funds during
different risk phases. An example of this might be specialist export support schemes that
will be limited in the time period for which they are available.
Some lenders like to lend for longer terms and some prefer short-term lending. Some
lenders specialise in construction lending and are equipped to monitor engineering and
construction of a project, some are not. Some lenders will accept and rely on guarantees of
different sponsors during the construction, start-up or operation phases, and some will not.
Some lenders will accept the credit risk of a turn-key operating project, but are not inter-
ested in the high-risk lending during construction and start-up. Lenders also have various
geographic, industry and other limits in their portfolios so their ability to engage in different
projects will depend on an institutional asset allocation strategy.
Interest rates will also vary during the different risk phases of project financing and with
the different credit support from sponsors during those time periods.
15

Project Financing
Short-term construction lenders are very concerned about the availability of long-term
take out financing by other lenders upon completion of the construction or start-up phase
and will insist that the take-out lenders be present from the outset of the construction
financing, with both groups paying particular attention to the events that will trigger the
movement between the two financing phases.
3 Review of criteria for a successful project financing

Exhibit 1.1 in the previous chapter shows a checklist for planning and structuring a successful
project financing. A discussion of each of the topics on that checklist follows.
Credit risk rather than equity risk is involved

A credit risk should be involved in lending to the project rather than an equity risk or a
venture capital risk. Lenders are not in the business of taking equity risk even if compensated
as equity risk takers as discussed below.
Exhibit 2.2
Cash flow from production
Changes in Taxes
liabilities Interest
Changes in Dividends
equity
Cash
Collection of
receivables
Accounts Cash sales

receivable
Credit sales
Production Inventory
costs
Depreciation
Investment Fixed assets
16

Following the banking crises in the first decade of the new century, central bank regulators
and specifically the Basel committee on banking supervision amended the capital requirements for
banks by increasing the amount of capital required to underpin different classes of bank assets.
In the case of project loans, a bank takes a higher level of risk in return for a higher reward.
The Basel lll Capital Accord Standards continue an upward trend in terms of bank capital that
regulators require to underpin more risky bank assets. The need to tie up bank capital in this
way is likely to restrict the amount of lending available for leveraged project financing deals in
the future. The question of whether a credit risk or an equity risk is involved usually arises in
connection with the adequacy of the underlying equity investment in the project, and the risks
assumed by the sponsors and interested parties. For example, for a $200 million project, 10%
equity would be $20 million, which may represent a sizeable equity investment by the sponsor.
It is natural for sponsors to want to leverage their equity investment with as much debt financing
as much as they can, but the higher the leverage is, the higher the risk is for the sponsors and
the lenders and bondholders. Commercial lenders advance funds only to the extent that they are
comfortable that projected cash flows will be adequate to meet debt service requirements with
a margin for risk. They expect to see a significant equity contribution as a cushion underneath
the debt and also as a tangible example of commitment by thesponsors.
Lenders may sometimes be compensated for riskier projects with higher interest rates but
there are limits. They are not expected to assume risks that go beyond conventional lending
risks. Some specialist lenders provide high risk loans for start-up situations, but would expect
to be compensated by a share of the ownership and/or profits, as well as interest on their
loan. This blend of debt and equity has been used in the oil industry, and examples can be
seen in the early development of the North Sea. Linked to this approach, project financings
and start-up companies often use a layer of debt superior to equity in case of bankruptcy, but
junior (subordinated) to senior debt. This subordinated debt has a high interest rate and may
have an equity feature such as warrants for common stock or conversion rights for common
stock. This type of debt is sometimes referred to as mezzanine financing. When that financing
takes the form of public or privately placed bonds rather than the bank debt, the bonds are
typically rated below investment grade and are referred to as junk bonds. (See Chapter 10
for a further discussion of types of debt.)
The equity in a project financing comes mostly from the sponsors but may also come
from other sources directly interested in the project such as end users, suppliers, operators,
contractors, or government or other agencies.
Feasibility study and financial projections

Assumptions used in the feasibility study must be realistic. Detailed cash flow projections
should be prepared, and matrices of results should be produced, using different revenue
and cost assumptions including the sensitivity of the project to changes in one or more key
input variables. Worst-case scenarios must be considered, and contingency plans prepared
(see Exhibits 2.3, 2.4 and 2.5). This is discussed further in Chapter 20.
The feasibility study should cover all applicable points suggested in this chapter and will
reflect the professional ability of the project sponsors, the degree of commitment, and the
financial and other resources they assign to the project.
17

Project Financing
Exhibit 2.3
Comparison of expected cash flow, best case and worst case (constant dollars)
25
Best case cash flow
20
Expected cash flow
15 Expected life
US$ million
Worst case cash flow

of project
10
5 Debt service
0
0 5 10 15 20
Years
Key conclusions drawn from the feasibility study should be independently verified and
confirmed by well recognised external consultants. Lenders may commission their own external
consultants as well to review the entire project and provide independent opinions, with the
costs borne by the project sponsors.
The feasibility study, financial projections and any supporting consultants studies must
confirm that the product, commodity or service that represents the projects cash flow gener-
ating capability can be produced at the costs contemplated, and sold at the prices and profit
margins contemplated.
Conservative projections of the projects assured internally generated cash flows must
be prepared and justified by appropriate independent feasibility and engineering studies. The
cash flow projections must be sufficient to service any debt contemplated, provide for cash
needs, pay operating expenses, and still provide an adequate cushion for contingencies as
well as offer the prospect of future returns for equity holders to continue their support for
the project. (See Exhibits 2.2, 2.3, 2.4 and 2.5.)
Lenders carefully review the projections to determine debt-service coverage over the loan
life, so those projections need to be realistic since the various loan covenants and oper-
ating ratios required by the loan agreement will be established to conform to the financial
18

Exhibit 2.4
Another example of a worst case cash flow (constant dollars)
25
20
15 Expected life
US$ million
Worst case cash flow 2

of project
10
5 Debt service
0
0 5 10 15 20 25 30
Years
projections. Earnings before interest, taxes, depreciation and amortisation (EBITDA) is often
used as a measure of cash flow available to service debt.
Assuring the cost of supplies and raw materials

For input-transformation-output types of projects, supply sources and contracts for feed
stocks or raw material must be assured so that costs incurred are consistent with the finan-
cial projections. Sources and availability of those project inputs must be reviewed, possibly
through market analysis that would indicate future supplies and probable future costs.
If a projects operation is dependent on imported raw materials, products or energy
sources, those resources need to be available freely and without the payment of excessive
fees or duties. Transportation costs for the product must also be considered and the suit-
ability of means of transport and facilities such as harbours, warehouses, docks, rail lines,
roads, pipelines and airfields should be assessed, especially in countries that are undergoing
significant internal redevelopment.
Where a transportation company controls the only feasible method of transporting raw
material to a project, the possibility of large future increases in transportation charges should
be considered. Long-term transportation contracts (with escalation) should be explored.
19

Project Financing
Exhibit 2.5
Revenues, operating expenses, taxes and debt service adjusted for inflation
and escalation
30
25
Expected revenues
20 Taxes
US$ million
15 Expected life
Projected operating expense
in excess of debt service of project
10
Debt service interest only

5 for three years, and level principal
and interest amortisation over 12 years
0
0 5 10 15 20
Years
Long-term take-or-pay contracts are sometimes used to ensure a user has a source of
supply. A similar contract structure can be used by projects that depend on an assured source
of supply, called a supply-or-pay, or put-or-pay, contract. In such a contract, the supplier is
obligated to provide the product or service at certain prices (with escalation features) over a
period of time. Where the supply of a product to a project is vital to the success of a project,
such a contract will enhance the project and conversely the absence of such a contract may
raise serious concerns as to the projects viability. If the supplier cannot furnish the product,
under such a contract it must provide the product from another source, or reimburse any
excess costs that the purchaser incurs in procuring the product from another supplier.
It follows that any long-term supply contract must also be enforceable. So part of the
risk assessment should include the reliability of the supplier, its ability to perform, and the
risk and its impact on the project if a supply contract with a foreign supplier may be subject
to a force majeure interruption or an economic boycott beyond its control.
The practical value of a long-term contract with a supplier, at an attractive price and
where the supplier is a sole source, must also be considered. Will the supplier use the threat-
ened prospect of very high prices on future renewals to force renegotiation of the supply
contract before its term expires?
20

Energy supplies assured at a reasonable cost

Long-term supply contracts for feed stocks, coal or energy (with appropriate escalation provi-
sions) are necessary for the financial feasibility of many projects. Energy costs are especially
important because of their tendency to rise and fluctuate over time. In the past, a number of
project financings and their lenders have run into serious financial trouble because of their
failure to anticipate cost increases in energy inputs such as electricity, natural gas, oil, coal
and water. Where there are inadequate electrical energy supplies, the project may have to
build its own generating plant, or provide back-up facilities especially in a power project
where there may be long-term supply contracts to customers that support the projects cash
flow and the possibility of the main plant going off-line for periods. Many countries have
frequent power supply problems that need to be considered in the plant design process.
A market exists for the product, commodity or service

The financial success of a project usually depends on the continued existence of a market
for the product, commodity or service produced or furnished at prices that will provide the
anticipated cash flows necessary to service debt, cover operating expenses and provide a
return to the equity investors. Expert market surveys should provide a basis for the antici-
pated volume and price of the product, commodity or service to be produced and internal
marketing surveys prepared by the sponsor should always be triangulated against external
independent marketing studies. Competition from substitute products, suppliers closer to the
markets, and less expensive sources of raw materials, feed stocks or energy should form part
of any industry or market analysis.
Some projects are financed on the basis of long-term contracts to sell the product,
commodity or service produced by a project to one or more users at certain time intervals,
and at agreed prices with appropriate escalation. The predictable cash flow from such contracts
increases the prospect that the project will be profitable, provided production costs are as
anticipated, and the purchaser is financially strong and reliable. It also avoids future reliance
on purchasing a key input from what may be a volatile spot market.
These contracts assume two main forms, take-or-pay or take-and-pay.
Take-or-pay contracts
In a take-or-pay contract, the obligation of the purchaser to pay is unconditional, even if the
product, commodity, or service is not delivered. Where the project is to provide a service,
such as transmission of a product through a pipeline, a long-term through-put agreement a
type of take-or-pay contract may be used to ensure a stream of revenue to service debt.
Through-put agreements take many forms, but when used as a guaranteed source of the revenue
(with appropriate escalation), the purchaser of the product or service is obligated to make a
payment, regardless of whether the service is used or not, provided delivery takes place. As
such, stakeholders would expect to see these arrangements reported as contingent liabilities.
Conventionally, there are two component parts to such contracts: one that covers fixed
costs including debt service and possibly a minimum equity return and is always paid; and
21

Project Financing
a second component that represents the variable operating costs and any additional equity
return and is paid if the product is required and delivered. A contract will often include
so-called hell or high water provisions whereby the obligation to pay exists even if the
project fails to generate any goods or services.
Variations of these agreements may be called tolling agreements, minimum pay contracts,
all-events-tariffs, ship-or-pay contracts or may take the form of a deficiency agreement.
Through-put agreements are also used where a raw material is to be furnished to a project
for some value-added services, such as a refinery (see Chapter 23 and the case studies at the
end of the book). A cost-of-service tariff goes a step further and provides protection against
escalating costs as well as risks to the continued existence of a market. Properly drafted,
take-or-pay contracts may be equivalent to guarantees of a stream of revenue but need to
consider the long-term nature of the transaction. A 65-year fixed price power purchase
contract to supply Hydro-Qubec (a 34% shareholder in the project) with electricity produced
from the Churchill Falls Labrador Corporation hydro-electric station was signed in 1969.
It fixed a price for electricity produced in Labrador, Newfoundland and sold to another
Canadian province, Quebec. However, since 1969, end-user electricity prices have risen with
the Newfoundland producer apparently contractually obliged to sell power at a historically
low price to Hydro-Qubec. Since the power distribution lines meant all power produced
had to transit through Quebec, it seemed that one Canadian province gained at the apparent
expense of another, a politically sensitive situation that has received much media coverage.
To illustrate the scale of the issue and its political sensitivity, reported figures suggested that
Hydro-Qubec reportedly received profits from the contract of approximately Canadian $19
billion up to 2009, while Newfoundland and Labrador received Canadian $1 billion over
the same period. There were two unsuccessful attempts to challenge the contract in court
but a recent proposed power sale to the US may ease some of the tension.1
Take-and-pay contracts
In a take-and-pay contract, the purchaser is obligated to take the product or service that it
is provided. An alternative and more descriptive name for this style of contract would be
take-if offered or take-if-tendered. Once more, the two component parts co-exist to cover
fixed and activity dependent costs. A clause may be included in the agreement so that the
purchaser can refuse to take delivery, provided it pays a capacity charge that covers the fixed
cost elements of the project company, including debt service obligations.
Other contractual arrangements designed to support the debt and equity service in a
project would include long term sales agreements, where pre-specified quantities and quality
indicators govern a sales contract where a purchaser is obliged to take goods or services
produced if they meet these specifications.
Transportation of product to market

Transportation arrangements for moving the product from the project facility to the market
must be assured at a cost consistent with the financial projections. The mode and avail-
ability of suitable transportation whether by rail or ship should be reviewed, together
22

with the possible need to construct any facilities needed such as roads, railroads, harbours,
docks, pipelines, warehouses or airfields. The vulnerability of the project to future increases
in transportation costs by companies controlling the only feasible means to move the product
to market should be taken into account. Long-term transportation contracts (with appropriate
escalation) may solve this problem.
Adequate communications
Reliable telephone and other communications systems are essential to all projects today.
The availability of support systems including satellite and internet links as well as telephony
cannot be taken for granted. Overseas telephone calls can still take hours to complete in some
parts of the world, resulting in costly delays in decision-making and thus in accomplishing
objectives. Consequently, adequate and well supported communication systems are key to
successful projects, and some cost provisions may be needed in the project budget to ensure
these are continually available.
Availability of building materials

Building materials to be used must be available at a cost consistent with the estimated
construction costs, including any transportation costs. The availability of local sources for
building materials should be checked as part of contingency planning for the possible use
of alternative materials. With a large project in a small country, the need for building mate-
rials and craftspeople to assist in the construction can cause ripple effects on the countrys
economic development as materials are pulled to the capital city away from other areas also
under development.
Projects have encountered difficulties because of inadequate planning for building mate-
rials; for example, reliance on the availability of local supplies of cement, that turn out to be
unavailable, with the result that cement has to be imported from long distances at substantially
higher cost. The delivery of just a few building, machinery or electronic components that do
not meet specifications can delay an entire project until the proper replacements are found.
When imported building materials, manufactured goods or machinery are needed for the
project, project managers need to secure import permits and customs clearances sometimes a
complicated and time consuming process and include import fees or duties at a reasonable
level in the budget. The effects of any existing or potential trade embargoes that may affect
imports of materials also need to be evaluated as these may delay the project or require a
project re-design if the original specification cannot be met. Re-designs or re-specifications
affect costs and also other features of projects, including financing arrangements.
Experienced and reliable contractor

The expertise and reputation of the contractor chosen to construct a project facility must
be well established. The contractor must have sound technical expertise to complete the
project, so that it will operate in accordance with cost and production specifications and
should have previously completed similar projects successfully. The contractor should have
23

Project Financing
the financial resources and experience to overcome problems in engineering, construction,

start-up or operation that might arise.
Contractors need local, on-the-ground experience, as well as familiarity with the climate,
culture, government infrastructure and geographic circumstances of a particular project.
Although many government contracts require acceptance of the lowest bid for a contract,
or a subcontract, this can be short-sighted unless the low bidder satisfies the criteria
outlined above.
Experienced and reliable operator

The operator of the project, once it is up and running, must have the financial and technical
expertise to operate the project in accordance with its cost and production specifications. The
operator may be an independent professional operating company that specialises in providing
such a service, one of the projects sponsors or co-sponsors, or another stakeholder involved with
the project. Experience and expertise in operating similar projects at other locations is essential.
Lenders prefer that one of the sponsors have not only a financial interest in the project but
also the technical expertise to operate the facility, and experience of operating similarfacilities.
Sometimes entrepreneurial companies see a chance to engage in new businesses that
provide good investment opportunities, and they may proceed on the assumption that they
will be able to assemble a good team to operate the new facility. However, these kinds of
arrangements are fraught with problems. A number of reputable individual operating people,
brought together to operate a project, will not necessarily work in harmony as a team. They
will not be used to dealing with each other; each may come from a different background,
and have a different way of doing things. It will take some time before such a group of
people can be organised into an effective operating team. This is not an appropriate risk
for lenders. Nor is diversification, as several oil companies discovered when they went into
the coal mining business, believing it to be similar to the oil industry.
In some foreign operations in which a foreign joint venture partner or government agency
assumes ownership and/or control of the facility over a period of time, questions may arise
over who will operate the facility and the competence of such an operator. Again, this is
not a risk for lenders but for equity holders. Protection may be afforded to lenders by a
long-term contract with an experienced operator that the host government guarantees will
survive a change in ownership control.
Management personnel
Good management personnel as well as experienced operating personnel are needed. The
general management of a project company makes the basic policy decisions, arranges the
financing, provides information to lenders and investors, monitors and administers the project
company and ensures the loan is repaid, primarily from the projects cash flows. So good
internal systems and controls are critical, as is the ability to maintain production levels and
market share. The management team must be experienced, reliable and have a good working
relationship with the project lenders, so the sponsors must be able to attract and retain a
good management team.
24

Lenders will also want to see that each of the sponsors basic businesses as well as the
project company are well managed.
The assignment of management and technical personnel to large visible projects in foreign
countries leads to the risk of kidnap or extortion of personnel, shown in Exhibit 1.1 as Risk
31 and the linked area of marine piracy. Sadly, the likelihood of these events is increasing in
many areas where project finance is growing and not all kidnaps have a successful conclu-
sion. Along with appropriate insurance coverage, project sponsors should establish adequate
personal security measures for staff working in areas where these are known problems, and
make arrangements with political intelligence providers to receive regular briefings and allow
early warnings of deteriorating situations.
No new technology
The project should not involve new technology, since again this is an equity holders risk.
The reliability of the process and the equipment to be used must be well established. If a
project is to be largely self-supporting without an all-encompassing guarantee from a govern-
ment agency or some other form of credit, then unless it uses existing technology, it will be
difficult to find financing from conventional sources. Projects to produce oil from oil shale
or tar sands, gas or oil from coal, energy from garbage, gasohol from feed grains or similar
promising but untried processes, are unsuitable for project financing in the absence of a
guarantee from a very strong credit. Lenders who rely on a projects cash flows to service
debt expect the project to use proven technology and engineering.
Electricity generating plants provide a good example. A 200 mega-watt coal-fired plant,
using standard machinery and equipment successfully used in other generating plants of
similar size, and which may be purchased out of inventory from a manufacturer might easily
qualify for bank financing. In contrast, a 500 megawatt lignite-fired plant to be built along
the same principles, but with custom-built boilers, machinery and equipment not previously
extensively used and tested in similar facilities required greater credit support from guarantors
as the reliability of the cash flow it would generate would be unproven because it was using
new technology. The new technology would cause the project be classed as a risk for equity
holders, not debt providers, unless a strong financial guarantee was offered to support the
project. After a number of years the new technology becomes mainstream and, continuing
with our example, there are a number of lignite projects underway today.
Contractual agreements among joint venture partners

Clearly written contracts are key to successful projects. At the base of any project is a joint
venture agreement and possibly an incorporated special-purpose vehicle (SPV) company or other
legally separate entity. All the agreements among the joint venture partners are of importance
to lenders, who want to know the identity of the companies, their ownership structure and
the people who will own, operate and manage the project throughout the life of the loan (see
Chapter 27 for a more detailed discussion of entities for jointly owned or sponsored projects).
A good joint venture agreement will contain satisfactory provisions on these items
amongst others:
25

Project Financing
changes in percentages of participations by any of the partners;

withdrawal and replacement of partners;
addition of new partners;
responsibility rights, and obligations of partners to each other if one partner fails to meet
its financial obligations or commitments to the remaining partners;
procedure for settlement of disputes among partners;
voting rights of the partners on operation and management of the project; and
assurance that the project facilities will be managed by a qualified operator for the life
of the loan, particularly where the host country increases its ownership participation.
Political environment, licences and permits

The political environment for the location of the project, as well as the type of project, must
be supportive of the investment and stable, with any required permits readily available, and
any restrictions realistic. Good working relationships with the government officials who will
be involved with the project are key to its long-term success.
The need for a stable political environment is not confined to projects located in devel-
oping countries. In recent years a stable and friendly political environment has not always
been assured even for projects located in North America and Europe.
Hundreds of licences and permits may be required to build projects, some of which may
not be available until after completion of the project, for example, certain clean air and clean
water licences. Some permits may be obtained whilst operating in order to continue keeping
an operating license. Lenders want assurance that such permits will be granted in a fair and
objective manner, based on standards and tests which are known at the outset of theproject.
Severance taxes can also seriously affect the economics of a project. A severance tax is
a tax imposed on the production of a particular natural resource, such as gas, oil or coal.
This is a popular way to raise revenue, since the coal tax-payer/voter is subsidised. However,
the uncertainty over future severance taxes can raise serious problems for a project financing,
since they reduce the ability of the project to adjust prices to meet costs, make the product
less competitive and adversely affect the ability of the project to service debt.
No risk of expropriation
Expropriation of a successful business is always a risk; it can be direct or indirect, fast
or creeping. Expropriation risk can be appraised by examining the infrastructure of the
country, its neighbours, its history, its power structure and its economic and political history.
International lenders usually make a regular practice of keeping up to date on country,
economic and political developments based on their internal expert analysis and other expert
sources for the purposes of asset allocation, setting country limits and following large credits
such as project loans.
Concession agreements from central or local governments may form the basis of the
project. They may be supported by separate agreements between project sponsors and the
countrys central bank or other government agencies responsible for natural resources or
industrial development. These agreements should preserve continuity among the sponsors, the
26

SPV company and the government when changes occur in the host country leadership, but
are best characterised as letters of general understanding rather than binding commitments.
Insurance against expropriation is also sometimes available but typically costly (see Chapter
22). Examples of expropriation risk include the Dabhol project in India. An article about
the key issues at the time is included in the case studies at the back of this book.
Common concerns regarding the risk of expropriation by the government of a developing
country can be greatly lessened if the project is owned by a number of prominent local
investors from the host country or from several countries to spread risk. Another strategy is
co-financing with the World Bank or one of the area development banks. This may include
cross-default clauses, so that an expropriation of the mine, change of substantial ownership,
or failure to pay debt will result in a concurrent default with other international loans. This
would jeopardise a countrys credit to an unacceptable degree.
Creeping expropriation through new or increased taxes, or failure to renew licences
or import or export permits, or even changes in government policy on foreign ownership is
more common. Canadas one-time past policy of discouraging foreign investment in natural
resources and forced divestiture of existing investments may have been well-intentioned from
the standpoint of Canadian policy, but was a form of expropriation from the standpoint of
affected investors.
The policies of some public utility commissions in the United States on assets to be
included in the rate base have resulted in utilities having to sell securities at substantially
under book values, in effect expropriating utility investors.
Environmental restrictions in Europe and the United States have also resulted in utilities
having to sell their securities at substantially under book values, in effect expropriating utility
investors. Many plants, mines and foundries have also had to be shut down for environmental
reasons long before their economic lives were exhausted.
Government agencies created to market minerals from mines, whilst taking royalty
payments may be mandated to monitor production. They may have an additional role to
oversee and minimise the economic impact of transfer pricing that is, by over- or under-
invoicing between foreign and domestic units of, say, a foreign mining company as a device
to transfer capital out of the project country as another form of host government control.
Such monitoring may be seen as accessing data with a view to offering a route to potential
expropriation of the project if it is perceived as very successful.
Country and sovereign risk

Country risk and sovereign risk are widely used terms, subject to many definitions in finan-
cial dictionaries, but those definitions are reasonably consistent. Country risk consists of all
political, legal, regulatory, economic, exchange rate, environmental and other risks associated
with investing, lending, setting up operations or trading with a foreign country. It includes
for example, the risk of a lender making a loan to a private company across a national
border. Adverse country risk exists when the host country of the private company is not in
an economic position to permit transfer of the amount of currency needed for the payment
of interest and principal on any foreign debt (private debt has a lower priority than food
payments or national debt payments to external lenders). Adverse country risk also exists if
27

Project Financing
an embargo exists on certain products or repayment of debt is not permitted for domestic
foreign policy reasons.
The project feasibility study should identify the nature of the country risk, appraise the
significance and potential impact of the risk if realised and discuss strategies to transfer (by
hedging or insuring) or mitigate such risks.
Sovereign risk is a subset of country risk that pertains to the government, including the
risk that the government of a foreign country will default on its obligations; refuse to comply
with a previously signed agreement; change monetary policies, tariffs or foreign exchange
regulations; or impose regulations restricting the ability of borrowers, issuers securities, or
other parties from meeting their obligations. This has application in project finance where
the sovereign nation is the regulator but may also be one of the investors or joint venturers
in the project. Under these circumstances, a loan to the project is in part, at least, a loan
to the nation. As in expropriation, specialist advice can help sponsors to appraise and deal
with this risk.
Linked to this risk is the last risk in Exhibit 1.1 of Chapter 1 that of a well-developed
commercial legal system in place to protect property and contractual rights of host country
and foreign project stakeholders. For fast growing economies or newly industrialising econo-
mies, this can pose challenges for early project sponsors as the legal system tries to catch up
with current commercial and legal practices. Whilst it is easy to say that the well developed
US and UK legal systems offer good protection, it may be a matter of national pride to
use the local legal system as the governing law for any agreements. This is also an area for
expert advice.
Currency and foreign exchange risk

Currency risk problems arise where revenues, expenses, capital expenditures and loans are in
more than one currency and, therefore, subject the project to potential losses from currency
fluctuations. Where this problem exists, strategies must be devised to match currencies of cash
to be received in the future with cash required for future payments. This is because lenders
will look to the sponsors to make up any foreign exchange losses by providing additional
funding during construction and any future time when they are the principal obligors.
Careful analysis must be made of the expected cash flow of a project to determine
what currencies will be used to finance the project, including the host country currency,
and what currencies will be generated by the project. The exchange of one currency into
another must be carefully managed. Artificial conversion rates can, of course, significantly
adversely affect the project. Hedging in forward currency or commodity markets should
be done where possible at a reasonable cost using products such as forward currency sales
and currency swaps. A multi-currency loan may help control this risk but can also create
operational complications with limits placed on drawdown tranche sizes that may or may
not align with the project. The bank or financial adviser to the project can provide expert
advice and help in dealing with these problems.
When a project is located in a developing country, the countrys currency is frequently
considered a soft currency, tending because of domestic inflation to depreciate more rapidly
than a hard currency such as the US dollar, euro, British pound sterling or Japanese yen.
28

In such cases the project sponsors incur little risk in converting hard currency into local
currency for local expenses, but run significant risks if project revenues are in the local
currency and debt obligations are in a hard currency. This is a serious risk for a local power
project financed by foreign lenders. For projects that produce commodities traded on world
markets, such as petroleum and mineral products, the solution for the project is usually to
invoice in the same currency as the project loan, generally US dollars.
If the project is located in a country where there are or have been restrictions around
free exchange of the currency, a pre-emptive move by project sponsors would be to ensure
that the rights and obligations of the project company to deal in local or foreign currencies
are spelled out in an agreement that includes the express consent of the central bank of the
host country.
Adequate equity contribution

The key project sponsors or promoters must make equity contributions consistent with their
capability, interest in the project, and the risk and financial structure of the project. Lenders
will require the sponsors of a project to have a sufficient financial investment, such that it
will be difficult for the sponsors to abandon or ignore the project.
The project as collateral for asset lending

Lenders may be willing to rely to some extent on project facilities and properties as collateral
and security for debt repayment. Therefore, in planning a project, it is important to try to
locate and structure the project and its facilities so that they may have value to third parties.
There may be local legal impediments, however, restricting the use of foreign-owned assets
as collateral in the same way locally owned assets could be used. There may also be issues
with remitting sales proceeds from local project asset sales.
Many projects are uniquely valuable to the parties involved but may have only limited
value to third parties in a foreclosure or sale. In this case, any additional credit support for
such projects must obviously then come from other sources. The term asset lending is used
to describe circumstances in which lenders are willing to look to the collateral value of the
asset securing the loan as a significant back-up source of funds to repay the debt. But this
type of lending, generally does not apply to project finance. In the case of project finance,
loans are repaid with cash flow, not asset sales, and banks are reluctant debtors in possession
of assets on which they have foreclosed, not least as it is outside their area of expertise, and
they are known to be forced sellers of these assets and thence likely to sell at lower prices.
Satisfactory appraisals
Independent appraisals of oil or gas or other mineral reserves and other project assets and
cash flows must be available to lenders. The risk in a resource project is that the actual
production and the revenue derived from it will be insufficient to pay operating costs and
amortise project debt in accordance with the financial plan. For example, if a production-
payment type of financing is involved, the value and amount of reserves must be of sufficient
29

Project Financing
size to justify any collateral value sought by lenders and include a margin of safety. Appraisals
of the value of plant and equipment to third parties are necessary if such assets are relied
upon to any extent as collateral and for insurance purposes.
Consequently, lenders want to be as certain as they can be that potential ore deposits,
gas fields or oil deposits necessary to the project actually exist. The quality of such reserves,
the technical feasibility of recovery, the proportion of the reserves that are economically
recoverable, the ability and cost to extract such reserves must be ascertained to the extent
possible. The timing of resource recovery or production must be established. Some banks
employ their own engineers to conduct such appraisals but private engineering firms are also
available to perform such appraisals at a cost to the project company.
Adequate insurance coverage

An adequate insurance program must be available both during construction and operation of
the project because an uninsured casualty loss can be a disaster for all concerned. Therefore,
as part of this process, risks should be evaluated and insurance coverage maintained at levels
sufficient to provide protection. Reviews and changes in coverage should be made as conditions
change, since a dedicated project company usually has little cushion on which to fall back
in the event of such a loss, except for insurance proceeds. However, insurance proceeds are
assigned to lenders, so all agreements need to be clear as to the circumstances under which the
proceeds from an insurance claim must be used to restore the project or to repay the debt to
the lenders. Under certain circumstances, insurance proceeds during construction and/or start-
up may be payable to the sponsor or a company providing any completion guarantee. This
is only satisfactory so long as a responsible sponsor or other guaranteeing party is required
to complete or pay back the lenders and has strong enough financial resources to be able to
do so whilst the problems resulting from the incident requiring insurance are resolved. In the
past, naive lenders have failed to consider the period of delay between incidents and insurance
payouts and the need to manage any collateral effects of the trigger incident.
Business interruption insurance will provide protection against the possibility that the
project cannot be operated and interruptions to the flow of goods and/or services from a
project should also be considered when structuring any offtake contracts (see above under,
A market exists for the product, commodity or service).
Insurance is only as good as the financial strength of the weakest link in the chain of
reinsurance lenders may restrict where reinsurance can be written to avoid reinsurance
into illiquid markets based on currencies with limited exchangeability into US dollars, or
euros or those with long central bank delays in approving reinsurance transfers into strong
currencies. Many groups of project finance lenders will request a specialist insurance review
before and annually during the life of a financing package and want to oversee payments
of premia from bank accounts that they can monitor.
Force majeure risk

Force majeure (which literally translated means superior force) risks are those types of risks
that result from certain events beyond the control of the parties to the project financing and
30

thereby exempt parties from the legal consequences of non-performance. The scope of force
majeure risks is specific to each project but events commonly contained in force majeure
clauses include:
war (declared or undeclared) or other military activity;

strikes, lockouts and other labour disturbances;
riots or public disorder;
expropriation, requisition, confiscation or nationalisation;
changes in laws, rules or regulations;
blockades or other closings of harbours or docks;
severe storms and natural disasters; and
epidemics or quarantines.
The consequences from non-performance for each event should be clearly laid out in the
contract and need to be mirrored in all agreements for the project so all force majeure risks
are addressed identically in every contract or agreement for a project.
Force majeure events may also occur in the project supply chain, affecting key suppliers
of raw materials or services such as transportation. Parties required to take the service or
product of the plant under long-term through-put or take-or-pay contracts, or take-if deliv-
ered contracts are similarly subject to such risks.
Lenders will seek to allocate risks of this sort to the sponsors, suppliers and purchasers
through contractual obligation or insurance protection.
The following are practical points when negotiating certain of the more common events
included in force majeure clauses.
1 War (declared or undeclared) or other military activity: it may not be clear when a war or
other military activity should provide an excuse for non-performance. For example, does
the commencement of war or other hostilities involving the project country constitute a
physical impediment to performance, or should there be a requirement of hostile activity
at or near the project site?
2 Strikes, lockouts and other labour disturbances: while these events can physically prevent
performance, they also raise questions as to foreseeability and avoidability. Have these
events occurred frequently in the past? Should the conduct of a partys employees excuse
performance? Or should these events be restricted to those involving the employees of
others? Is a settlement of the dispute possible? Are replacement employees available? Some
insurance cover may be available, but may be expensive and restricted in scope.
3 Expropriation, requisition, confiscation or nationalisation: these events are often the source
of lengthy force majeure negotiations. When the non-performing party resides in the project
country and is prohibited from performing by an act of the government of such country, an
award of damages by a court in another country may be unenforceable. The issue becomes
more difficult when the non-performing party is an agent of the host country govern-
ment. Under these circumstances, there could be an argument that the entity controlling
the non-performing party has caused the impediment, and thus a claim of force majeure
might be difficult to support. Courts outside the projects host country may be reluctant
31

Project Financing
or unable to intervene in what may be viewed as an act of state. Documentation in this

area needs careful guidance from experts.
4 Natural disasters: certain natural disasters such as severe storms or floods may be normal
conditions during certain times of the year at the project site. Since these can be reasonably
anticipated they should not excuse non-performance. To avoid ambiguity, it is worth-
while to exclude such events as long as the risk has been addressed so that the project
revenues are not compromised.
Delay and cost overrun risks

A delay in completion of a project facility creates a compound problem. Interest on the
construction loan continues to run, thus raising the capitalised costs of the project and
resulting in a cost overrun. At the same time, the expected stream of revenue is delayed
since the plant cannot operate to produce the product or service. If the delay continues for
any length of time, cost of labour and materials may further increase due to inflation. The
process of continually examining and tracking financing requirements is shown in Exhibit 2.6.
This creates serious problems in a project financing, where the ability of expected revenue
to cover operating costs and amortise debt is dependent upon the assumed cost of the project.
Unless the remaining construction costs are paid, the facility will not be completed, and the
project will not generate funds to repay project debt. This puts the entire project in jeopardy.
An overrun cost with no provision for responsibility for payment puts considerable pressure
on lenders to advance additional funds.
Overrun risk can be covered in a variety of ways.
1 Construction contract approach: the sponsors can guard against over-run risk to some
extent if they can obtain some form of fixed-price or turn-key contract from contractors
and subcontractors. Under those circumstances, the contract price will be higher because
of the higher risk exposure for the contractor. Alternative approaches such as pain sharing/
gain sharing or alliance contracting as exemplified by BPs Andrew Field development
encourage contractors to evaluate and track the contract and exploit efficiencies. In this
example, a cost and delivery date was negotiated between all contractors and BP. The
contractors were incentivised to collaborate by the agreement that if costs were saved, all
of them would share in the upside. If however costs overran, the increase would also be
shared. The project came in under budget.
2 Additional capital from sponsor: under this approach, the sponsors or investors must agree
to come up with the additional capital, sometimes in the form of subordinated debt rather
than a capital contribution, permitting return of the additional investment to the investors
in some form other than as dividends or a distribution of capital, which might otherwise be
in violation of loan agreements. This may be in the form of an escrow account containing
sufficient funds to complete the project. An escrow account is, in effect, a blocked account
established and funded by the sponsors. Funds are paid out from the escrow account for
some specific purpose on the occurrence of some event. In the case of an escrow account
to provide funds for completion, funds would be paid out to contractors to cover certified
cost overruns. Any excess not used would be returned to the sponsor upon completion.
32

3 Standby credit facility: another method to address a possible overrun is through a standby
credit facility from the original lenders. In such a standby credit arrangement, additional
borrowings may have to be covered by a lengthening of take-or-pay contracts, or price
adjustment of the product or service or additional guarantees or capital contributions by
sponsors may be necessary.
4 Completion guarantee extension to debt maturity: a completion guarantee by the project
sponsor is an undertaking whereby the entire debt of the project is guaranteed until the
project is complete and operating according to specifications. This type of guarantee can
contain a provision that debt will be guaranteed until maturity in the event completion is
not achieved by a certain date. This puts pressure on the sponsor to provide cost overrun
funds needed for completion.
5 Take out of lenders: the loan agreement can require the sponsor to purchase the assets
and take out the lenders if the project is not completed and operating according to speci-
fications by a certain date. As a practical matter, such an agreement sets the stage for
lenders to renegotiate the loan on more favourable terms and conditions.
Exhibit 2.6
Meeting continuing financing needs
11
Investment of
cash
10 1
Cash available Use of cash
9
Risk 1
management Need for cash
Project
company
2
8 Tax and
Execution accounting
situation
7
Strategy to 2
approach Credit
markets standing
3
Analysis of
alternatives
6
4 Identification
Determine of best methods
objectives financing
5
Possible
alternative methods
of financing
33

Project Financing
Adequate ROE, ROI and ROA

Lenders wish to ensure that a project has a satisfactory economic incentive as measured by
projected ROE (return on equity), ROI (return on investment) and ROA (return on assets)
for the sponsor investors. Lenders expect the investors in a project to be successful and to
have the potential for being very successful. Lenders recognise that there is no better incen-
tive for the success of the project and for the investors to have the potential to receive an
excellent return on their investment.
Realistic inflation and interest rate assumptions

The projections and feasibility study should:
assume realistic inflation rates. Such rates will vary from country to country, which should
be borne in mind when investors, lenders and equipment sources for a project are located
throughout the world;
include projections of fixed and/or floating interest rates that will be available to the project
throughout construction and operation. This is an area where the financial adviser and/or
lenders to the project can provide expert help. Since a substantial part of the capitalised
cost of a project will consist of interest expense, it is important that realistic interest
assumptions be used for financial planning in the feasibility studies; and
state the base exchange rate for all currencies used in the project. In the absence of any
more definitive information, it should also assume that future exchange rates will vary from
year to year and will be calculated with a constant purchasing power parity. By way of
example, if a Japanese export credit has a low interest rate, the apparent advantage will
be eroded by the fact that the debt service will increase year by year from the appreciating
value of the Japanese yen resulting from the lower underlying inflation rate.
Environmental risks
Both the sponsors and lenders to a project must be very concerned regarding harm to the
environment which may result from the contemplated construction and operations. Recent
examples of the damage and clean up costs can be seen in the Makondo Well blow-out in
the Gulf of Mexico and its impact on BP as the operator in 2010 and in the Exxon Valdez
oil spill in Alaska in 1989. Other examples include the Aurul SA tailings dam failure in 2000
which took place in Romania but contaminated water sources in Hungary with cyanide.
A careful investigation of the history of any environmental damage to the property resulting
from past usage is warranted because the new owners and lenders to the project may be held
liable for any environmental clean-up required, regardless of when or how it occurred. This
becomes important in redevelopment of industrial sites, for example, for housing (brownfield
sites). In the past, irate stakeholders have attempted to sue lending banks for compensation
for losses caused by environmental mishaps resulting from projects they have financed.
Insurance protection may only be available for limited cover and at very high prices, and
the best option may be to engage and inform key stakeholders groups as the project progresses,
34

recognising that this will be an additional cost. The Equator Principles, a globally recognised
benchmark for managing social and environmental risks in project finance, is a voluntary code
of conduct signed by many major lenders and other project finance stakeholders. Signatories
pledge to follow the best practice based on the International Finance Corporation (IFC) Policy
and Performance Standards on Social and Environmental Sustainability, and on the World
Bank Group Environmental, Health and Safety General Guidelines.
Foreign Corrupt Practices Act and other similar legislation

There are substantial opportunities for project financings in developing countries, but the
legal systems in many of those countries have not yet been developed to accommodate
contemporary commercial practices and the intricacies of project financing ethical norms and
those countries are often not the same as in the Western business world.
In some developing countries, incentive payments are customary and even necessary to
facilitate the awards of contracts, permits and even the right to bid on contracts. The chal-
lenge for project sponsors is that this is not a level playing field. There is tension between
moves in Western economies towards transparent and accountable corporate practices that
meet ethical standards, and more relaxed approaches elsewhere. The need to find future
investment opportunities for sustainable returns for shareholders can highlight this tension
for natural resource companies. This is an area where extreme caution needs to be exercised
as in several jurisdictions, such as China, receiving a bribe is also an offence. In Chongqing,
in China, in May 2011, the local Chinese shareholder in the Chongqing Hilton Hotel (an
American chain) was jailed along with a number of other people, including government
officials following a trial that found that he had paid bribes and the officials had received
them in connection with certain organised crime and other activities in the hotel nightclub.
The UN and the Council of Europe have instituted codes of conduct for their employees,
most notably the UN Convention against Corruption and the OECD Convention on Bribery
of Foreign Public Officials in International Business Transactions. The latter was ratified by
38 countries as of March 2009. In the United States, the Foreign Corrupt Practices Act 1977
(FCPA), prevents US companies from bribing foreign officials and requires US companies
accounting practices to accurately reflect payments to foreign officials and agents.
FCPA makes it unlawful to incentivise or bribe government officials to obtain business,
and it includes several types of prohibited behaviour in its antibribery provisions. Other
US law includes the International Anti-corruption and Good Governance Act (2000) which
regulates US assistance programs.
The basic antibribery prohibition makes it unlawful for a company (as well as its officers,
employees or agents) to offer, pay, promise to pay, or even authorise the payment of money
or anything of value to a foreign official for the purpose of obtaining or retaining business
or directing business to another person.
The second antibribery provision outlaws making a payment of any kind to any person,
knowing that all or a part of the payment will be offered or promised to a foreign official
as a bribe. A person need not witness a bribe taking place in order to know about it.
A company may not avoid liability under FCPA by closing its eyes and ignoring obvious
facts that should have reasonably put the company on notice that its intermediary or agent
35

Project Financing
was engaging in these payments. However, the FCPA also notes several exceptions and affir-
mative defences. So-called grease payments to low-level employees who perform routine
governmental action are exempt from prosecution. If the written laws of the foreign offi-
cials country permit the payment, or the payments are made as reimbursements to foreign
officials for expenses associated with visits to product demonstrations or tours of company
facilities it may be exempt.
Specific legislation around payments, facilitation and bribery also exists in France,
Germany and the UK to name just three other countries active in overseas projects.
Protection systems against kidnapping and extortion

Protection systems are in place against criminal activities such as kidnapping and extortion.
This was addressed above under Management personnel.
Commercial legal system to protect property and rights

A commercial legal system is in place to protect property and contractual rights. This was
addressed above under Country and sovereign risk.
1
Feehan, JP, and Baker, M, The Churchill Falls contract and why Newfoundlanders cant get over it, Policy
Options, September 2010, pp. 6570: www.irpp.org/po/archive/sep10/feehan.pdf.
36

Chapter 3
Use of a financial adviser
The employment of an independent financial adviser is essentially an economic and a corpo-

rate governance decision. It is beneficial when the cost of the advisers value-added services is
less than the ultimate savings, and it also offers a neutral third party to negotiate on behalf
of the sponsors and other stakeholders. The adviser can assist in structuring the transaction
and in negotiating with providers of finance and brings a unique, in-depth knowledge of
deals and players in this marketplace, whilst contributing to the credibility of the project
through a review of its supporting documentation.
The separation of the roles of a financial adviser and the bank putting together a
syndicate of lenders to provide the debt element of a project financing is also important
from a corporate governance point of view. The premium that is paid for an independent
adviser is to ensure that the company gets unbiased advice. However in different coun-
tries and in different industries the term financial adviser especially in a project financing
context can mean many different things. So, a financial adviser can be an individuals tax
consultant, the project modeller, a loan broker, or a bank that will not participate in the
financing but will manage the offers from banks or bank groups to supply the financing
element and advise the company on selection of the best package. There are differing
views on whether a bank that is a financial adviser should also participate in the final
project financing.
There is also confusion between the role of the financial adviser to a project financing
and an advising bank. Some project financings will include a bank that has specialist know
ledge of the industry, an advising bank and that banks reward may be enhanced if it is
asked to provide specialist reports on the project for the bank group.
Any proposed financing needs to appeal to the lenders and investors who have been
identified as likely to provide funds on acceptable terms. The prospectus or offering
memorandum (covered in the next chapter) must be accurate and truthful and skilfully
targeted to investors and lenders, with the firmness of their commitment carefully judged.
This may be difficult for the sponsor or management of the project company, especially
for new projects or new sponsors, so the choice of a well-known financial adviser with
an excellent track record can enhance the projects chances of concluding a successful
financial package.
A project financing may be broken down into four different types of tasks for the adviser,
in conjunction with the sponsors:
1 developing a relationship with the sponsors;

2 designing and contracting for the preliminary feasibility study;
3 planning and selecting the optimal financing structure and key providers; and
4 monitoring and administering the loan agreement.
37

Project Financing
1 Developing a relationship with the sponsors

In addition to the more formal role of a project adviser linked to expectations around impar-
tiality, the adviser can also be in the unique position of being able to act as a mediator should
disputes arise. The adviser may have to use extensive diplomatic skills to tell sponsors that
a pet project is not financeable and thence not feasible, so a skilled adviser will spend time
developing a relationship with the sponsors rather than adopting a transactional approach.
Indeed, one of the criticisms of the relationship management within banks is that personnel
changes are relatively frequent, and so the adviser acts as a core of stability over what can
be a long period of time. Frequently advisers will develop relationships with sponsors and
work on many projects for them.
2 Designing and contracting for the preliminary feasibility study

Any project needs a feasibility study to justify the investment and the returns to its stake-
holders. Feasibility studies may range from a simple investment appraisal calculation or a
complex model supporting a long narrative document. The purpose is to determine whether
the proposal has sufficient merit to warrant further expenditure of time and effort so that
the costs of developing a feasibility study could be viewed as the purchase of additional
information to enable better valuation of the option to continue with the project.
At this stage, the function of the adviser is to:
determine the objectives of the sponsor;

review the plan of the sponsor;
raise questions and issues that must be answered; and
suggest alternate ways to accomplish the sponsors objectives.
It is important to have good financial input into a project decision as early as possible, as
some weaker projects can be improved or restructured before being presented to would-
be financiers. Some proposed projects may be rejected at early stages on the grounds that
financing cannot be arranged, when expert input might be able to cause the project to be
restructured and overcome the barriers to financing.
The new area of behavioural finance can explain the occurrence of pet projects which
though financially or operationally unfeasible may still command investments of thousands
or even millions of dollars. In such an event, the adviser needs to guide the sponsors to
recognise the underlying reasons for the continuation of the project and the impact they will
have on any external financing decisions.
Some projects complete construction before investigating financing alternatives such as
equipment finance sources, tax-based leasing alternatives and government-backed incentive
programs, as well as export financing programs with the result that the cost of debt and equity
for the project may be higher than would have been the case had alternatives been considered
at an earlier stage. Once contracts are let and supplier partnerships formed, it is very difficult
and expensive to renegotiate these agreements in order to meet the project financing objectives.
So it makes sense to run the project management and project financing activities inparallel.
38

3 Planning and selecting the optimal financing structure and

key providers
This phase covers everything from the review of the preliminary feasibility study to arranging
the financing and advising on the selection of banks or other providers of funds for key
roles. This phase includes an analysis of the project in which all of the relevant factors in
a complete feasibility study are evaluated.
As noted earlier, the financial adviser provides credibility by helping to prepare and
in effect endorsing the financial projections. A strong financial adviser can also assist with
negotiations with government agencies and suppliers, and with preliminary negotiations with
various providers of funds to the private debt markets. They will have expertise to offer on
the amount of equity support and borrowing which will be required, and the key providers
and players in these markets.
Specialist consultants may support the financial adviser by providing useful assump-
tions to be used in the feasibility study for such factors as interest rates, currency
exchange risks and inflation risks, or the sponsors may have developed their own internal
scenarios. They can also help with formulating accounting objectives and in projecting the
amount of capital needed to finance the project. Appraisals can be provided and reviewed
for accuracy.
The financial adviser can synthesise this information to offer opinions on the optimal
way to arrange financing of the project, taking into consideration the currencies the project
will generate, the location of the project and the capital needed and can prepare a financial
model of the project and test the feasibility of the various financial plans with various risk
case scenarios if requested.
From this, a proposed loan term sheet can be prepared based on the cost of the project,
the expected interest rates, the expected inflation rates, the projected economics of operations
and the anticipated cash flow to form the basis of the information memorandum.
Typically, an information memorandum (called an offering memorandum) is prepared,
which discusses the following points.
The sponsors and promoters of the project are identified

The background and track record, as well as the experience and reputation of the principal
officers, are described. The purpose is to establish a reputation of expertise, responsibility
and integrity for the sponsors. While the information is factual, and sponsors are normally
legally liable for its contents, a financial adviser can present facts which support the premise
that the sponsors are well qualified to undertake the project in question.
Other interested parties to the project are identified

This identifies third-party guarantors and stakeholders, other than the sponsors, who will be
making an important contribution to the success of the project. These may include suppliers
of equipment to the project, suppliers of raw materials to the project, takers of products
from the project, the contractor and various interested governmental agencies. A description
39

Project Financing
of each of the interested parties and their pertinent qualifications and expected contributions
to the project is included.
Location and design of the project

Issues relating to the project location and previous instances of the use of any technologies
or this project design would be included in this section.
Estimated construction costs

The estimated construction costs and the contractual basis for these estimates are included
here. The construction schedule and the expected cost of interest, including any penalties for
delays on the construction loan are explained. The purpose of this section is to establish a
best estimate of the total capitalised cost of the project that will have to be financed, and
the likely requirement for any cost overrun facility.
The financial plan

This section of the memorandum reviews the cash flow projections for the project and the
expected use of those funds, including the principal and interest payment of the debt. It
explains the assumptions used and the working capital needs of the company. Equity contri-
butions, supplier loans and other borrowings are discussed. Contingency plans, in the event
some of the key assumptions are not correct, are reviewed.
The proposed terms for financing

This is the heart of the memorandum, and outlines the amounts, priorities, maturities and
timing of the financing.
The offering memorandum is described in greater detail in Chapter 4.
4 Monitoring and administering the financing

Whilst in some cases, the financial advisers role may disappear once the project financing
agreements are concluded and signed, sponsors may also recognise the need for a qualified
specialist to continue to manage what may be a complex set of providers of finance to the
project, and contract that role back to the financial adviser rather than keep it in-house.
For groups of sponsors, it may be particularly useful to delegate monitoring and administra-
tion to a single external financial adviser unless such a role may be covered by members of
the project management team. Monitoring and administration tasks relating to the project
financing can be linked to the phases described in the previous chapter:
1 construction;
2 start-up; and
3 operations.
40

Construction
Monitoring and administration of the project during construction entails matching the take-
down of debt to the financial plan and construction schedule. If the loan agreements permit
a choice of alternative currencies or terms, the financial adviser or lead banker can provide
advice on the advantages and disadvantages of the different financial strategies. Hedging
advice can also be given.
It is important that the construction be kept on schedule and that delays in construction
and overrun exposure do not surprise lenders. Estimates of costs and time to completion
are prepared from time to time, with the help of internal accountants, and may be verified
by independent accounting firms to give such studies more authenticity in order to enable
accurate project tracking.
Start-up
Monitoring and administration of the project finance agreements during the start-up period
involves monitoring the actual operating costs and economics of production against the
financial plan and production goals. The market realised and projected for the product(s)
or service(s) produced, and the sales revenues realised, are compared against the original
financial plan.
Unexpected problems that may affect the economics of the project are tracked, such as
additional costs imposed by regulatory authorities, or unforeseen taxes. If different currencies
are generated by sale of the product or service, advice may be provided on ways in which
such currency exposures can be managed through swaps or other mechanisms to service debt
principal and interest payments.
Operations
Once it is clear that the plant is operating to the projected costs, volumes and efficiencies
contained in the operating plan and financial plan, and the project completion has been signed
off by the designated independent experts, the project begins to assume the characteristics of
a going concern rather than a project financing and completion guarantees may be allowed
to drop away from the project.
The duties of the financial adviser then become the traditional responsibilities of monitoring
operations, cash flows, ratios and other developments which may have a positive or negative
effect on the company. (See also Chapter 9 where we describe a risk classification system.)
As risks become known and confidence in the success of the project grows, opportunities for
savings through refinancing can be explored, though many lenders feel that if they have taken all
the risks, they want a stable period of reward and restrict refinancing for a designatedperiod.
At all stages it is to the advantage of all parties to keep each other fully informed. If
difficulties arise, a constructive mutually supportive approach is much less likely to degenerate
into combative litigation with no winners. If lenders learn of momentous developments at
short notice and if trust starts to disappear, lenders may act precipitously to call the loan
or force a rescheduling, or even force bankruptcy.
41

Project Financing
5 Selection of an outside adviser

If an external financial adviser is appointed to help sponsors to negotiate a project financing,
suitable candidates might include:
commercial banks;
merchant banks or investment banks;
major contractors;
major finance companies; and
independent consultants.
Characteristics of a potential financial adviser that a sponsor should consider include: repu-
tation, standing in the marketplace, knowledge of the industry, project finance experience,
past relationship with the sponsors, technical expertise, familiarity with any country risk and
compatibility with the officers assigned to the project.
The separation of the advising bank role and the main lender or arranging bank role is
a matter for each project sponsor group to decide for its own specific case. An independent
adviser role with no lending involvement has merit; an adviser who takes a small piece of
the financing is also a possibility; finally a strong lender that has the ability to commit or
underwrite a part or all of the project debt without an independent adviser is also a role
pursued by many experienced project sponsors. The ideal is the sophisticated sponsor that
structures and arranges the financing package for the project, advises its internal stakeholders
and presents the deal to the banks, keeping all agency costs inside its corporate walls. These
are rare, but do exist.
As the banking industry has reshaped over the years, the lines between investment banks
that traditionally would have acted as impartial advisers for a fee and commercial bankers
that would have used their absorptive capacity to underwrite deals and then sell them down,
has blurred, even within the same banking groups. A more formal separation of the two roles
is under discussion again in the UK, presaging a return to Glass-Steagall-like rules. Whatever
the arguments, sponsors need banks who understand the project, its technical fundamentals,
its decision-making dynamics, its suppliers and customers and its plans. Such knowledge and
relationships are not developed quickly and require trust and commitment from all sides.
6 Engagement letter
Once a decision has been made to employ a financial adviser, or to formalise any relation-
ship with a supplier of project finance capital, an engagement letter should be signed with
the adviser or providers. The letter should be carefully negotiated to spell out the deliver-
ables by the adviser or financing entity and the fees to be charged to the sponsor at various
times and under various circumstances. The scope of work to be performed, the people to
be engaged and the timetable for such work by the adviser to earn those fees should also be
stated clearly. If the adviser is to be responsible for raising debt and/or equity, the fees for
such work, who will pay those fees, and when those fees will be paid should be described.
The right to terminate the contract, and the liabilities of the parties in the event of such
termination should be agreed.
42

The most important purpose of an engagement letter is to record the agreement in order
to prevent future misunderstandings.
An adviser may require a preliminary engagement letter and a retainer fee before taking
a serious look at the proposed project because it separates the serious project promoters or
sponsors from the casual tyre-kicker and it recognises the investment of the adviser in the
project. A preliminary engagement letter may be limited in scope as all parties become better
acquainted and can always be amended to a more formal engagement letter at a later date
if the project looks feasible.
43

Chapter 4
The offering memorandum
To make an informed decision in response to a borrowers proposal, the would-be provider

needs to have adequate information about the investment or loan and the returns they may
expect. Just as for an initial public offering (IPO) or share issue, a project financing requires
an offering memorandum that fully describes the project and outlines managements policies
and plans. One of the primary purposes of hiring a financial adviser is to receive profes-
sional assistance in preparing the offering memorandum in a form and substance that will
appeal to providers of finance.
The offering memorandum, which may also be called the financing memorandum,
proposal or prospectus is a more developed version of a term sheet that outlines the basic
terms of the deal on offer (see Exhibit 4.1). The purpose of this document is to provide lenders
and equity investors with the information needed to make a preliminary decision to commit
funds to the project. As such it is an important selling tool that can clearly demonstrate the
planning ability and general competence of management to financial stakeholders andlenders.
The offering memorandum should be signed off by the sponsors, who warrant the accu-
racy of its contents and be realistic, with attainable financial projections. Loan covenants
and ratios should closely track these projections and demonstrate clearly that the project
company can service its debt and equity in line with expectations.
Cash is king. Lenders are primarily concerned with cash flow that will cover debt service
over the projects life and over the loans life, with an adequate margin of safety. Examples of
this margin might be a 2:1 debt service over the projects life and 1.5:1 over the loans life.
The offering memorandum should contain the following information.
1 Proposed financing and summary of terms

The offering memorandum opens with a one-page summary (often the term sheet) which
briefly describes the proposed financing. This is followed by a summary of terms for each
type of financing requested containing the information shown in Exhibit 4.1, and briefly
described as follows:
the amount, timing and purpose of the financing;

the type of financing requested (such as unsecured debt, equipment leases, secured debt,
subordinated debt, convertible debt, debt with warrants);
a description of the securities to be offered;
the proposed interest rate;
the proposed currency;
the proposed final maturity, repayment schedule and average life; and
a brief description of the proposed covenants to be included in the loan agreement.
44

Exhibit 4.1
Summary of terms
Amount:
Type of financing:
Use of proceeds:
Drawdown dates:
Final maturity and average life:
Interest rate:
Commitment fee:
Definitions:
Financial covenants:
Required prepayments
Optional prepayments without penalty
Restrictions on refinancing
Optional prepayments under certain circumstances
Optional prepayments with penalty
Protective covenants:
Working capital
Short-term debt
Long-term (funded) debt

Senior
Subordinated
Lease obligations
Dividends, other stock payments and repurchases of

stock
Guarantees and other contingent liabilities
Supply and purchase contracts
Mortgages, liens charges and other encumbrances
Sale and lease-back transactions
Cross defaults, common terms and inter-creditor

agreement implications for this transaction
Governing law
Change of ownership and assignment of interests

Project Financing
2 The project company

The project company section will summarise important background information regarding the
project company (such as its date and state of incorporation and organisation) and include
names, locations and proposed lines of business for the project. If the project company is
already in existence, the offering memorandum briefly states and explains any recent financial
results, as well as managements plans and expectations for the coming years.
3 Capitalisation
Based on the most recent balance sheet, the section on capital structure shows the project
companys existing and/or pro forma capitalisation using the format contained in Exhibit
4.2. The offering memorandum describes all proposed long-term debt and lease obligations
as shown in Exhibits 4.3 and 4.4, respectively. It provides a breakdown of existing and
Exhibit 4.2
Existing and pro forma capitalisation
(Dollars in millions)
31 December, 20-- 31 December, 20--
Actual Pro forma
Short-term debt US$ US$
Long-term debt US$ % US$ %
Senior
Subordinated
Preferred stock*
Common stock
Surplus
Retained earnings
Total long-term capital US$ 100% US$ 100%
Senior long-term debt/
total long-term capital
Long-term debt/
total long-term capital
Total debt/
total long-term capital + short-term debt
* At liquidationvalue.
46

Exhibit 4.3
Schedule of long-term debt*
Long-term debt Year-end (Dollars in millions)

before Repayments
proposed
Year Year Year Year Year Year Year Year Year Year
issue
1 2 3 4 5 6 7 8 9 10
Description of
existing debt
(mortgage notes and
so on)
Sub-total
Proposed issue
Total
Ending current
portion
Ending L-T portion
Interest expense:
Short-term debt
Long-term debt
Total
* As a continuation of the schedule, provide the following information on each of the companys existing
long-term debtobligations.
1 Interest rate and finalmaturity.
2 Source of thefinancing.
3 Major protectivecovenants.
proposed short-term bank lines and, if applicable, indicates usage by month for the recent
years. The memorandum also states and explains any contingent liabilities or guarantees
and gives a complete breakdown of equity ownership, including the percentage ownership
of officers, directors and other major stockholders, with an emphasis on the ownership by
key project stakeholders and financially strong stockholders.
47

Project Financing
Exhibit 4.4
Schedule of lease obligations
Finance leases1
Minimum annual rental payments
Next five Next five
201X 201X 201X 201X 201X year period year period
Type of asset leased
List groups if appropriate:
Total
Present value of finance leases:
Average interest rate used to compute
present value:
Other leases2
Minimum annual rental payments
Next five Next five
201X 201X 201X 201X 201X year period year period
Type of asset leased
List groups if appropriate:
Total
Total rentals payments
1 Long-term, non-cancellable leases whose original term constitutes a substantial portion (75% +) of the
useful life of the underlyingasset.
2 Cancellable leases and non-cancellable leases whose original term does not constitute a major portion of
the useful life of the underlyingasset.
4 Products/markets
This section should describe the project companys product(s) or service(s) and the market(s)
for each including a discussion of historical and projected growth in the markets served. If
the project company has been in existence, sales and pre-tax profits by major products for
the past five years are shown using the format contained in Exhibit 4.5. The memorandum
should describe any plans for major new products or services and the project companys
research and development program.
48

Exhibit 4.5
Breakdown of sales and profits
Net sales Pre-tax profit contribution
Half year- 201X 201X 201X 201X 201X 201X 201X 201X 201X 201X
ending
(month and
day) US$ US$ US US$ US$ US$ US$ US$ US$ US$
% % % % % % % % % %
Product,
division or
subsidiary
Total =100% =100% =100% =100% =100% =100% =100% =100% =100% =100%
Less:
Corporate overhead
Other unallocated expenses
Interest (total)
Taxes
Net income
5 Marketing
This section discusses the project companys marketing strategy and outlines how it plans
to sell and distribute its products or services and how they will be priced. It analyses the
companys customers and any concentration of sales volume among them. It highlights any
current or anticipated sales contracts, including take-or-pay contracts, take-and-pay contracts
or similar arrangements. This section may often be written with input from a recognised
external expert, or include an expert report.
6 Competition
This part of the memorandum describes the nature of competition in the project companys
industry and names the major competitors with, if available, the market share enjoyed by each.
It elaborates on the companys projected position in the industry, examines the strengths and
weaknesses of competitors and anticipates competitor responses to this project. Independent
expert industry trade growth publications and government data should be included, if appro-
priate, to define the companys position in the market.
49

Project Financing
7 Manufacturing and production

This section explains the location, nature, physical size, capacity and utilisation of the project
companys existing and proposed manufacturing and/or production facilities and whether they
will be owned or leased. Proposed capital expenditures for the next five years and a brief
description of the companys manufacturing methods and costs, sources, availability and cost
of the raw materials and/or components used together with any existing or proposed supply
contracts for raw material, feed stock and energy form a picture of the cash flow dynamics
of the project. This section is also where the companys status under federal, state and local
environmental and safety regulations is detailed.
8 Management/personnel
Stakeholders need an organisational chart of the project and its sponsors with brief biogra-
phies for key members of management, indicating relevant salary and bonus arrangements.
Brief biographies of the companys directors, both executive and non-executive indicating
their outside affiliations are also critical in showing the calibre of the management and board.
Full disclosure of detailed information about project staff including directors and managers
is required by lenders prior to any signature, so any difficult issues should be raised and
addressed with appropriate legal guidance if necessary. The size of the proposed projects
labour force and its nature (for example, the level of skills, unionisation, strike history,
current contracts) offers insights into future cost containment.
9 Business risks
Best practice in project management includes a risk analysis, covered further in Chapter 5.
Conventionally this includes a list of the major business risks faced by the company together
with an analysis of probability, impact and mitigation steps taken or proposed by the
management team, including insurance. Any pending litigation that may affect the sponsor
companies should also be discussed here.
10 Historical and other financial information

If the project company has an operating history, summarise the project companys audited
income statements, balance sheets, sources and uses of funds statements and related
statistical data for the past five years. Sample formats are contained in Exhibits 4.6, 4.7,
4.8, and 4.9, respectively. Definitions for suggested ratios are included in Exhibit 4.10.
If the project company has an operating history, explain any abrupt changes or sustained
deterioration in the financial statistics (for example, abrupt declines in sales and earnings,
large increases in receivables or inventories unaccompanied by increasing sales and so on).
Be specific in pin-pointing problems, indicating what actions the company has taken or
is taking to resolve them.
If the project company has been in existence and has made any important acquisitions
during the past five years, explain their rationale. Provide income statements and balance
50

Exhibit 4.6
Historical (projected) consolidated income statements
31 December,
201X 201X 201X 201X 201X
Sales
Cost of goods sold
Selling and advertising expense
EBITDA
Depreciation and depletion
EBIT
General and administrative expenses
Interest earned
Interest paid
Other expenses (classify if material)
Taxes (other than federal)
EBT
Federal income taxes1
Tax credit available
Tax credit used
Income before extraordinary items
Extraordinary items
(describe the specific items)
Net income
Distribution of profits
Limits: debt to equity ratio
cover ratio (periodic)
cover ratio (loan life)
from profits
Gross dividend
Dividend tax
Retained earnings
Number of shares used for per share calculations2

Earnings per share2
Continued

31 December,
201X 201X 201X 201X 201X
Dividends per share2
Return on total assets3
Return on long-term capital3
Return on equity3
1 Distinguish between current and deferred income taxes. Disclose treatment and amount of investment
tax credit and tax loss carry (back) forward credit, ifapplicable.
2 Should be adjusted for stock splits and stockdividends.
3 See Exhibit 4.10 for definitions of theseratios.
Exhibit 4.7
Historical (projected) consolidated balance sheets
31 December,
201X 201X 201X 201X 201X
Assets
Investments property, plant and equipment (gross)
Accumulated depreciation
Property, plant and equipment (net)
Current assets
Accounts receivable
Inventory
Operating cash
Sub total
Sinking funds
Escrow account
Total
Liabilities and stockholders equity
Stockholders equity
Equity
Reserves
Currency adjustment
Continued

31 December,
201X 201X 201X 201X 201X
Sub total
Long term liabilities
Long-term debt (less current portion)
Other liabilities
Deferred taxes
Sub total
Current liabilities1
Tax outstanding
Current portion long term debt
Creditors
Dividends
Sub total
Total
Quick ratio2
Current ratio
Receivables turnover
Inventory turnover
Short-term debt/current assets
Short-term debt/current liabilities
Working capital ratio2
1 Should be broken down by specificaccount.
2 See Exhibit 4.10 for a definition of thisratio.
sheets for the acquired company for the three years prior to acquisition. In addition,
indicate the price and form of the transaction.
Describe the project companys financial policies (that is, dividend policy, capital structure
policy, return on investment objectives and similar policies), management information
systems, operating capital budgeting and long-range financial planning procedures. Describe
any existing loan and/or significant lease agreements, and indicate the availability of the
current years operating budget.
If information is available, compare the project company to major competitors in terms
of projected sales volume, margins and returns. Also, compare the companys projected
capitalisation and related ratios (see Exhibit 4.7) to those major competitors.
53

Project Financing
Exhibit 4.8
Historical (projected) consolidated cash flow statements
31 December,
201X 201X 201X 201X 201X
Operations
Revenues
Operating costs
Marketing
Increase in working capital
Interest earned
Interest paid
Tax
Fees
Net cash from operations
Investing
Capital cost
Abandonment
Scrap
Net cash from investing
Financing
Equity
Loans
Loan repayment
Loan prepayment
Dividends
Net cash from financing
Changes in cash
Beginning cash
Ending cash
If the project loan will be supported by a guarantee or long-term contract from a sponsor,
include the following information regarding the sponsor with the financing memorandum,
or indicate whether it is available upon request:
annual reports and pertinent regulatory filings for the past five years;
if applicable, consolidating financial statements for the past five years, preferably audited;
54

Exhibit 4.9
Historical (projected) comparative data
31 December,
201X 201X 201X 201X 201X
Income before taxes
Taxes
Net income
Total interest1
Imputed interest on leases2
Interest coverage:3
Before-tax
After-tax
Interest and rental coverage:3
Before-tax
After-tax
Depreciation
Other non-cash items
Cash flow/long-term debt3
Long-term debt/net property, plant & equipment
Net tangible assets/long-term debt3
1 Interest on short-term and long-termdebt.
2 Imputed interest on finance leases. If this data is not available, use 1/3 of total annualrentals.
3 See Exhibit 4.10 for a definition of thisratio.
interim reports for the current year;

the most recent interim or other proxy statements or other announcements issued to
shareholders; and
any recent prospectuses for equity or debt issues.
If the project loan or lease will be supported by the collateral value of the project or
equipment being financed, appraisals of the project or equipment should be included,
as well as the value of the project upon completion and a forecast of the used value at
various dates after being placed in service.
55

Project Financing
Exhibit 4.10
Formulae for calculating various ratios for industrial companies
Fixed charge coverages:
Interest coverage: Total interest expense + Before-tax income1

Before-tax Total interest expense
After-tax Total interest expense + Net income1
Total interest expense
Interest and rental coverage: Total interest expense + Imputed interest on Finance leases2 + Before-tax income1
Before-tax Total interest expense + Imputed interest on finance leases
After-tax Total interest expense + Imputed interest on Finance leases2 + Net income1
Total interest expense + Imputed interest on finance leases
Net tangible asset/ Stockholders equity Intangibles + Long-term debt
long-term debt Long-term debt (excluding current portion)
Liquidity ratios:
Cash flow ratio Net income1 + Depreciation3
Long-term debt
Working capital ratio Current assets Current liabilities
Long-term debt
Quick ratio (acid test) Cash + Marketable securities + Receivables
Current liabilities
Returns:
Return on total assets Net income1
Total assets
Return on long-term capital Interest on long-term debt + Net income1
Long-term debt + Stockholders equity
Return on equity Net income1
Stockholders equity
1 Adjusted for the effect of non-recurringitems.
2 Average implicit interest rate times present value of leases. If data are not available, substitute 1/3 total
annualrentals.
3 Other non-cash items should beadded.
11 Plans and forecasts

Provide income statements, balance sheets and cash flow statements forecasted over the
expected life of the project. The forecasts should incorporate the proposed financing and
should preferably be displayed at six month intervals. The formats contained in Exhibits
56

4.6, 4.7 and 4.8 are suggested. Provide statistical data for the forecast period using the
format contained in Exhibit 4.9. The forecast should be broken down by major divisions
or subsidiaries. Detailed assumptions should accompany the forecast. Include a scenario
analysis with a high and a low case and sensitivity analyses as explained in Chapter 20.
Explain, in detail, the use of the proceeds from the proposed financing. Where the proceeds
are to be used for construction of a facility, the presentation should indicate projected cost,
the amount of the initial investment, the estimated future investment, and the earnings and
cash flow the investment is expected to generate. The facility should be described. The
contractor should be identified and any special arrangements with the contractordiscussed.
Describe the project companys future direction. Discuss any plans for major changes in
the organisation, management or operating policies.
Outline future capital requirements and plans for financing such requirements.
12 Each case is different

All of the information outlined above will not be required in every case. However, a presen-
tation that follows this systematic and comprehensive approach should contribute to the
successful arrangement of a project financing.
In many project financings the company will be newly established and have no past
operating history, and in such cases heavy emphasis on the projected financial statements
and rationale for the financial outlook is essential.
In such instances background information and the operating history of the key sponsor
and/or guarantor is appropriate, including all of the information described above.
13 Potential future liabilities

Most project agreements with host governments, landowners or communities now include
an expectation that the site will be restored to its original condition and projects may
need to include those future costs as a part of the financial appraisal. Communities are
becoming less likely to bear these costs, especially if the clean-up or restoration exercise
may require specialist technical knowledge. Many Western brownfield sites (that is, indus-
trial and commercial properties that have been either abandoned or underused, but can be
prepared for reuse) have required a clean-up operation before a new project can be started.
The removal of asbestos, which requires specialist know-how, is just one exemplar hazard as
older buildings, constructed when different safety measures or insulation standards existed,
have had to be removed in a manner safe for all stakeholders. From examples in the North
Sea, where abandonment costs were once a distant issue and then in the 1990s became a
financial reality, expectations have now been formalised in accounting standards and also
recognised by fiscal authorities.
The problem for sponsors is that quantifying the termination costs of a venture including
removal, restoration and clean-up costs can be difficult to estimate at the start of a long-
term project. Nevertheless, it is imprudent to ignore them and provisions should be made
and adjusted once these costs are estimated, and included as a part of any project appraisal
or re-appraisal process.
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Chapter 5
Risks that a lender may assume
Any discussion of the risks that a lender may assume would not be complete without discus-
sion of the increasing competition between banks and lending institutions over the past few
years and the effects of the various credit crises on bank lending.
Private commercial banks have traditionally been a major source of funds for project
financings. New banks entering the field of project financing, and anxious to carve out new
relationships, have been particularly aggressive in seeking to make loans. This has been
especially true in the case of quasi-governmental banks that have sometimes been willing to
accept more project-related risk than private commercial banks. Such competition has led to
erosion of pricing, lowering of collateral requirements, extension of maturities and to lenders
assuming greater credit risk.
The trend towards an assumption of more risk by banks and a decrease in their rewards,
and thus easier terms for project finance is not necessarily good for long-range, orderly avail-
ability of funds from private sources. Substantial losses by the private banking sector will
result in a drying up of funds and a stiffening of terms that will make future projects much
more difficult to finance. So some balance is needed. Lenders must be adequately compen-
sated for use of their funds on a fairly risk-free basis if they are to continue in business.
Lenders advance funds only where they are highly confident that they will be repaid with
interest. Lenders advancing funds on any other basis are flirting with bankruptcy because
of the increased levels of more equity-style risk in the portfolios of such lending institutions
that are already highly leveraged. Investment companies, such as sovereign wealth funds, that
have low levels of leverage can take equity risks in projects but in contrast, lenders such
as banks that are much more highly leveraged, are not in a position to take equity risks.
After protracted loan negotiations during which borrowers are presented with what must
seem to be endless demands for covenants, events of defaults and ratios from lenders, an
exasperated borrower may ask a lender: Dont you people ever take any risk in a transac-
tion? The candid answer that most lenders will try to gracefully convey in polite terms is:
No, we dont take any risk because our stakeholders require that we not enter into a loan
in which there is any hint that we will not be repaid.
However, in spite of general denials of risk taking by lenders, there are certain transaction
risks which lenders may feel comfortable in assuming in some instances. Such exposure is
usually in the form of providing additional financing in certain circumstances. Such exposure
may also carry a higher cost to the borrower.
1 Country risk
There is increasing pressure on lenders to assume some of the country risk in a project
financing. Such country risk consists of a politically motivated embargo or boycott of a
58

project, debt repayments or shipment of product that may reflect the foreign policy of the
country. Country risk also considers circumstances in which the host country cannot permit
transfer of funds for debt service because of its own economic problems.
In some circumstances, lenders may feel comfortable with assuming some or all of the
responsibility and risk of solving such problems, should they arise.
The disinclination of lenders to participate in a loan to a particular project located in
a particular country does not necessarily indicate a lack of confidence in the project or the
country. Most lenders like to diversify their portfolio risk as much as possible, to limit their
credit exposure to particular companies, industries, countries, or geographic regions. Failure
to participate may merely reflect that limits of exposure have been reached.
One mechanism to encourage lenders to accept a higher degree of country risk has
been the inclusion of multilateral lenders such as the World Bank as participants in critical
projects in countries with perceived higher levels of country risk. These loans will very often
be quite small, and may be subordinated, but the presence of a lender of this calibre may
give other commercial lenders a sense of confidence in a project. Cross default provisions
will ensure that there are very real pressures to make sure that payments are made on this
loan, lest other World Bank financed projects in the country are frozen and future lending
by this supranational agency would cease.
2 Sovereign risk
Lenders used to making credit judgements for loans to countries as sovereign entities are often
in a position to make lending decisions where the project is owned or guaranteed entirely
or in part by an agency of the government of a country. However, the exact ownership
and legal status of a state agency may not always be easy to ascertain. For this reason, it
is critical that a potential lender should read the articles of association and/or charter of
any such entity to make sure that there are no surprises. If an entity that was believed to
be a state agency has clearly stated in its articles of association that this is not the case, its
liabilities may not be considered to be the liabilities of the sovereign nation and a different
financial and risk appraisal will need to be completed. In newer, fast developing economies,
assumptions and confusions about the creditworthiness of borrowers that may appear to
be fully supported by the sovereign state, can cause difficulties for foreign lenders that can
escalate into much larger international or trade related issues, should problems arise.
3 Political risk
Political and regulatory risks are inherent in doing business. They affect all aspects of a
project, from site selection and construction through completion, operations and marketing.
They are difficult to evaluate. Where possible, these risks are assumed by sponsors. Where
this is not possible, lenders sometimes assume such risks. Production payment contracts for
oil or gas production in a developing country are examples of assumption of political risk.
The ultimate political risk is expropriation, and banks are sometimes exposed to this
risk purposely by a borrower to lessen the likelihood of expropriation.
The distinction between country risk and political risk is a thin one.
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Project Financing
Windows of opportunity open and close in the commercial political risk insurance market,
so these risks could be covered albeit at a price. The transfer of risk to the insurance market
requires expert knowledge and advice. (More on this in Chapters 12 and 22.)
4 Foreign exchange risk

So long as capital expenditures, operating expenses, revenues and borrowings are in the same
currency, exchange risk will not be present.
Where this is not possible or desirable, the lender may be asked to assume some of
the risk through multicurrency loans which give the borrower an option, based on a fixed
exchange rate, of repaying in different currencies. Both borrowers and lenders need to
remember that the practical mechanics of multicurrency loans can be complex and it is
important that there is a clear understanding of how this will work in practice before the
transaction is completed. Lenders can sometimes hedge this risk, using the instruments
described in Chapters 24, 25 and 26.
It is also worth remembering that the hierarchy of creditors may be specific to a coun-
trys legal jurisdiction and different from that of lenders home countries. Local lenders, that
may be providing payroll services to a project company, may enjoy priority in a creditor
hierarchy as compared with foreign lenders. If there is going to be local currency working
capital provision for a project, and most projects will require this, all participants in the
financing need to have a clear picture of how the creditor hierarchy would work in a worst-
case scenario. No large foreign lenders want to have payments delayed because a smaller
local lender is ahead of them in the queue for worst-case project cash flows. The use of an
Inter-creditor Agreement can assist with this.
5 Inflation risk
The lender must ultimately rely on projections of the cost of construction of the project and
the cost of operations.
The use of correct inflation factors in estimating these future costs is an area in which
the lending banks with specialist economics departments may have more expertise than the
project company or its promoters, though the professionalisation of project managers has
generally improved the quality of cash flow projection presentation. Therefore, by providing
advice on inflation factors used in preparing projections and in later making a loan on
the basis of such projections, a lender has assumed the inflation risk that is present in the
transaction, making the decision based on their perceptions at the time of approval. If larger
borrowings are required because of higher than expected inflation rates, the lender may have
to provide additional loans and assume additional credit exposure. This topic is discussed
further in Chapter 20.
6 Interest rate risk

Loans with floating interest rates, measured by a margin over the cost of funds, may be used
for construction loans and long-term financing, as well as for working capital and short-term
60

needs. Forecasts of future interest rates used or capitalised construction costs and future debt
service requirements are dependent upon realistic interest rate assumptions and lenders may
seek to manage this dynamically through the use of interest rate swaps and other financial
instruments discussed in Chapters 24, 25 and 26.
On a practical note, regardless of what happens with the project, payments that are
required under hedging contracts must still be made. It is a good idea to ensure that those
divisions within the bank involved in any hedging program have a complete understanding
of the profile of cash flow delivery by the project and that those cash flows will be suitable
to meet the obligation to deliver funds against any hedging contracts used.
7 Appraisals
Some project loans to finance production of oil and gas are made on the basis of the
appraised value of the resources, and the ability of an operator to recover such resources.
Similar loans are sometimes made for mining coal or other minerals.
In such loans, lenders are assuming the risk that the resources actually exist and will
be recovered at the forecasted levels. In making such loans, lenders must rely on opinions
of internal appraisers, as well as independent external appraisals.
This type of financing has been used extensively in North America, and for some very
large financings of North Sea projects.
The accuracy of such appraisals, based on experience in different geological settings and
thus the amount lenders have been prepared to advance when making production loans,
has increased as competition among lenders has increased. The specialist expertise required
to structure these loans has diffused through the specialist project finance bank population,
moving from the US to Europe, Asia, Africa and South America. Resource rich countries
such as Canada and Australia have also produced banks with this expertise.
8 Availability of permits and licences

Where permits and licences must be obtained and renewed before the plant will operate,
the lenders, in effect, assume the risk that such permits and licences will be obtained in a
reasonable time. There is also an assumption that sponsors will pay the associated costs.
9 Operating performance risk

Once the project is complete and operating to specifications, it begins to assume the char-
acteristics of an established operating company. As the completion guarantees drop away,
the lenders in many project financings become dependent on the continued uninterrupted
operation of the project and sale of its products or services to provide the cash flows neces-
sary to repay the project loans.
Where the project has been carefully planned, lenders protect themselves by requiring
strict compliance with operating specifications and costs before the completion guarantee
is terminated. The lending risk is similar to the risks encountered in commercial loans to
independent companies engaged in similar businesses.
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Project Financing
Looking forward to the point where the project is deemed to be complete and sponsor
support falls away, the future cash flows of the project company may be subject to
unusual operating costs, raw material cost increases, regulatory risks and markets for the
products. However, the lenders will be protected to the extent they have laid off risks
of raw materials and markets on to suppliers and users. The lenders can further protect
themselves by requiring the project company to maintain ratios and loan covenants for
maintenance of working capital, payment of dividends and build-up of cash. Lenders can
sweep the cash on a regular basis and use excess cash to repay principal or fund an
escrow account for future loan payments. The waterfall of accounts is addressed further
in Chapter 20.
10 Price of product
Where the project is to produce a commodity that is to be sold largely on the open market
rather than under any long-term contract, the lender must appraise the future market for
the commodity and make judgements as to whether such price projections are realistic. If a
project loan is made on the basis of cash flows to be produced by such price projections,
the lender obviously has assumed a commercial risk of the project. Lenders with particular
expertise in a commodity are sometimes willing to assume such a risk, so some banks may
specialise in, say, gold mining finance.
Another approach to shifting risk of commodity prices to lenders is to provide for
repayment of the loan to be based totally, or in part, on the future price of the commodity.
This arrangement has upside potential as well as downside risk for the lender. The risk is
certainly not a usual lending risk. In Chapters 24, 25 and 26 we describe instruments that
lenders can use to control this risk.
11 Enforceability of contracts for product

Even if a project is supported by take-or-pay contracts with adequate escalation clauses, a
question still arises as to whether the contract is enforceable, and whether the contracting
party is a reliable party that will live up to its contractual obligations. Possible force majeure
defences to performance must be considered. Should a loan be made, for example, on the
basis of a long-term contract to sell coal to a public utility is it possible that the responsible
public utility commission might declare the contract unenforceable at a later date? (Also, see
Chapter 2 under A market exists for the product, commodity or service on the problems
experienced by the Hydro-Qubec/Churchill Falls Labrador Corporation hydro-electric power
project and the Dabhol project case study by Piyush Joshi at the end of this book.)
An assessment of the financial strength and the ability and integrity of all contracting
parties to be able to meet their contractual obligations would form part of the projectapproval.
12 Price of raw materials and energy

Where a project is dependent on its ability to purchase raw materials or energy at a certain
price in order to produce its product at a competitive price, lenders may be willing to assume,
62

that such raw materials or energy will in fact be available at the projected cost on the basis
of their knowledge of the markets.
13 Enforceability of contracts for raw materials

If a project has long-term contracts for raw materials, that are used in the underlying financial
projections, a question still arises as to their enforceability and as to whether the contracting
party is reliable and will live up to the commitments. If the raw material is imported, the risk
of import restriction or force majeure events in the exporting country must be considered.
If the prices are attractive compared with the market, are they sustainable?
14 Refinancing risk
If the project is arranged on a basis whereby the shorter-term construction financing is to be
provided by one group of lenders, and the long-term financing package that follows on from
the completion of the construction phase is to be provided by another set of lenders, the
construction lenders run the risk of not being taken out by the long-term lenders. Construction
lenders prefer the long-term take-out financing package to be arranged at the time of the
construction loan. However, this is not always possible because of long lead times.
Construction lenders can protect themselves by providing incentives to sponsors to arrange
the long-term debt. This might be accomplished, for example, by gradually escalating interest
rates, by triggering additional sponsor guarantees, or by requiring a take out by thesponsor.
Project financings often tend to have the same group of lenders for both construction
lending and long-term lending.
A different form of refinancing risk, one that lenders have become increasingly more
concerned about, and that directly relates to refinancing the whole project, is the refinancing
of the project loan quite early in the project life, once the major risks of construction and
operation have diminished. The cause of concern is that lenders provide long-term finance
for a project on the basis that the lenders assume considerable risks in the projects early
stages but receive their reward over the whole life of the project loan.
A borrower, however, will be tempted to take the view that once the difficult part of
the project is over and the project is in a steady state, the risk profile is lowered and a
lower spread over the cost of funds is appropriate. So, borrowers may seek to refinance the
project at a lower interest rate comparatively early in the project life.
In order to ensure that the initial lenders receive the reward that they envisage at the
start of the project, where they may be agreeing to finance a project for, say, 20 years,
clauses may be inserted in the loan agreement to either forbid refinancing within a certain
closed period at the beginning of the project, or to permit refinancing but with a significant
payment to the existing lending group that will recognise their loss of potential earnings.
15 Force majeure risk

Force majeure risks are those types of risks that result from events beyond the control of
the parties to the project financing (see Chapter 2). The objective of lenders is to shift the
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Project Financing
various force majeure risks to the sponsor, or to the sponsors suppliers and purchasers
through contractual obligations or insurance protection. To the extent that those risks are
not shifted, the lenders have assumed force majeure risk.
16 Legal risk
The host country of the project may not be that of either the sponsor or the lender. Well-
developed case law for project finance has grown up in Western jurisdictions and this can
be problematic for projects where a host government is involved and may wish to use
local law that is less well developed in this area. It is important to have discussions about
the enforceability of agreements so that they are not written in such a way that they are
not valid and enforceable in the host country or the pertinent jurisdiction of the country.
Arbitration processes have improved enormously over the last 20 years and this route can
help resolve difficult situations. Lenders should always use a local counsel to double-check
that there are no conflicts between foreign and local perceptions of how the project and its
funding package will operate inside a host country.
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Chapter 6
Choosing a lead bank
Historically, project finance activity was centred in cities with major capital markets New
York, London and Tokyo. Additional specialist centres of industry banking expertise grew up
in locations that were important to certain industries such as Athens, Hong Kong and Singapore
for ship lending, Houston and Dallas for oil and gas lending, and Los Angeles for film finance.
Today, as the epicentre of economic growth has shifted way from the West, newer centres have
grown up to provide local knowledge and local funding but successful project financing still
requires good access to major capital markets and the support of large, experiencedbanks.
Although in theory, borrowers have a large choice of banks, not all banks are capable
of structuring and arranging complex project financings. Because banks tend to specialise in
particular activities, a borrower should choose carefully when selecting a bank for a major
banking relationship, either for conventional financing or for project financing. In Chapter 3
we discussed the separation of the roles of financial adviser and lead bank. Not all project
sponsors elect to do this, so the role of a lead bank may also encompass much of the finan-
cial adviser as well. If this is the case, then the governance issues around potential conflicts
of interest need to be transparent to all parties.
1 Factors to consider in selecting a bank

Pricing is an important criterion for most borrowers when choosing a bank. Bankers will
state privately that lenders seem little concerned with any other criterion. However, whilst
in the recent past competition was so intense that differences in pricing were small, some
evidence suggests that the supply of project finance is tight at the time of writing.
Some of the following factors should be considered when selecting a bank.
Size
If the project is a large one, the size of the bank should be related to the size of the project.
The bank should have sufficient lending capacity to take on a significant part of any loan
and the contacts to be able to arrange and deliver a successful syndication to the borrower.
This criterion shortens the list of the banks eligible for some kinds of projects.
Experience
The bank should be experienced. A lender does not want a bank that will run for cover
at the first sign of trouble. A bank experienced in financing the particular kind of project
involved is preferable, since it would already be familiar with specific issues and be alert to
any potential problems.
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Project Financing
Support
The borrower needs to feel confident that the bank will exert itself, and support the project
in the event of a credit crunch or any other events that may result in restriction of funds
available. Agreements routinely carry clauses about the availability of funds for the project.
Documentation
Documentation is always complex, involving covenants, negative pledges and ratio restric-
tions. However, lenders are under an obligation to protect their shareholders, and the skill
of the borrowers counsel sometimes results in longer and more complex documentation
than would otherwise be the case. Ultimately, the ratios and restrictive covenants are a
matter for negotiation. What a borrower is seeking is a lender who understands the needs
of bank shareholders and other stakeholders within the banking industry and can reconcile
these with the needs of sponsor shareholders and the other stakeholders within the project
without resorting to complex legal language and loan or equity covenants that may cause
future problems. The more complex the transaction and the more risks that needed to be
articulated and allocated to various parties, the lengthier the documentation, the longer the
negotiations and the higher the documentation costs. If documentation has to be produced
in different languages or negotiated to work within different jurisdictions, then that increase
in the numbers of parties to the transaction will also result in increased costs. Good project
finance bankers have experience in this area and can advise their clients appropriately whilst
also understanding the commercial pressures to conclude a transaction.
Working relationships
The borrower must feel comfortable that the lender will be realistic, flexible and positive in
finding solutions to problems, should some difficulty arise under the agreement. It is also
useful to ascertain at the outset how the bank will manage the relationship within a team
to ensure continuity, or with an individual relationship manager. Frequent staff changes
within banks, especially with complex deals, can be very frustrating for sponsors and other
stakeholders. Good project management techniques and sound documentation to allow for
handovers allow banks to offer the best form of good relationship management. Should
problems arise, the first resort should be to a good working relationship to develop a solu-
tion and only when this is obviously failing should there be resort to the more expensive
route of legal advice and redress.
Leaving management decisions to management

Borrowers require a bank that will not try to interfere in the day to day operations or
general management decisions of the project. Experienced loan officers, who may be excel-
lent at appraising credit risk, do not necessarily possess special skills in managing enterprises
with which they have had no operating experience. An enthusiastic lending officer is not a
project director by proxy. If additional management expertise is needed, lenders should seek
experienced outside help.
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Choosing a lead bank
Country exposure
In constructing their lending portfolios, banks utilise a portfolio management approach in
the same way that equity investors will construct their portfolio. This means that banks will
have limits for their credit exposure to loans in a particular country, particularly developing
countries. (There are also often limits for loans to particular sectors such as real estate.) The
borrower should make sure the lender has the capacity to complete the transaction within
its credit limits.
2 Choice of a sponsor by a bank

Having critically reviewed the factors a sponsor should consider in selecting a bank, it is
only fair to also discuss the characteristics a bank seeks in a sponsor.
Bankers view their spreads and profits from lending as being barely sufficient for survival.
Since inexperienced bankers may not differentiate the risks of project financings from conven-
tional financings, the risk-reward ratio assumes even greater problems for a sophisticated
lender in a project financing. This is not to say that experienced banks do not want to
participate in project financings. However, it does mean such banks prefer doing business
with sponsors and projects that will succeed.
The characteristics of a successful sponsor are as follows.
1 The feasibility study and financial planning are professional and thorough.
2 The contractor and operator are experienced, have good track records and are known
for their integrity.
3 The market for the product and/or service to be produced by the project is assured.
4 Political problems and country risk problems are recognised, continually appraised and
controlled within mutually agreed limits.
5 The identity, the authority and continuity of the project manager and of the project
management team are clear from the outset.
6 If the sponsor is a joint venture, the individuals who have the authority to negotiate the
financing package on behalf of the joint venture with the lender should be clearly identi-
fied and their negotiating capacity and delegated authority concerning the joint venture
clearly articulated. In some cases, each partner may wish to be present at the negotia-
tions, in others one partner may represent all the joint venture partners and internal
discussions between the partners are conducted away from the main bank negotiations.
A single joint venture partner may have some delegated authority to agree to pre-defined
terms on behalf of the others.
7 The continuity of the operating and financial management is assured over an extended
period that runs beyond the end of the project loan life.
8 The management of the project has an excellent reputation.
9 There is confidence that communication with management will be excellent and that all
pertinent financial and production information will be furnished in a pre-agreed format
and on a timely basis.
10 The sponsor should be of some financial substance.
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Project Financing
11 The sponsor should be motivated by adequate projected profits made available through
dividends to make the project succeed.
12 The sponsor has past experience in successful project financings and is aware of the
kinds of problems that may arise and how they might be resolved.
Whilst the lead bank may make the decisions about how a syndicate of lenders may be put
together, the borrower should also try to retain some input to these decisions. Ideally, the
way a loan should work would be that all communications would be channelled through the
lead bank to the other members of the syndicate, but many banks may join a syndicate in the
belief that this will allow them to develop a direct relationship with the sponsoring company
and press to have access to the sponsor. In a large syndicate, with bank staff turnover every
two years or so, this can put an enormous reporting burden on the sponsoring company and
the project company. All of this adds to the projects cost structure. By employing techniques
such as a record of project decisions and the history of the negotiations, the education of
all new project staff or staff in lending banks new to the project or even other external
advisory staff can be accelerated, allowing for those costs to be managed.
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Chapter 7
Contacting lenders and investors
As the first step in locating sources of finance (both lenders or investors) for a proposed
project financing, the project company (or its sponsor and its financial adviser which may
of course be a bank) should develop a list of potentially interested lenders and investors.
Once the list is formulated and refined, the company or its adviser should contact
investors and lenders in the order of their expected probable interest. These contacts can be
made by telephone, email or in person. Obviously a personal contact is most effective and
is essential in most cases to engender trust.
The purpose of the initial contact with an investor or lender is to present the project
by using the offering memorandum and to motivate the investor or lender to focus on
the proposal in order to determine whether the lender or investor has an interest in the
proposed financing. As indicated in Chapter 4, the offering memorandum is a selling docu-
ment and it should describe the proposed financing in sufficient detail to enable the lender
or investor to determine their interest in the transaction. Normally there would be a short
presentation followed by a question and answer session. The presentation is a marketing
opportunity but also needs to be accurate and truthful and not oversell or mislead, so an
excellent presentation can get the lender or investor interested in reading and considering
the offering memorandum and a poor presentation will have the opposite effect.
1 Following the first contact

After reviewing the offering memorandum, the lender or investor will be in a position to
discuss their views on the proposed financing. Presentations like this are like job interviews.
The parties are entering into what each hopes to be a longer term relationship with mutual
benefits, so the same three areas that govern any joint venture partner selection choices
apply here too task, relationship and context drivers all need to be compatible. Both
sides need to feel they can trust each other in good times and in bad, as that trust will
support the resolution of any problems that may arise without resorting to the letter of
the contracts.
As the next step in building this relationship, the interested lender or investor will typi-
cally want to visit the sponsoring company to meet management, tour the facilities and pose
questions resulting from the preliminary analysis. This visit presents an opportunity for the
company to assess the lender and to determine whether a good working relationship can
be developed between both parties. The company should determine whether the lender is
familiar with the companys industry and understands its problems. The company should
probe the lender to characterise its policy regarding restrictive loan covenants and modifica-
tions of loan agreements.
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Project Financing
Project financing is a two-way street. Because the project companys relationship with
its lenders will be long term, choosing a lender is an important decision that should not be
dominated by a desire to obtain the lowest possible interest rate.
2 Structuring the transaction and contact points

After the initial meeting, the lender or investor will complete its credit analysis (discussed in
Chapters 8 and 9) and seek internal credit approval. If there are a number of banks involved
then the lead bank will have decisions to make about underwriting a transaction (with the
acceptance of the associated risks) or waiting till all participating banks have received final
approvals more on this below under 3 Preparing the documentation. The lender and
investor interested in proceeding with the loan or investment will then be prepared to enter
into final negotiations with respect to rate and terms. Several meetings are usually necessary
in the case of complicated financings. When an understanding has been reached, the lender
will usually confirm the negotiated rate and terms by using a commitment letter signed by
both parties that indicates that final agreement is subject to approval of the project compa-
nys board of directors, the lenders (or investors) approval committees and the execution
of mutually satisfactory loan documentation. The time required for approval is a function
of the complexity of the project financing but also due account needs to be taken of the
possibility of delays due to holidays, absences and so on.
3 Preparing the documentation

Once the lenders or investors loan or investment committee approves the proposed financing,
preparation of the loan agreement and other closing documentation begins. Usually, this
involves several meetings and exchanges. Normally, the following parties are participants
in these exchanges.
1 The senior financial officer for the project company.

2 Other key members of the companys management as may be appropriate.
3 Company legal counsel and outside legal counsel if necessary.
4 Representatives of the lead lending bank and other major funding providers including
those banks taking large tranches of the loan.
5 Staff legal counsel of the lender or investor.
6 Special outside counsel for the lender or investor.
In addition to its own legal fees, the project company usually is responsible for the fee of
the lenders special counsel, appraisal fees and printing costs (if applicable).
4 Syndication
Many large proposed project financings approach the lending limits of a lender, so it is
in the best interests of the borrower to split the loan among a number of lenders so that
they can share the risk, as well as to establish multiple banking relationships so there is
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Contacting lenders and investors
no dependence on a single bank. It also allows the bank group (and indeed all the project
stakeholders involved in the financing) to develop good working relationships with a view
to providing additional financing for the sponsors operations if required in the future. The
inclusion of more than one set of views of the transaction can enhance the understanding
of it for all parties, since each provider of funds will have a slightly different approach to
the transaction.
The process of dividing up a financing package is termed syndication and is now used
in many debt and equity contexts, though its origin was in the syndicated loan markets.
Syndication can take several forms and there are a number of specialist roles.
To begin with, a bank can bid to underwrite the entire financial package or a given
layer of it as we shall see later, many project financings have multiple layers of debt
and/or equity. This bought deal approach means the successful bank bidder assumes the
underwriting risk and is reliant on its own capacity to absorb the transaction or its ability
to find other bank participants. Bought deals will specify terms and conditions, including
pricing, and there are examples of banks being unable to find takers for a specified deal
at the negotiated price. In one case, the sponsors agreed to renegotiate but the failure to
syndicate successfully the first time around delayed the project start up. As a consequence,
the bank concerned lost credibility in the market.
Alternatively, a bank might agree to assume a role where it agrees to put a syndicate
together on a best efforts basis. Managing and co-ordinating the syndication process (and
possibly even carrying some underwriting risk, dependent on the deal), is called book
running. The bank that arranges or structures the deal is called the arranging bank, and
may or may not be the same as the advising bank.
Howsoever the process begins, once there is a need to talk to other banks, the loan
is then split into tranches or layers with different reward packages attached to different
sized pieces. So the larger the piece or tranche, the greater is the potential reward. Voting
power on syndicate matters is also linked to tranche size. Dependent on the size of tranche
taken by each participant, there may be lead managers and other roles. Other rewards
come to banks with specialist roles such as co-ordinating the funding, acting as a refer-
ence for pricing purposes, and acting as a provider of specialist expertise. Clearly there
can be possibilities for conflicts of interest and these should be declared as part of good
governance processes.
Finding banks to participate can involve allies or even rivals of the lead bank; some
sponsors use the opportunity to build closer relationships with banks that support them in
other areas of their activities. Some sponsors have built US and UK syndicate groups that
know the sponsor well and can therefore react quickly to project finance requests. Getting
a new bank familiar with a sponsor takes time and can delay credit approvals. Syndicates
should not be overly large as the group needs to react swiftly to events in the project.1
Documentation negotiations can also take several forms the days of the documenta-
tion coming from the sponsors lawyers and banks being ordered to sign it are largely in
the past. No sponsor wants significant delays and petty negotiations from naive lenders
that would delay the project. However, lenders will always have somewhat different views
regarding the terms that make negotiating the financing package more time-consuming and
subsequent changes more difficult.
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Project Financing
Finally, communication mechanisms with the project company and/or the sponsor need to
be clarified early. Costs rise if a member of staff needs to be hired just to deal with commu-
nications with syndicate members and whilst the ideal might appear to be that everything
is channelled through the lead bank, syndicate members also like to feel they have a direct
relationship with the project company and the sponsors.
1
More details of the loan syndication process can be found in Rhodes, T, Syndicated Lending: practice and docu-
mentation, 5th edition, 2009, Euromoney Books.
72

Chapter 8
Credit risk appraisal
The objective of financial analysis by a lender or investor contemplating supplying funds to

a project company varies according to the specific interests of the party involved.
1 Stakeholder interests
A trade creditor is interested primarily in the liquidity of a firm.
A term lender, on the other hand, with a long-term credit exposure is more interested in the
internally generated cash flow ability of the project company to service debt over the long run.
The term lender evaluates this ability by analysing the capital structure of the firm, the major
sources and uses of funds, its profitability over time and its projections of futureprofitability.
An investor in a project companys common stock is concerned principally with present
and expected future earnings and the stability of these earnings over time. As a result, the
investor will concentrate analysis on the profitability and specifically the earnings before
interest, tax, depreciation and amortisation (EBITDA) and cash flows of the company. The
investor will be concerned with its financial condition in so far as this condition affects the
stability of future earnings.
The management of a project company will also be interested in the performance metrics
that trigger additional rewards to them, so these need to be disclosed to external financial
stakeholders such as lenders and investors. In the UK, recent revelations about reward asym-
metries within the Public Private Partnership capital project financing schemes (see Chapter
30) where the sponsor made what was perceived to be excessive profits whilst wards in
hospitals financed under this scheme were being closed suggest this area of stakeholder atten-
tion needs to be addressed in each project. Managers should be interested in all aspects of
financial analysis that external stakeholders, including suppliers of capital, use in evaluating
the company. In addition, the management of a project company should employ similar
financial analysis for the purposes of internal control and profitability on investment in the
various assets of the company.
2 Credit analysis from the standpoint of a term lender

From an analytical point of view, banks generally prefer a strong, sound balance sheet as a
starting point for providing term financing to a borrower. However, project companies are
by their nature highly leveraged. Consequently, in a proposed project financing the future
anticipated internally generated cash flow (EBITDA) is extremely important since that is
the source from which loan repayments will be made. Thus, stability and growth in sales
revenues and stability in expenses and profitability relationships to sales are very important
in term lending and especially project financing.
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Project Financing
The lender must thoroughly analyse the market and competition for the borrowers
products, relations with suppliers, sources of raw materials or critical components and the
stability of important cost components of the borrowers operation. Such historic analysis
is important only as it bears on the future when cash will need to be generated to repay
the loan.
Likewise, projections of future sales, earnings, cash flow and balance sheets are critical
in evaluating the prospects for a term borrower in a project finance situation. The assump-
tions used in preparing the projections are as important as the numbers themselves. The
lender needs to review the projections critically and to think through and test the validity
of the underlying assumptions.
In reviewing projections, it is important to look at total cash needs of the enterprise.
Loan payments and capital expenditures are significant cash requirements. A most common
error made by term lenders in project financing is to provide funds to acquire fixed assets,
but fail to provide adequate working capital funds for the trading assets necessary to support
the sales the new fixed assets will generate. This is just one of the reasons why it is very
important to break the cash flow down at the beginning of the project so that within period
funding peaks can be managed with correctly specified working capital facilities. It is easy
to overlook cash needed to fund increased receivables and inventory to support sales growth
or to recognise that utility bills and salaries need to be paid before first cash flow appears
in the bank account.
In its credit analysis of a prospective borrower, a bank will consider both general manage-
ment issues and detailed financial data.
3 General considerations in credit decisions

Management
The overall assessment of managements capability is extremely important in assessing credit
risk for a project company. What are the managements objectives and how do they plan
to achieve them? What are managements financial and operating policies? If the present
management team has worked together in the past, has it been effective in implementing
such policies? Has management provided for unforeseen events? How is the management
being rewarded?
Level and stability of earnings

Project companies must demonstrate an ability to generate good revenues consistently and
to maintain adequate coverage and margins. The relationship between the level and stability
of future earnings and the total amount of long-term debt outstanding (existing debt + new
issue + estimate of subsequent debt financing) is important in reaching a credit decision.
Stability of earnings is generally more important than the earnings level. A project company
with modest but relatively predictable future earnings will be viewed more favourably than
a project company with high but volatile returns.
74

The industry
Where does the project company rank within the industry: (i) what are the trends within
the industry and economy; (ii) the companys position within its industry; (iii) competition;
and (iv) past performance, if applicable? It is often interesting to plot a new project on a
cost map for projects of this type (that is, to compare a new gold mine and production
costs with production costs from existing gold mines to investigate sustainable competi-
tive advantage).
Financial resources
A project companys current liquidity is important. Cash flow relationships and current
assets are important both from the standpoint of relative size (for example, current ratio,
net current assets) and of quality (for example, inventory turnover, receivables turnover,
accounting procedures used to value inventories and receivables).
Asset protection
This might be called collateral protection. Total long-term debt/net plant and net
tangible assets/total long-term debt are calculated to determine the degree of protection
afforded by the companys assets. The emphasis placed on asset protection varies with the
nature of the industry. For example, it may be very important for real estate or natural
resource companies.
Indenture provisions
Existing and proposed indenture provisions relating to any bonds issued must be reviewed
to determine the repayment schedule in the event of liquidation and whether management
retains sufficient freedom of action to react to changes in the competitive environment without
violating the terms of issue.
Guarantees and securities

When specific guarantees (for example, parental guarantees, bank letters of credit) exist or
the debt is secured by a lien on tangible assets, further analysis is necessary to determine
the value of these guarantees or liens.
Cash trap
Willingness to dedicate part or all of cash flow from the sale of the projects product or
service to the payment of interest and principal on debt through the use of an escrow account
designed to capture the cash flow before it reaches the project company.
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Project Financing
4 Financial ratios
Financial ratios are important in project finance because they offer a mechanism for main-
taining the financial shape and structure of the project company and possibly of the guarantors
as well.1 These ratios would be clearly defined inside any loan agreement and would form
part of conditions precedent tests prior to drawdown and maintenance tests in the form of
regular covenants that the ratios continue to be met.
The analysis of financial ratios involves two types of comparison. First, the analyst can
compare a present ratio with past and expected future ratios for the same company. The
second method of comparison involves comparing the ratios of one firm with those of similar
firms or with industry averages at the same point in time. General financial ratios for various
industries are published by DataStream, Reuters, credit rating agencies, trade associations, in
stock analysts reports and are also available through services such as Bureau van Dijk and
its FAME and OSIRIS databases.2
Financial ratios can be divided into four types pertaining to liquidity, debt, profitability
and coverage. The first two types are ratios computed from the balance sheet; the last two
are ratios computed from the income statement and, sometimes, from both the income state-
ment and the balance sheet.
Liquidity ratios
Liquidity ratios are used to judge a firms ability to meet short-term obligations. One of the
most general and most frequently used of these ratios is the current ratio:
Current assets
Current liabilities
The higher the ratio, the greater the ability of the firm has to pay its bills. However, the
ratio does not take into account the liquidity of the individual components of the current
assets, such as inventory, receivables and so on.
The acid test ratio is a more accurate guide to liquidity and is expressed as follows:
Current assets less inventories

Current liabilities
Since this ratio excludes inventories, it concentrates on cash, marketable securities and
receivables in relation to current obligations and, thus, provides a better measure of liquidity
than the current ratio (though clearly if the inventory is in the form of gold bars, it is as
good as cash).
Of course, other components of the current ratio or acid-test ratio require verification.
These include the liquidity of receivables and inventory. These must be viewed in relation
to industry experience.
76

Debt/leverage ratios
Debt ratios are used to measure the long-term liquidity of industrial companies. Several debt
ratios may be used. The debt/net worth ratio is computed by simply dividing the total debt
of the firm (including current liabilities) by its net worth:
Total debt
Net worth
When tangible assets are significant, they frequently are deducted from net worth to obtain
the tangible net worth of the firm, which would form part of the profitability ratios. However,
project companies are typically highly leveraged and coverage ratios are a more appropriate
method of analysis.
Profitability ratios
Although project companies may be, by definition, start-up companies, even if in a well-known
field of operation, and the emphasis in this book is very much on cash flow, profitability
ratios are also important in two areas:
for the financial health and longevity of the project company itself; and
for the financial health and longevity of the sponsor companies.
The term profitability ratios covers a number of ratios that have differing importance in
the different industries where project finance is used, but several ratios are key indicators
such as the percentage of operating expenses, or gross margin:
Operating expenses
Net sales
...and other ratios looking at the progression of profitability as money moves down the
income statement.
Other traditional ratios that are of interest to project financiers include those around
return on capital employed:
Profit before interest and tax

Capital employed
...or a measure of return on assets, for example, total assets:
Profit before interest and tax

Total assets
The positive and negative covenants traditional in project financings will normally preclude
asset sales or sale and leasebacks without prior consultation with the banks. There are also
clauses about not disposing of assets or indeed purchasing further assets without prior consul-
tation with the banks. Finally, there are often clauses about an obligation not to decrease
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Project Financing
the equity in a company or to issue any new shares without prior consultation with the
banks, and very often those new shares may be pledged in favour of the banks as part of
the security package. Less visible may be covenants restricting the granting of credit to third
parties or guarantees to third parties where these would of course be reported in the notes.
Coverage ratios
Coverage ratios are designed to relate the financial charges of a firm to its ability to service
them. Bond rating services make extensive use of these ratios. One of the most traditional
of the coverage ratios is the interest coverage ratio:
Cash flow in a given year

Interest payable in that year
...or simply the ratio of earnings before interest and taxes for a particular reporting period
to the amount of interest charges for the period. It is important to differentiate which
interest charges should be used in the denominator. The overall coverage method stresses
the importance of a companys meeting all fixed interest, regardless of the seniority of
the claim.
One of the principal shortcomings of an interest coverage ratio is that a firms ability to
service debt is related to both interest and principal payments. These payments are not out
of earnings per se, but out of cash. Consequently, a more appropriate coverage ratio relates
the cash flow of the firm (approximated by earnings before interest, taxes, depreciation and
amortisation) to the sum of interest and principal payments. The cash flow coverage ratio
may be expressed as:
Annual cash flow before interest and taxes

Interest + principal payments [1/(1 income tax rate)]
Because principal payments are made after taxes, it is necessary to adjust this figure by [1/
(1 income tax rate)] so that it corresponds to interest payments, which are made before
taxes. If the tax rate is 34% and annual principal payments are US$100,000, before-tax
earnings of US$156,250 would be needed to cover these payments.
A broader type of analysis would evaluate the ability of the firm to cover all charges
of a fixed nature in relation to its cash flow. In addition to interest and principal payments
on debt obligations, preferred stock dividends, lease payments and possibly even certain
essential capital expenditures are included. An analysis of this type is a far more realistic
gauge than a simple interest coverage ratio in determining whether a firm has the ability to
meet its long-term obligations.
Common examples of these ratios will include the loan life cover ratio:
Operating cash flow

Outstanding debt
78

Or variations of forms of a debt service cover ratio, which is calculated on an annual basis:
Operating cash flow for a given year

Interest and principal payments for that year
5 Commercial debt ratings

The use of public bond markets for project financing outside the United States has increased.
To allow investors to have an indicator of risk, such issues will often carry a rating assigned
by one or more recognised rating companies that gauge the creditworthiness of the issue. The
major international credit rating companies for project finance are: (i) Standard & Poors;
(ii) Moodys Investors Service; and (iii) Fitch Ratings.
The rating systems use similar symbols, as shown in Exhibit 8.1.
Exhibit 8.1
Summary of corporate bond rating systems and symbols
Moodys S&P Fitch

Aaa AAA AAA The obligors capacity to meet its financial commitment on the obligation is
extremelystrong.
Aa1 AA+ AA+ An obligation rated AA differs from the highest rated obligations only in
Aa2 AA AA small degree. The obligors capacity to meet its financial commitment on the
obligation is verystrong.
Aa3 AA AA
A1 A+ A+ An obligation rated A is somewhat more susceptible to the adverse effects
A2 A A of changes in circumstances and economic conditions than obligations in
higher rated categories. However, the obligors capacity to meet its financial
A3 A A
commitment on the obligation is stillstrong.
Baa1 BBB+ BBB+ An obligation rated Baa or BBB exhibits adequate protection parameters.
Baa2 BBB BBB However, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity of the obligor to meet its financial
Baa3 BBB BBB
commitment on theobligation.
Ba1 BB+ BB+ An obligation rated Ba or BB is less vulnerable to non-payment than
Ba2 BB BB other speculative issues. However, it faces major ongoing uncertainties or
exposure to adverse business, financial, or economic conditions that could
Ba3 BB BB
lead to the obligors inadequate capacity to meet its financial commitment
on theobligation.
B1 B+ B+ An obligation rated B is more vulnerable to non-payment than obligations
B2 B B rated BB, but the obligor currently has the capacity to meet its financial
commitment on the obligation. Adverse business, financial, or economic
B3 B B
conditions will likely impair the obligors capacity or willingness to meet its
financial commitment on theobligation.
(Obligations less than B are highly speculative or in work out.)
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Project Financing
The two most widely used systems of bond ratings are those of Standard & Poors and
Moodys. In both systems the term high grade means low credit risk, or conversely, high prob-
ability of future payments. The highest grade bonds are designated by Moodys by the letters
Aaa, and by Standard & Poors by AAA. The next highest grade is Aa or AA; for the third
grade both rating agencies use A. The next three grades are Baa or BBB, Ba or BB, and B,
respectively. There are also C grades. Standard & Poors uses plus or minus signs to provide
a narrower credit quality breakdown within each class, while Moodys uses 1, 2, or 3 for the
same purpose. Bonds rated triple A (AAA or Aaa) are said to be prime; double A (AA or Aa)
are of high quality; single A issues are called upper medium grade, and triple B are medium
grade. Lower rated bonds are said to have speculative elements or be distinctly speculative.
The new Basel Capital Accord encourages this form of external benchmarking to allow
financial institutions to make externally validated decisions about the quality of theirassets.
Bond issues that are assigned a rating in the top four categories are referred to as invest-
ment grade bonds. Issues that carry a rating below the top four categories are referred to
as non-investment grade bonds, or more popularly as high yield bonds or junk bonds.
Thus, the corporate bond market can be divided into two sectors: the investment grade and
non-investment grade markets.
This becomes important when considering which financial institutions may be eligible
to invest in a project. Certain large investors such as pension funds may be restricted in the
grades of debt in which they can invest.
The process of rating debt requires the rating agency to become an insider and to have
access to very detailed information about the project and the sponsor companies. Thus the
rating process takes time and is a further project cost. Some projects may seek a shadow
rating to seek an opinion on the debt which is commissioned but not made public this can
be helpful to a projects financial management in looking at the longer term and converting
bank finance into a possible public debt offering, potentially reducing costs. Some traditional
lenders do not believe that a single rating can be used to assess all the risks associated with
a project. According to one source:
You cannot rate a project with a group of numbers or letters. There are too many risks.
A project is only as good as its weakest link. And that will be the ultimate problem.
What will they do when the project goes wrong?3
Whilst rating agencies are important stakeholders in project finance, the rating process
also operates at the country level. As a result, providers of funds will look at country and
sovereign risks as well as project specific risks when making a decision to support aproject.
1
For a more detailed discussion of financial ratios, see Drake, PP, and Fabozzi, FJ, Analysis of Financial Statements,
3rd edition, 2012, John Wiley & Sons, ch. 4.
2
See endnote 1.
3
The lure of the bond markets, Project & Trade Finance, May 1994, p. 42.
80

Chapter 9
Risk analysis of a project loan
When considering the impact of granting a project loan on the banks overall portfolio of
loan assets, banks employ a loan classification system. This system involves assigning project
loans to different credit quality categories based on the projects perceived risk and other
relevant attributes that in the experience of the banking community have been found to be
important for assessing the likelihood of default.
During every examination cycle, bank regulators review a banks loan portfolio. In the
United States, for example, the Office of the Comptroller of the Currency (OCC) is the
primary supervisor for nationally chartered banks (state chartered banks are under state
banking departments). The three primary objectives of these reviews are:
First, examiners assess whether the bank has adequate systems to identify, measure,
monitor, and control the amount of credit risk in their loan portfolios. A key component
of such systems is the process that the bank uses to monitor and rate the relative
risk of their loans. Second, examiners assess whether the banks financial statements
accurately reflect the condition of its loan portfolios and conform to generally accepted
accounting principles (GAAP) with regard to loan loss reserves, the accrual of interest
income, and the reporting of troubled debt restructurings. Third, examiners assess
whether the bank has adequate capital cushions to support the banks lending activities
and credit risk exposures.1
Although bank regulators have a standardised system that they mandate banks use for
reporting purposes, the loan classification system that banks use for internal purposes is
more complex.2 An example of such a risk classification system is an internal risk rating
system for assessing the probability of default. Although more complex, in practice banks
try to enforce consistency with the regulatory system, especially at the demarcation point
between pass and non-pass loans. Banks then use their internal risk classification system
for analysis, comparison and pricing of loans.
The purpose of this chapter is to provide project sponsors with an overview of the factors
considered by banks in classifying loans. In the final analysis, however, competition and the
desire for business determine pricing and terms. Nevertheless, comparing loans, pricing and
terms through use of a risk analysis provides an objective starting point for appraising risk
and commencing negotiations for a project loan.
1 Credit risk in a project loan

In its broadest sense, the definition of credit risk in a project loan is the possibility of
failure to obtain liquidation of the loan according to its original terms. This could entail the
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Project Financing
possibility of a loss of all, or some portion of, principal or earned interest or the deferral of
either. There are, however, other ancillary project loan risks. These include:
the likelihood of a work-out;

the need to advance additional funds to reinforce the original loan;
a conversion of principal and/or interest to another form of obligation or security; and
a simple modification of the original loan terms.
The element of risk attaches to a project loan subject to a successful work-out with full
recovery, because such a loan still entails an opportunity loss from excessive demands on loan
officer and senior management time, legal and collection expense, the risk of litigation, time
value of money loss due to delayed payment, and possible damage to the lendersreputation.
Since risk assessment is largely a function of judgement, there are limits to the degree of
uniform results that can be expected. The heavy reliance on judgment is something characteristic
of project finance, where each project has unique properties and is not always easy compare
to other projects.3 However, it is possible, through a careful assessment of risk classification to
at least ensure that the same risk-related factors will be considered by all bank lending officers
for all loans, even though the degree of applicability of each factor will vary from case tocase.
2 Purpose of a risk classification system

A risk classification system is designed to assist lending officers in assessing the degree of
risk inherent in an existing or prospective credit. Since risk should be a major variable in
loan pricing and loan terms, such a classification can also be a useful standard in arriving
at pricing decisions and loan terms commensurate with the risk of loss. Such a classification
system will also be helpful when comparing project financing loans with conventional loans
to established companies.
The risk classification system does not replace judgement. The lending officer is provided
with a relatively comprehensive description of risk criteria, and must determine in each case
which factors are relevant and to what degree they are operative (that is, the relative weight
assigned to each of the risk factors).
Although the risk classification criteria (discussed below) focus essentially on the charac-
teristics of the borrower (and other key stakeholders in the case of project loans), the purpose
of the system is to classify loans. However, in most cases, classification of the borrower,
sponsors or other key stakeholders such as offtaking companies, chartering companies or other
providers of financial support will assist in determining the classification of the the loan. On
the other hand, in a number of instances there will be circumstances (for example, formal
guarantees, collateral, loan terms) that will give rise to a different rating for a project loan
than for the borrower factors that influence recovery risk apart from the risk of borrower
default. In limited instances, where two or more loans have been made to the same borrower
under different terms, split classifications may be appropriate.
The risk classification system that we present in this chapter is intended to ease the
application of risk criteria to specific project loans. It would be extraordinary for a given
borrower to fall within the same risk classification on all the criteria listed.
82

Obviously the borrowers financial condition should receive primary consideration when
appraising credit risk and its ability to repay a loan and live up to the terms of the loan
agreement. If there is any doubt about the loan being repaid, the loan should not be made.
The risk classification analysis is aimed at determining the ancillary risks and the effect such
risks should have in appraising the desirability of a loan, and the pricing and terms of theloan.
3 Risk classification criteria

Principal factors:
Industry:
structure and economics;
maturity; and
stability.
Company:
general characteristics;
management;
financial condition;
capital sources; and
financial reporting.
Risk classification modifiers:

agreement;
collateral; and
guarantees.
Criteria
Industry
Structure and economics:
competition (monopoly, oligopoly, strength of supplier and the like);
role of regulation and legislation;
importance and stature of industry in the economy;
degree of control exercised by industry participants over demand and selling prices; and
industrys economic dependency on other industries or governments.
Maturity:
stage of industrys life cycle;
ease of entry; and
rate of capacity additions.
Stability:
sensitivity to business cycles;
sensitivity to credit cycles;
supply/demand balance;
vulnerability to technological innovation;
vulnerability to production and distribution changes;
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Project Financing
susceptibility to changes in consumption patterns; and

mortality rate.
Company or project
General characteristics:
position and role in industry hierarchy (for example, leader);
absolute size and size relative to industry standards by sales, assets, profits;
market share;
scope, in terms of both markets and products;
diversification of revenue sources;
reputation and record of accomplishment;
control over availability and price of supplies and raw materials;
vulnerability to uncontrollable or unpredictable events (for example, acts of God); and
product characteristics differentiation, substitutes, patents, brand loyalty and so on.
Management:
industry experience;
managerial breadth and qualifications;
managerial depth and turnover rate;
calibre and structure of board;
management controls and forward planning; and
management reputation.
Financial condition:
debt and capitalisation ratios;
liquidity ratios;
cash flow and coverage ratios;
profitability ratios;
quality of assets; and
quality of earnings.
Capital sources:
equity:
access to both public and private markets or just private;

degree of public ownership;
breadth of ownership; and
liquidity and stability of market for equity securities; versus market demand for
companys stock;
long-term debt:
access to both public and private markets or just private;

bond rating(s); and
investment demand for companys issues;
commercial paper:
commercial paper rating;

existence of back-up lines; and
investment receptivity and secondary market liquidity;
84

commercial bank relationships:

size and stature of lead bank;
dependence on single or few banks; and
strength of relationships;
investment banker:
stature and size of investment banking firm; and

scope, size and financial condition.
Financial reporting:
acceptability and soundness of accounting practices;
reputation and stature of audit firm; and
audit opinion (the quality of that assessment is covered in the above point).
Modifiers
Agreement:
type:
current line;
revolving credit;
term loan; and
other;
security provisions;
repayment or amortisation provisions;
restrictive covenants;
lender position in credit (lead bank, uninfluential position); and
quality and reputation of other lenders.
Collateral:
type:
certificates of deposit:
i lender; and
ii other bank;
short-term governments;
long-term governments;
municipals;
corporate bonds;
equity securities:
i common stock; and
ii preferred stock;
accounts receivable;
inventories:
i finished goods;
ii in-process;
iii raw materials; and
iv commodities;
fixed assets:
i real property;
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Project Financing
ii plant; and
iii equipment;
valuation considerations:
securities:
i marketability: national exchange, OTC, market demand;
ii price stability;
iii registration;
iv quality of obligor; and
v transaction costs;
accounts receivable:
i type of receivables (corporate, government, individual);
ii quality of debtors;
iii warranties, contingencies; and
iv audit (frequency of monitoring and reporting);
inventories:
i marketability;
ii conversion costs and sales commissions;
iii obsolescence risk;
iv perishability risk;
v physical location; and
vi audit;
fixed assets:
i physical condition;
ii marketability;
iii sales commissions;
iv movement expenses;
v conversion costs;
vi transferability of title (legally, practically);
vii physical location;
viii liens or assignments; and
ix obsolescence risk.
legal considerations:
UCC filings versus dominion over collateral;

perfection of liens; and
conflicting liens.
Guarantees:
collateralised or uncollateralised; and
enforceability (legal jurisdictional considerations).
4 Description of risk classification grid

Exhibit 9.1 shows a risk classification criteria grid. The columns of the grid are the quality
category and we describe each below. The rows show the risk classification criteria as
explained in 3 Risk classification criteria.
86

ProjectFinancing.indb 87
Exhibit 9.1
Risk classification criteria grid
Industry Highest quality 1 Highest quality 2 Good quality 1 Good quality 2 Good quality 3 Fair quality
characteristics
Structure and Monopoly or tight Oligopolistic with Limited number of Diminishing degree Numerous Highly fragmented
economics oligopoly with limited or restrained firms with moderate firms engaged with unhealthy
minimal competition competition competition in unrestrained competition
competition
Regulatory and/ Regulation and/ Diminishing degree Regulation Regulatory and/ Regulatory and/
or legislative or legislative insignificant or or legislative or legislation
environment environment neutral environment mildly heavy handed and
supportive as a result supportive, or at least unfavourable detrimental
of a strong lobby not restrictive
Essential industry Major industry Important industry Moderately important Fringe industry of Non-essential
industry modest importance industry subject
to sharp demand
decline
Seller has substantial Seller has some price Diminishing degree Supply, demand and Diminishing degree Buyer controls both
control over demand discretion and is able price are determined demand and price
and price to influence demand by an auction-type
free market
No interdependence Diminishing degree Normal supply Diminishing degree Limited Exceptional
on any other single and sales interdependence on dependence on
industry interrelationships another industry another industry
but no concentrated
interdependence
Maturity Mature industry Diminishing degree Maturing industry Maturing industry Immature or overly
approaching or at, past shake-out stage just completing mature industry
but not past, peak of and beyond major shake-out stage or subject to growth
life cycle growth problems fully matured but problems, shake out
not yet in significant or decline
decline
Continued
18/06/2012 07:50

characteristics
Prohibitive barriers Strong entry barriers Diminishing degree Moderate entry No entry barriers Exceptionally easy
to entry with very few new barriers with some entry
entrants regular entry
Stability Not affected by the Generally regarded Sales and profits Sales and profits Could have trouble Highly cyclical
business cycle as well insulated moderately affected sensitive to a serious during a serious characterised by
against recession by recession recession but actual recession boom and bust
confined to small losses periods
part of industry
Not susceptible Has initiated and Such changes as Diminishing degree Susceptible only Highly susceptible
to production or benefited from such do occur do not to unanticipated to production or
distribution changes changes threaten the industry revolutionary distribution changes
changes
Favourable supply/ Favourable supply/ Supply and demand Supply and demand Some excess capacity Chronic unfavourable
demand imbalance demand imbalance in balance except in balance during even during normal supply/demand
at all times except during during serious normal times times imbalance reflecting
recession recession substantial excess
capacity
Mortality rate zero Negligible mortality Failures confined Diminishing degree Mortality rate High mortality rate,
rate to newest, smallest moderate compared perhaps reflecting
firms and limited to other industries some external factors
exclusively to internal and stable, or
factors somewhat lower but
increasing
Not susceptible Significant control Pattern changes Pattern changes Pattern changes Dramatic
to change in over changes evolve only over sometimes difficult to predict revolutionary
consumption in consumption extended periods unpredictable but creating some changes occur
patterns or patterns permitting ample industry has good uncertainty in consumption
introduction of response record of response patterns rendering
substitute products adequate response
highly uncertain
18/06/2012 07:50
characteristics
Company
characteristics
General The leader in its Highly regarded Diminishing degree Held in normal Undistinguished Poor reputation
industry major factor regard stature
Highly dominant and Co-operation Co-operation of Diminishing degree Incapable of Diminishing degree
influential within its important to most firms in this independent action.
industry the successful category required Reacts to initiatives
promulgation of new to promulgate new of others
initiatives within initiatives but no
industry has veto single firm has veto
power power
One of the very Diminishing degree Medium-sized Diminishing degree Small
largest in terms of
sales, profits and
assets
One of the largest Diminishing degree Either one of larger Average market share Slightly below Small market share
market shares market shares or one for the industry average or declining
growing significantly market share
Generally national Diminishing degree National or Diminishing degree Generally a local or Diminishing degree
or multinational in exceptionally strong regional firm
scope regional firm
Well-diversified Diminishing degree No major Diminishing degree Significant Single product line or
revenue sources dependence on a dependence on captive supplier
single product or limited revenue
service sources
Unexcelled Regarded as a May have minor May have normal Has more than Frequently
reputation for trouble free company problems business problems average share of encounters serious
performance business problems business problems
and experiences
significant swings in
results
Continued
18/06/2012 07:50

characteristics
Substantial control of Moderate supply No supply control but Diminishing degree Supplies subject to
availability and price control supplier competition periodic shortage.
of supply sources assures fair prices Occasional rationing
and adequate and strong supplier
availability price control
Invulnerable to Decentralisation Diminishing degree Uncontrollable Such occurrence
uncontrollable events would greatly soften events or natural could be fatal
or natural disasters the impact of such disasters could have
occurrences a serious but not
fatal impact
Highly differentiated Diminishing degree Some differentiation Diminishing degree Non-differentiable Non-differentiable
product. Few possible. Comparable product with product with many
comparable substitutes limited, a number of comparable or better
substitutes. Strong perhaps by product comparable substitutes. No brand
patent protection complexity. Some substitutes available. loyalty and mediocre
or consumer brand loyalty Good quality product quality
franchise. Excellent and good quality reputation
qualityreputation reputation
Management Extensive industry Diminishing degree Limited experience in
experience under the industry without
a wide variety of extensive exposure
conditions to normal industry
problems
Excellent managerial Diminishing degree Adequate managerial
qualifications qualifications with
reflected in some deficiencies
performance,
partly measured by
rating in previous
risk classification
categories
18/06/2012 07:50
characteristics
Unusual Diminishing degree Adequate Insufficient depth Depth a problem
management depth management depth with some outside with vacancies in key
with succession with each critical recruiting necessary spots causing serious
in all functional function covered to fill vacancies in exposure
areas provided for with at least one secondary functions
internally qualified successor
Active Board of Diminishing degree Some outside Outside directors, Inside Board
Directors composed directors of if any, not an which does not
of nationally moderately important effective check on discharge normal
recognised business stature exercise management responsibilities
leaders serves as average control over
strong check on management
management
Tight comprehensive Same Very good, timely Soundly designed Control system Controls are weak;
management control control system system provides functions but has system is largely
system adequate technical short- reactive and
management control comings. Some risk reportive; major
and information of controls failure in overhaul is desirable
limited instances
Established Same No reason
reputation for to question
unquestioned management
integrity integrity, although
reputation is not
widelyknown
Financial Liquidity, Ratios substantially Ratios close to but Ratios around Ratios slightly below Ratios stretched
condition capitalisation and above industry not below industry industry average industry average but still acceptable,
coverage ratios at or average, at least in average certainly not below
near the top for the top quartile third quartile
industry
Continued
18/06/2012 07:50

characteristics
Profit margins at or Diminishing degree Profit margins normal Diminishing degree Chronic under-
near the top of the for industry performer
industry
High-quality earnings Record of steady Diminishing degree Earnings at least Earnings record is
steadily increasing at results with above moderately trending unimpressive but
a sustainable rate average sustainable upward, although has demonstrated
up trend there may be some earning power
moderate variability
Substantial excess Diminishing degree Consistent policy Diminishing degree Under-capitalised,
debt capacity at all of moderate excess relies heavily on debt
times debt capacity
Soundly valued, high Diminishing degree Assets of
quality assets questionable quality
difficult to value
Capital sources
1 Equity Access to the equity Could sell stock Able to sell stock Able to sell stock Little likelihood of Companys
market under all except during severe under normal market only during bull successful stock circumstances
market conditions market decline conditions markets sale under most render sale of equity
conditions unfeasible
Widely held Same Some ownership Relatively closely Very closely held
ownership with concentration, held
nationwide perhaps regionally
distribution oriented
Market for stock Traded on major Traded on a Traded OTC with Thin OTC market No quotes available
highly liquid and exchange secondary exchange some dealer support with no dealer
relatively stable support
under almost all
circumstances.
Traded on NYSE
18/06/2012 07:50
characteristics
Strong market Good investor Investor interest Investor interest Little investor interest No investor interest
demand with active interest under most reflects general sporadic
trading at almost all market conditions market conditions
times
2 Long-term debt Able to sell long- Only severe credit Able to sell debt Access to institutional Questionable access No access to
term debt, relatively conditions would publicly or privately market during to other than the additional long-term
advantageously impair good under normal credit most credit market commercial bank debt
under all market reception in public or market conditions conditions and public market but generally
conditions in public private market. Could market during credit accommodated
or private markets still sell even then at expansion
a wider spread
Debt would be rated Debt would be rated Debt would be rated Debt would be rated No rating or No rating
AAA to high AA AA to high A solid A low A to high BBB speculative rating
Securities have Securities command No undue selling Selling effort Securities have very Not applicable
strong investor good investor effort required in generally required limited appeal
appeal interest except in normal markets and appeal limited to
weak markets certain categories of
investor
3 Commercial Access to the Able to sell paper Able to at least Able to sell paper Might not be able Commercial paper
paper commercial paper during all except renew outstanding under normal to renew maturities market an uncertain
market at all times most extreme market paper during all conditions during market source of funds or
contractions except most extreme contractions company is unsuited
market contractions to the issuance of
commercial paper
Prime commercial Same Medium commercial Low commercial Below A3, P3 Not rated
paper rating (A1, P1) paper rating (A2, P2) paper rating (A3, P3)
Maintains 10 (1%) Same
backup lines
Continued
18/06/2012 07:50

characteristics
Dealers maintain a Same Average dealer Considered a No secondary market Not applicable
secondary market support and investor relatively inactive and limited investor
and investor interest name in the market interest
receptivity is high
4 Commercial Excellent Same Good relationships Good relationships Satisfactory Fair relationship with
bank relations long-standing with several large with a few banks of relationship with a bank of modest
relationships with banks; lead bank moderate size and a bank of medium size and influence
many large banks is well-known, influence including size and influence,
including several in respected, probably at least one large and access through
Top 10 Top 10 money-centre bank correspondent
system to a large
money-centre bank
Maintains Same Maintains Diminishing degree Uses credit lines
commitments commitments in extensively, Nominal
substantially in excess of anticipated excess commitments
excess of maximum needs
anticipated needs
5 Investment Working relationship Same Some annual contact Contact as needed Dormant relationship No investment
banker with major bracket with active better with generally well- with investment banker
relationship firm, in sound known firm regarded firm banker of modest
financial condition local or regional
with a reputation stature
for integrity and
performance
Financial Follows sound Same Follows aggressive
reporting accounting practices accounting practices
considered normal considered unusual
for the industry for the industry
18/06/2012 07:50
characteristics
Big 8 audit firm Same Highly reputable Same Audit firm of
audit firm unascertainable
quality and
reputation
Clean audit opinion Same Qualified opinion
exceptions not
serious
Source: Peter K Nevitt

18/06/2012 07:50
Project Financing
Highest quality 1
This category is reserved for those few firms that are truly outstanding, by any criteria. They
will be leaders in mature industries that are exceptionally strong, probably monopolistic or
oligopolistic, and that are essential to the important world economies. Their industries will
further be virtually invulnerable to external forces, including regulation and legislation, tech-
nological innovation, business and credit cycles, and changes in patterns of production or
consumption. The firms themselves will be dominant in their industries, large by absolute and
relative standards, innovative and imaginative in research and development (R&D), produc-
tion and marketing. Generally multinational in scope, they will have unsurpassed reputations
for superior performance, and will have both breadth and depth of customers, products and
suppliers. By any test, they will possess exceptional financial strength, will have virtually
continuous access to all public and private debt and equity markets, and all obligations will
have the highest possible ratings. Finally, these firms will have extraordinary managerial
talent, with worldwide recognition for managerial expertise and leadership capacity.
Highest quality 2
Firms in this category will also be of the highest quality, but by somewhat more normal
standards. They will be highly regarded major participants in strong, healthy industries,
probably oligopolistic, that are highly important to the economy. Their industries will have
demonstrated great resilience to external forces, especially business and credit cycles, and
will have a favourable outlook on supply/demand balances, regulation and legislation and
so on. These firms will be among the largest in their industries, will have reputations for
product excellence, and will be innovative and imaginative in several key areas. They will
be multinational or national in scope, will have excellent reputations for performance, and
will have a broad base of customers, products and suppliers. Their financial condition ratios
will be substantially better than industry averages, they will have unqualified access during
normal times to public and private debt and equity markets, and their obligations will have
excellent independent ratings. Their managements will have considerable industry experience,
excellent managerial qualifications, unusual depth and recognised leadership.
Good quality 1
This category is intended for above average firms in strong, healthy industries. Their industries
will generally be characterised by limited competition, moderate to substantial importance
in the economy, and considerable maturity. The industries will further be fairly resilient to
external forces (economic cycles, technological change, consumption and distribution pattern
changes and so on), and will have a supply/demand balance generally favourable to partici-
pants. The firms will be well regarded, either as one of the larger participants or of growing
importance. They will generally be national or exceptionally strong regional firms with no
major dependence on a single product or service and with minimal problems. Financial condi-
tion ratios will be somewhat above industry averages, profits will be generally increasing,
they will have some excess debt capacity, and will have fairly unrestricted access to debt
96

and equity markets during normal times. Further, they will have good bank relationships,
a good credit record and good credit ratings. Their managements will have broad industry
experience, strong depth and will be quite professional in approach. The firms will have
clearly demonstrated their capacity to survive difficult times.
Good quality 2
This category is intended for the large proportion of average firms in sound industries. Their
industries will be noted for normal competition among numerous firms, moderate impor-
tance in the economy, in which regulation is not highly detrimental. The industries will be
mature beyond shake-out, and without major growth problems. They will be stable during
normal economic conditions, supply and demand will be in approximate balance, and they
will have modest vulnerabilities to other external forces. The firms will be held in normal
regard in their industries, they will be of medium size with adequate market shares, and they
will probably have some normal business problems. Their financial condition ratios will be
average for the industry, they will have followed a policy of maintaining excess debt capacity
during normal times, and will have a record of fairly steady earnings performance, with profit
margins typical for the industry. They will have limited access to debt and equity markets,
sound banking relationships, and a good credit record. Finally their managements will be
professional and will have adequate managerial qualifications and broad industryexperience.
Good quality 3
This category is for below average, yet healthy, firms in competitive industries. Their industries
will be characterised by many firms engaged in unrestrained but not destructive competition,
moderate importance in the economy, in which regulation and legislation may be somewhat
detrimental. The industries will typically have matured beyond their peak, but are not yet
declining, will exhibit some instability in economic downturns, may have excess supply
during recession, and are moderately vulnerable to other external forces. The firms will be
held in normal regard in their industries, they will be of medium to small size with modest
to average market shares and normal business problems. They will probably be regional in
scope, with fair protection from erosion of market. Financial condition measures will be at
or slightly below industry averages, they will have some excess debt capacity except during
rapid and unanticipated rapid economic expansions or contractions, and their access to debt
and equity markets will be somewhat uncertain. They will, however, have pretty good banking
relationships, a relatively clean credit record and fair credit ratings. Their managements will
have adequate industry experience, but may lack depth or breadth in some areas. The firms
will have limited capacity to survive difficult times, but are basically healthy businesses.
Fair quality
This category is intended for marginal firms in fragmented, intensely competitive industries.
Their industries will be characterised by somewhat destructive competition among many
competitors, possibly heavy-handed and detrimental regulation, modest importance in the
97

Project Financing
economy, and some immaturity. The industries may be subject to growing pains or in decline,
entry will be relatively easy, and they will be somewhat vulnerable to external forces, espe-
cially economic cycles and technological changes. The mortality rate will likely be fairly high,
substantial excess capacity may exist, and the industry may be highly dependent on another
industry for supplies or sales. The firms in this category will typically be undistinguished in
their industries, probably smaller than industry average, with a small and somewhat unstable
market share. They will generally be local or semi-regional in scope, with limited products
and beset with some serious operating problems. Their financial condition ratios may be
significantly below industry averages, stretched, but still acceptable. Assets will be largely
illiquid, the firms will generally be undercapitalised, will rely on debt financing, and will
have unstable and uncertain earning power. They will have relatively few sources of finance,
perhaps dependence on a single bank, but a good credit record. Credit ratings will generally
be weak or non-existent. Their managements will have limited industry experience, perhaps
some functional deficiencies, limited depth and a board of modest influence. However, they
will be honest by all outward signs. These firms will have uncertain futures, but should
survive with some encouragement and assistance.
Other categories
Whilst loans that fall between Highest quality 1 and Good quality 3 would be catego-
rised as pass, the OCC recognises several further categories of weaker credits: special mention;
substandard; doubtful and loss. The first raises concerns about the loan asset quality and
potential concerns about repayment, so would equate to the category Fair quality. Below
special mention, are three more serious categories: substandard, doubtful and loss, also
known as classified loans, that require the bank to take actions in terms of placing assets
categorised as doubtful or loss on a non-accruals register with a short term review cycle
to consider writing off loans that remain delinquent, directly affecting profitability. Certain
categories of substandard loans also require placing on a non-accruals list.
Many banks now fine tune internal risk rating systems to differentiate further between
probability of default, amount of loss given default and the expected loss (the product of
these two numbers). Additionally, some banks are choosing to re-map their loan classifica-
tions to align more closely with criteria set out by ratings agencies.
1
Testimony of Jennifer Kelly, Senior Deputy Comptroller for Midsize and Community Bank Supervision, Office
of the Comptroller of the Currency before the Subcommittee on Financial Institutions and Consumer Credit
Committee on Financial Services U.S House of Representatives, 8 July, 2011, pp. 23.
2
For a further discussion of a credit risk rating systems for banks, see Comptroller of the Currency, Rating Credit
Risk: Comptrollers Handbook, April 2001. A survey of the use of loan classification systems is provided in
Majnoni, G, and Laurin, A (eds), Bank Loan Classification and Provisioning Practices in Selected Developed
and Emerging Countries, The International Bank for Reconstruction and Development/The World Bank, World
Bank Working Paper, 2003.
3
This is in contrast to other forms of credit risk analysis, such as retail credit scoring, that rely on statistical
methods or computer classification systems.
98

Chapter 10
Types of capital and debt
The capital markets are very pragmatic. To the capital markets, a project financing is simply
an investment candidate for portfolio inclusion that must satisfy the investment objectives
and portfolio constraints. As such, a project financing must compete with other potential
loans and investments on the basis of levels of risk, yields, terms and liquidity.
There are three general categories of capital and loans used in a project financing:
1 equity;
2 subordinate debt (sometimes called mezzanine financing or quasi-equity); and
3 senior debt which in a project financing will usually be secured or asset-based. This
category may also include large equipment leases and asset securitisation of future cash
flows even though they are not formally debt, as a way of recognising the priority of
these project funding streams.
1 Equity
The equity investment in a project financing represents the risk capital. It forms the basis
upon which lenders or investors decide to advance more senior forms of capital to the
project. Equity investors are the last in priority for repayment. However, the upside potential
is substantial: this is the motivating factor for investors providing equity capital. For some
projects, enhancing the upside potential are favourable tax benefits (for example, investment
tax credits and bonus depreciation) provided for by the tax authorities of some countries.
Equity is typically described as the subscription price paid for common or preferred stock.
The principal sources of equity are local investors and strategic partners. There may also be
provisions in the tax code of some countries that provide an incentive for non-traditional
equity investors to participate as equity investors. An example is that of renewable energy
projects in the US where significant tax incentives are provided for equity investors to support
this greener alternative to fossil fuels. The tax treatment of these investments is such that it
has brought in investors that are referred to as tax equity.1 This is a hybrid between debt
and equity available to project developers who do not have the ability to utilise tax benefits
but can offer them to other entities (typically tax-paying financial entities such as banks,
insurance companies, as well as utility companies) that can use those benefits in exchange
for equity capital by those entities.
Lenders look to the equity investment as providing a margin of safety. They have two
primary motivations for requiring equity investments in projects that they finance.
1 Lenders expect the projected cash flows generated by the project to be sufficient to pay
operating expenses, service debt and provide a very comfortable margin of safety to meet
99

Project Financing
any contingencies that might arise. The more burden the debt service puts on the projects
cash flow, the greater the lenders risk.
2 Lenders do not want the investors to be in a position to walk away easily from the
project. They want investors to have enough at stake to motivate them to see the project
through to a successful conclusion.
The appropriate debt-to-equity ratio for a given project is a matter for negotiation between the
sponsors and senior lenders. Many factors are taken into consideration, including customary
debt-to-equity ratios for the particular industry or country involved, market expectations and
risks, that include consideration as to whether the commodity or product is being provided
to an assured market, evidenced by an unconditional long-term contract, or is subject to
the uncertainties of general future market conditions. Just as in the case of going concerns,
debt-to-equity ratios for a project financing might range all the way from less than one to
one to as high as three or four to one, with subordinated debt being counted as equivalent
to equity for the senior lenders.
There is a popular misconception among some prospective project financiers that project
financing requires little or no equity investment by the owners or sponsors of the project,
and that the project can be completely financed on the basis of optimistic projections and
financial plans. Lenders, reluctant to provide such financing, are told by such financiers that
they simply do not understand project financing. However, unless guarantees are available
from very creditworthy guarantors, lenders will always require a substantial equity invest-
ment in a project. Even where guarantees are available, lenders will still want sponsors or
investors to have enough of an equity investment at stake in the project to ensure their
continued interest and attention to complete and operate the project, and make it asuccess.
Although the amount may not be large, holders of substantial debt may receive equity
shares in connection with their subordinated loans, known as equity kickers.
Equity may be in the form of preferred stock as well as common stock. The preferred
stock may pay a dividend, and may be guaranteed by a sponsor willing to guarantee but
unwilling to own stock for some legal or other reason.
2 Subordinated loans
Subordinated loans, called mezzanine financing or quasi-equity, are senior to equity capital
but junior to senior debt and secured debt. Subordinated debt usually has the advantage of
being fixed rate, long term, unsecured and may be considered as equity by senior lenders
for purposes of computing debt-to-equity ratios.
Subordinated debt can be advanced by an investor as part of its original investment in the
project. A subordinated loan is often used by a sponsor to provide capital to a project that
will support senior borrowings from third party lenders. The sponsor may, for example, be
an owner of the project, a supplier providing subordinated trade credit, a user anxious to get
the project operational, or a government interested in getting the project built. Subordinated
debt can sometimes be used advantageously for advances required by investors, sponsors
or guarantors to cover construction cost overruns or other payments necessary to maintain
debt-to-equity ratios, or other guaranteed payments.
100

Where all or part of the project companys assets are acquired as used property from an
existing company, the seller is a logical source for subordinated debt. The project company
in such a situation is often in a strong bargaining position to give a little on price in order
to gain concessions on terms, interest rate, maturities, covenants and equity kickers.
Other conventional sources for subordinated debt include finance companies, risk capital
companies and risk portfolio managers of insurance companies.
Subordinated debt can be generally or specifically subordinated. A general subordina-
tion is called a blanket subordination. A specific subordination spells out in detail the type
of debt to which it is subordinated. Typically, a specific subordination may be limited to
specific senior third party loans, meaning that such subordinated debt ranks the same as
other unsecured loans or trade creditors. In the event of liquidation, subordinated debt has
claims on assets after unsubordinated debt.
The subordination language determines the precise extent and circumstances of subor-
dination, including repayment of principal, payment of interest, term of the subordination
and a description of lenders and creditors to which the loan is subordinated. Subordinated
debt by a sponsor has the following advantages over capital contributions.
1 As debt, the borrowed amount will eventually be repaid if the project is successful,
without tax consequences, whereas a repayment of capital is more complex from a
corporate and tax standpoint.
2 Subordinated debt contains a specific schedule for interest payments and repayment of
principal. Dividends on stock are optional.
3 The project company may have restrictions on payment of dividends that are not appli-
cable to debt.
4 The advantages and upside potential of an equity stock position can be preserved by the
sponsor lender through stock warrants or stock conversion rights under a subordinated
loan agreement.
5 A greater market exists for risk debt loan funds than for risk equity.
6 The combination of subordinated debt with warrants or conversion rights enables a
sponsor lender to orchestrate the point in time when the sponsor assumes control for
tax and financial accounting purposes.
7 Under regulating statutes such as anti-trust laws and laws regulating public utilities, a
stock position may create problems that a subordinated loan will not create.
8 Interest paid on debt may be deductible for income tax purposes.
9 A subordinated loan by a supplier in the form of subordinated trade credit for purchases
from the supplier may have little downside potential for the supplier, yet may provide
a degree of subordination useful to the project in borrowing working capital, as well as
providing a source of working capital.
10 An interested government agency sponsor that cannot take an equity position in a project
for policy reasons, may be able to provide subordinated debt as seed capital to attract
senior debt.
Subordinated lenders are cash flow lenders. They are unsecured. If the subordinated lender is
to be repaid, the project company must earn its way out of the senior debt. A sophisticated
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Project Financing
subordinated lender to a project must be satisfied that the project company can consistently
generate operating earnings (that is, cash flow) in order to:
service senior debt principal and interest; and

build equity.
Subordinated lenders will be especially sensitive to the capabilities of the management of the
project to production and market share while servicing debt.
Subordinated lenders in leveraged buyouts commonly use an earnings coverage test of
net income after tax, plus interest, as a percentage of outstanding debt, and look for 20%
to 25% as a target range. Subordinated lenders as well as long-term lenders usually do not
add back depreciation since, over the long term, the company will need those amounts to
replace plant and equipment.
Sweeteners (the equity kickers described next) used to attract investors include stock at a
price below market at the time of the loan, warrants to purchase stock, or rights to convert
debt to equity at reasonable prices allowing for upside potential.
Equity kickers
In the case of weaker credits, lenders may require an incentive in addition to a relatively
high interest rate to make a financing sufficiently attractive. Such incentives are called equity
kickers. Basically, there are four types of equity kickers.
1 Convertible debt: such debt is usually subordinated to senior debt. Either all or part
of the principal amount of the financing is convertible into the common stock of the
borrower based upon a specified formula that is advantageous to the debt provider,
who holds the option to convert. Normally, the conversion price (that is, the price
the lender pays for the common shares) is 20% to 30% above the market price of
the borrowers common stock at the time the debt was issued, so the implied assump-
tion is that the stock price will rise even further to make the conversion attractive.
If appropriate, lenders typically require the borrower to register stock resulting from
conversion if requested to do so.
2 Debt with stock warrants: this is similar to convertible debt. The debt itself may or may
not be subordinated. A warrant, simply stated, is a call on a companys common stock at
a specified price, usually at least 15% in excess of the current market price if the stock is
publicly traded. Of course, any number of warrants can be issued with the debt. Usually
a lender has the option to use the debt to pay for the exercise of its warrants. Warrants
have been the most popular type of equity kicker among lenders in the past. There are
two principal reasons.
In many cases their use enables a lender to negotiate a more favourable overall deal as
compared with using convertible debt. The relationship between the interest rate and
the equity feature is less apparent in the case of debt with warrants than for convertible
debt. As a result, by requesting warrants, it is easier for a lender to secure additional
compensation over and above a high interest rate.
102

Debt with warrants gives the lender greater flexibility because the debt and equity

features typically are separated. The lender can retain the debt portion of the financing
and either sell the warrants or exercise them and sell the resulting common stock.
3 Original issue stock: at the time of the original loan the lender is permitted to purchase shares
of common stock at a bargain price based on projections. This gives the lender an oppor-
tunity to share in the upside potential if the project is successful, with little downsiderisk.
4 Contingent interest: while not an equity kicker, per se, a contingent interest arrangement
requires the borrower to make interest payments over and above the coupon rate. The
additional interest payments are normally tied to increases in some variable such as net
income, net operating income or sales. A maximum overall rate typically is specified
primarily to establish a ceiling on the cost to the borrower.
Financial covenants
Nearly all project finance subordinated debt will be privately placed and therefore contain
various financial covenants (consistent with senior debt) to ensure that the companys opera-
tions comply with its projections, or to allow the lender to become quickly aware of problems
should they arise.
A further discussion of financial covenants is provided in Chapter 12.
Interest rate and term

The interest rate for project financing subordinated debt depends on: (i) prevailing market
rates; and (ii) provisions in the loan agreement. The term loan pricing means the loans
interest rate and other fees, so the total return to the lender. The benchmark interest rates
used in determining the basic loan interest rate (or cost of funds) is the swap rate curve,
basically the interest rate at which high-quality banks lend to other high-quality banks for this
time period, so the AA rated interest rate for that time period. There is no single universal
interest rate, but rather a structure of interest rates where structure means that there is an
interest rate for each maturity and by credit rating.
The interest rate on a subordinated debt is typically a floating rate. The interest rate
depends on the terms of the loan and the borrowers credit rating. A project sponsor can
create synthetic fixed-rate financing by using the swap market to convert the floating rate to
a fixed rate provided there is a counterparty. Swap terms for project financings are often in
the range of three to 10 years to maintain some flexibility if circumstances change.
Debt markets are highly efficient. It is rare for borrowers to obtain cheap or below-market
rate financing. The interest rate obtained reflects the credit risk, terms and other provisions.
Reducing a rate that might be offered by the lender comes about only by the borrower giving
up something such as giving the lender an equity kicker or an embedded interest rateoption.
Unsecured loans by sponsors

Unsecured loans by sponsors provide another source of quasi-equity for project financing,
particularly where the senior debt is protected by a security interest in the key assets.
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Project Financing
Stripped interest debt or zero coupon unsecured loans can also be used to provide a
strip of financing between subordinated debt and senior debt where the senior debt has
shorter maturities.
3 Senior debt
The senior debt of a project financing usually constitutes the largest portion of the financing
and is usually the first debt to be placed. Generally the senior debt will be more than 50%
of the total financing. Most borrowings from commercial bank lenders for a project financing
will be in the form of senior debt.
Senior debt is debt that is not subordinated to any other liability. It is first in priority
of payment from the general revenues of the borrower in the event the borrower gets
into financial difficulty.2 However, senior debt falls into two categories, shown ranked
by priority:
1 secured loans; and

2 unsecured loans.
The distinction is important since secured senior debt holders have an advantage in liquida-
tion over unsecured senior debt holders.
Senior debt support or security can take a variety of forms.
The debt may be supported and repaid through dedicated cash flow legally protected by
an assignment of proceeds from take-or-pay contracts or dedication of cash flows from
sales to an escrow account to service senior debt.
As a secondary support mechanism, the debt may be secured by a lien on the borrowers
key assets, that is perfected at the time the funds are advanced.
The debt may be protected by a security agreement that is triggered by an event of
default, such as the failure to meet a ratio requirement, or breach of some other
covenant. In this type of arrangement, once an event of default occurs, is formally
notified to all parties and is not cured or put right, the lien, charge or mortgage that
provides the legal evidence of the security interest may be perfected or put in place
and the loan then becomes secured by the lien (which may also need to be registered).
Certain more serious events of default may give rise to an immediate right for the
senior debt holders to perfect the security interest supporting their loan. A negative
pledge, where a borrower promises not to offer the security to any creditor is a much
weaker arrangement for lenders.
The debt may be unsecured but still maintain its stature as senior debt if other classes of
debt are subordinated by their terms.
The debt may be unsecured but protected by a negative pledge that prevents key and
valuable assets of the borrower being pledged to some other creditor, thus preserving
those assets for the senior debt holders.
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Unsecured loans
Some kinds of senior debt are referred to as unsecured loans. Typically, this is debt backed
by the general credit of the borrower, and is not secured by a perfected security interest in
any asset or pool of assets (see Exhibit 10.1). Such an unsecured loan will usually contain
a negative pledge of assets to prohibit the liquid and valuable assets of the company being
pledged to a third party ahead of the unsecured lenders. The loan agreement may include
ratio covenants and provisions calculated to accelerate the loan or trigger a security agree-
ment, should the borrowers financial condition begin to deteriorate. An unsecured loan
agreement may also contain negative covenants that limit investments and other kinds of
Exhibit 10.1
Unsecured debt obligation
Lender
2 Notes
2 Loan 3 Debt
proceeds service
1 Loan
agreement
Borrowing
company
Summary
1 The borrower enters into a loan agreement with thelender.
2 The borrower signs and delivers notes to the lender, and the lender pays the loan proceeds to
theborrower.
3 Debt service is paid directly by the borrower to thelender.
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Project Financing
loans, leases or debt obligations of the borrower. Common affirmative covenants include
agreements that the business will be properly managed, proper books and records will
be kept, financial information will be furnished, insurance coverage kept in force and the
business operated according to law. Large unsecured loans are available only to the most
creditworthy companies with long histories of financially successful operation and good
relationships with their lenders.
Since projects tend to be new enterprises with no operating histories, projects rely upon the
reputations of their sponsors, owners and managers for standing in the financial community.
Unsecured loans may be available to projects whose strong sponsors, owners and managers
have established good reputations over a long term with the financial community, where
sufficient capital or subordinated loans have been provided to meet the equity risk capital
needs of the project and there is evidence of strong, lower risk cash flow.
Banks and commercial finance companies are the usual source for senior debt for project
financing. Banks are traditionally balance sheet and ratio lenders and many banks have project
finance or industry specialists to follow and shepherd the loan. Most important, banks are
generally the least expensive source for project financing.
Unsecured loans to projects are often provided by sponsors. Where the project intends
to raise a significant amount of capital by secured loans or by leasing, an unsecured loan
will serve a purpose similar to a subordinated loan in that it will be junior to the security
protection of the lease obligations and secured loans. An unsecured loan by a sponsor can
be later subordinated to a new senior loan from a third party if such a loan becomes neces-
sary and feasible.
Unsecured loans to projects may include stock warrants or stock conversion rights to
increase the upside potential of the loan to the sponsor lender or third party lender.
Secured loans
Secured loans are available to most projects where the assets securing the debt have value as
collateral, that means that such assets are marketable and can readily be converted into cash
(see Exhibit 10.2). Banks and particularly their asset-based lending groups are good sources
for secured loans. Commercial finance companies are another good source. The secondary
collateral support of real property, personal property, as well as the primary repayment and
debt servicing through assignment of revenue generating contractual rights including those
to payments due under a take-or-pay contract, are all used as security in project financings.
In a fully secured loan, the value of the asset securing the debt exceeds the amount
borrowed, as any sale will need to cover costs associated with taking possession of the
assets, selling them and paying off all monies due under the loan. The lender relies primarily
on the cash flow of the project for repayment with the value of the collateral as secondary
support. However, the reputation and standing of the project managers and sponsors, and
the probable success of the project, also enter into the lending decision. Lenders will not
lend to a project or company where they expect to have to seize and sell the secured asset
in order to collect their loan. The security interest is regarded by lenders as a secondary
protection of loan repayment in the unlikely event the loan is not repaid in the ordinary
course of business but the primary reliance is always on the cash flow.
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Exhibit 10.2
Secured debt obligation
4 Debt
Lender
service
3 Notes
3 Loan 1 Loan Security

proceeds agreement trustee
2 Security
agreement
4 Debt
Borrower
service
Continued

Project Financing

Summary
1 A loan agreement is entered into between the borrower and thelender.
2 A security agreement is entered into between the borrower and a security trustee, and a security interest
in certain assets is assigned to the securitytrustee.
3 The borrower signs and delivers notes to the lender. The lender delivers the loan proceeds to
theborrower.
4 The borrower pays the debt service to the security trustee which, in turn, distributes the debt service to
thelender.
The existence of a security interest makes a secured loan superior to unsecured debt,
trade creditors and other unsecured creditors. In the event of financial difficulties, the secured
creditor in control of key assets of a project is in a position to demand that its debt service,
payments of interest and principal continue, even though unsecured creditors are paid nothing.
Furthermore, the secured creditors can insist on payment at the same time that unsecured
creditors may find themselves forced to advance additional funds to the borrower.
The superior rights of a secured lender enable projects to borrow on a secured basis
where other sources are not available. However, the existence of secured loans, and the
rights of secured creditors, make any borrowing from other lenders on an unsecured basis
more difficult.
Security under a secured loan may consist of a single asset, a pool of assets, contractual
rights and a changing class of assets such as accounts receivable.
Sometimes a secured loan can be structured on a non-recourse basis whereby the lender
will look solely to the security for repayment of the loan principal. A truly non-recourse
loan secured by an asset may be carried off-balance sheet by the project company.
The enforceability of security interests requires a word of caution. Inexperienced lenders
sometimes take for granted that a security agreement can be easily perfected and enforced
if the borrowers financial circumstances begin to deteriorate. This is not always the case.
Banks do not like being debtors in possession as obligations relating to ownership of the
project assets may also pass to the bank. Considerable difficulties may be encountered in
perfecting security interests and actually seizing control of the assets subject to a security
agreement. This is particularly true in the case of properties located in developing countries
with underdeveloped legal systems. For this reason equipment leases are sometimes used
instead of secured loans because the rights of a lessor are more easily enforced.
Nature of security for senior debt

Where the holders of senior debt of a project hold a security interest in the key assets of
the project, the security interest is evidenced by a first lien on some or all of the following:
real estate;
mineral rights;
108

equipment;
contracts for raw materials and services;
easements;
marketing contracts;
stock shares representing ownership of the property;
leases of equipment;
leases of real estate; and
licences, permits and concession agreements needed to operate the project or facility.
The objective of a security interest is to permit the senior lenders to step in and take
control of a project, should it get into trouble. Investors may also be asked to pledge
their equity shares.
Where a negative pledge is used in an unsecured loan to protect the right of lenders under
such an agreement to later assert a senior security interest in the assets of the borrower, the
negative pledge should extend to all of the above.
Real estate may be an exception to assets usually pledged as security for senior bank
debt, because real estate can usually be financed for a much longer term. (A real estate loan
is secured debt of a different nature.)
A security interest is only as good as the ability of the holder to enforce the transferability
of title and effective control of the asset or property interest. Lenders should ascertain whether
proposed collateral constitutes property on which a valid lien can be created, perfected and
enforced under the legal system governing the loan agreement and the project.
Security agent for senior debt

Where a number of lenders are involved, a security trustee may be named to act on behalf
of all of the secured lenders to hold the security interest in the assets, and to collect cash
flow and distribute debt service to secured lenders in the order of their priority for payment.
Any such trust arrangement should be consistent with any inter-creditor agreement (see 5
Inter-creditor agreement). Typically, a security agent will act on instructions from a majority
or two-thirds of the senior lenders as a group, with each senior lender having a vote propor-
tionate to its outstanding loan.
Secured loans other than senior debt

Secured loans other than senior debt may be used to finance specific equipment or properties
of the project. These would include:
mortgages on real estate;

equipment loans on specific items of equipment:
by suppliers; and
by third parties;
leases of real estate; and

leases of equipment.
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Project Financing
Since the objective of senior lenders is to control the key assets of the project so that they can
step in and operate the project if it gets into trouble, there are likely to be conflicts between
senior lenders and lessors, or lenders secured by a particular asset. Typically, the senior loan
agreements will define the extent to which the project can enter into such transactions to
finance equipment that will be outside the security pool of the senior lenders.
4 Concerns of senior lenders

Senior lenders to a project will usually have the following concerns.
1 The lenders expect the financing arranged at the outset to be sufficient to finance the
project. They do not want new lenders coming in at a later date with new demands for
security interests in new and past company assets.
2 Lenders expect the security ranking to be equal among senior lenders. In the event of a
problem, they expect sharing in project assets to be on a pro rata basis. One senior lender
cannot have an advantage over another.
3 Senior loan agreements should contain cross default clauses. The default on one loan
agreement then triggers the default on all senior loan agreements.
4 Any prepayment of senior debt should be proportional to all the senior lenders in propor-
tion to their loans to the project.
5 Experienced lenders know that, in the event of a problem, all the lenders may not agree
on the correct course of action. Some lenders may have other loans to one of the project
sponsors or, in the case of a project located overseas, to the host country. Some lenders
may find it not politically feasible to demand payment from a particular project because
of the political relationship between the country of the lender and the host country of the
project. Voting rights under a security agreement, and default provisions, may take this
factor into consideration. Experienced lenders do not expect to find themselves outvoted
by politically motivated lenders.
6 Senior lenders want to be protected against the cash flow from sales being diverted from
dedication to servicing debt.
5 Inter-creditor agreement
Any financing that involves a number of separate lenders to a single borrower requires an
inter-creditor agreement. Parties to an inter-creditor agreement include lenders under different
loan agreements, lenders with loans of different maturities, and different classes of lenders,
such as senior lenders and subordinated lenders. The purpose of the inter-creditor agreement
is to provide procedures, agreements and understandings:
for co-ordinating priorities of loan repayment;

for accelerating the maturity of loans;
for establishing loss sharing, if any;
for offset sharing; and
for co-ordinating foreclosure of any collateral security for the benefit of all lenders.
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The purpose of an inter-creditor agreement is to prevent disputes from arising between

creditors that might jeopardise the interests of all the creditors. If the quality of a loan
begins to deteriorate, lenders will try to protect their position in the best way possible, and
to obtain some advantage over other creditors, including other lenders. The purpose of the
inter-creditor agreement is to provide procedures to forestall this.
Project loans tend to be more complex than commercial loans. The definition of events
that trigger defaults are fairly restrictive in the legal documentation in an effort to keep
control over the project because of the higher than usual lending risks. Individual lenders
declaring an event of default and accelerating their loans would set off a chain reaction of
other lenders declaring similar defaults, and taking appropriate steps to protect their collateral
interests in the project.3 If this occurred in a precipitous manner, it would be harmful to all
the lenders. The purpose of an inter-creditor agreement is to prevent this.
Under an inter-creditor agreement, typically no lender is permitted to take legal action
outside this agreement. The agreement of at least half or two-thirds of the lenders, based
on principal balances, is required in order to act. An agent bank or lender is appointed to
act on behalf of all lenders to the project that are parties to the inter-creditor agreement.
For someone not familiar with the problems that can arise between creditors, an example
may be helpful. Suppose a borrower in deep financial trouble has one-year bank loans, five-
year notes and 10-year debentures, all of which are forms of senior debt. Suppose events
of default have occurred and the borrower sells off a division for cash. Who gets the cash?
Should it be applied to principal payments as they become due, which means the short-
term debt gets paid out? Or should long- and short-term debt share proportionately in the
proceeds? Convincing arguments can be made each way.
An inter-creditor agreement should be established at an early date in a large project
financing involving a number of creditors. Inter-creditor agreements become very difficult to
negotiate after it is obvious that a problem exists.
An inter-creditor agreement is also advantageous to the project borrower. Should a
financial problem arise, dealing with lenders through the agent bank or agent lender is more
manageable for the borrower than trying to deal separately with individual lenders or classes
of lenders. Nothing can be gained for a borrower from a quarrel among its lenders.4
1
In the US, the term tax equity is used to describe a passive ownership interest in an asset or a project, where
the return that the investor receives is not solely based on the cash flow generated by the asset or project but
also on tax benefits.
2
Legal statutes may rank certain creditors, such as government tax agencies and employee claims for wages, ahead
of senior creditors. Bankruptcy laws vary throughout the world. Moreover, where there are strong bankruptcy
laws to protect creditors, bankruptcy courts need follow those laws.
3
The one thing a lender hates more than a loan loss is a loan loss suffered by their bank whilst another compa-
rable lender gets repaid. Lenders will act irrationally and contrary to their own interests to prevent such aresult.
4
Loan agreements typically provide that legal fees in connection with enforcement of the terms of the agreement
will be paid by the borrower. In the event of a dispute among the lenders with long drawn out negotiations
between the lenders to determine their priorities or to negotiate an inter-creditor agreement, the legal fees can be
very substantial. Since the law firms and their respective clients expect that the legal fees will be paid by a third
party (the borrower), to prevent law firms operating without effective cost controls in running up huge hourly
fees, legal fee caps can be negotiated.
111

Chapter 11
Sources of equity and debt
There is a wide range of funding sources available to a project. A project company may
be capable of obtaining funding opportunities outside its domestic financial market or the
financial market of the host country.
While there is no uniform system for classifying the global financial markets, Exhibit 11.1
provides a schematic presentation of one possible system. From the perspective of a given
country, financial markets can be classified as either external or internal (also called national).
Internal markets can be sub-divided into two further groupings: the domestic market and
the foreign market. The domestic market of a country is used by issuers domiciled in the
country to issue securities that will subsequently be traded locally and the foreign market
of a country is used to issue and trade securities of issuers not domiciled in the country.
The rules governing the issuance of foreign securities are imposed by regulatory authorities
where the security is issued.
For example, securities issued by non-US corporations in the United States must comply
with the regulations set forth in US securities law. A non-Japanese corporation that seeks to
offer securities in Japan must comply with Japanese securities law and regulations imposed
by the Japanese Ministry of Finance. Nicknames have been used to describe the various
foreign markets. For example, the foreign market in the US is called the Yankee market.
The foreign market in Japan is nicknamed the Samurai market and in the United Kingdom
the Bulldog market.
The external market, also called the international market, includes securities with the
following distinguishing features:
at issuance they are offered simultaneously to investors in a number of countries; and

they are issued outside the jurisdiction of any single country.
The external market is commonly referred to as the offshore market, or more popularly,
the Euromarket (since even though this market is not limited to Europe, it began there).1
The claim or security instrument that a project company can issue may be either a
fixed currency amount (often denominated in dollars) or a varying, or residual, amount. In
the former case, the financial asset is referred to as a debt instrument. Loans and bonds are
examples of debt instruments.
An equity claim (also called a residual claim) obligates the project company to pay
the claimholder an amount based on earnings, if any, after holders of debt instruments
have been paid. Common stock is one example of an equity claim. A partnership share is
another example.
Some financial assets fall into both categories. Preferred stock, for example, is an equity
claim that entitles the investor to receive a fixed dollar amount. This payment is contingent,
112

Exhibit 11.1
Classification of global financial markets
External market
Internal market
(also called international market, offshore market
(also called national market)
and Euromarket)
Domestic Foreign
market market
however, and is due only after payments to debt instrument holders are made. Another
example is a convertible bond that allows the investor to convert debt into equity under
certain circumstances.
Possible sources of debt and equity for project financing include:
multilateral development agencies;

International Finance Corporation (IFC);
government export financing agencies and national interest lenders;
host governments;
commercial banks;
institutional lenders;
money market funds;
commercial finance companies;
leasing companies;
private equity providers;
buy-outs, buy-ins and buy-in management buy-outs funds;
bond markets;
wealthy individual investors;
suppliers of product or raw material;
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Project Financing
new product buyers or service users;

contractors;
trade creditors;
vendor financing of equipment;
sponsor loans and advances;
project collateralised bond and loan obligation pools;
insurance provided by private insurance companies; and
Islamic finance.
These possible sources for loans or equity capital can be further divided into two important
groups providing project capital: lenders and sponsors.
Commercial lenders:
banks;
institutional investors (local markets for equity and bonds):
insurance companies; and

pension funds;
commercial finance companies;
leasing companies;
savings and loan associations;
individuals;
investment management companies; and
LBO funds, money market funds and asset funds.
Commercial sponsors:
companies requiring the product or service;
companies supplying a product or raw material to the project;
multilateral development agencies:
the World Bank;

European Bank for Reconstruction and Development (EBRD);
Asian Development Bank (ADB);
African Development Bank (AfDB); and
other area development banks;
government export financing agencies and national interest lenders:
export-import banks; and

other government agencies;
host government:
government agencies; and

a central bank;
contractors;
trade creditors; and
vendor financing of equipment.
This chapter discusses each of these possible sources for loans or equity capital, including
coverage of Islamic finance.
114

1 Multilateral development agencies

The World Bank, EBRD, AD, AfDB and other multilateral development agencies provide
debt, or a mixture of equity and debt, for project financing.
Loans from these multilateral agencies have certain advantages:
the loans tend to be for longer terms than might otherwise be available;
the interest rates tend to be lower than would otherwise be available. Fixed interest rates
may be possible;
participation of the World Bank, EBRD, ADB, AfDB or other similar agencies endorses
the credit for other potential lenders; and
a co-financing arrangement or a complementary financing arrangement may be possible,
whereby commercial bank loans are linked with the multilateral agency loans, with
cross-default clauses.
The disadvantages of these loans are:
a lengthy approval process, that may delay the project for months or years; and
the funds provided may be in currencies difficult to hedge, and create significant
currency risks.
Other international agencies that may act as lenders are listed below. Sometimes these agen-
cies will provide guarantees to equity capital for a project.
Commonwealth Development Corporation (CDC).

Inter-American Development Bank (IDB).
International Bank for Reconstruction and Development (IBRD) the World Bank.
International Development Association (IDA).
International Finance Corporation (IFC).
European Investment Bank (EIB).
The World Bank is interested in encouraging loans for projects in developing countries from
the private sector by providing seed capital and permitting co-financing and complementary
financing of projects.
2 International Finance Corporation (IFC)

The IFC is a branch of the World Bank that specialises in the private sector. The IFC does
not provide financing for projects that can access the private sector for funds. Rather it
concentrates on raising funds for projects that would otherwise not be financeable. The
IFC is the largest source of equity and debt financing for private sector project financing in
developing countries that are members of the World Bank.
IFC loan programs consist of co-financing through the use of so called A and B loans.
The IFC makes fixed and variable rate A loans for its own account. IFC investments are
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Project Financing
limited to 25% of a projects cost and up to 50% for an expansion project (subject to other
constraints) B loans are made for the account of participating lenders including private sector
lenders. B loans are often syndicated to commercial banks, insurance company lenders and
leasing companies. The IFC administers the B loans, including collections and disbursements
to lenders. Participating in an IFC B loan appeals to some private lenders because of the
perceived protection against several risks. These include protection against country risk and
expropriation through association with IFC, exemption from country risk limits imposed by
bank regulators as part of the bank risk management process mentioned in Chapter 9, and
the benefits of an historic tradition of exclusion from rescheduling of IFC debt in the event
of a general rescheduling of a countrys debt.
Additionally, the IFC offers quasi-equity or C loans in the form of convertible debt and
subordinated loan investments that are subject to fixed repayment schedules. It can also offer
preferred stock and income note investments that require a less rigid repayment schedules.
Quasi-equity investments are made available whenever necessary in order to ensure that a
project is soundly funded.
All of the multilateral agencies offer advice and funding designed to support development
and changes to improve the lives of citizens of their member countries though the financing
structures may differ from the IFC.
3 Government export financing and national interest lenders

Export financing2 from government export agencies is generally available from two sources,
or a combination of both:
an export-import bank (often known generically as an Ex-Im organisation after the US

Ex-Im Bank); and
foreign aid.
Foreign aid, in turn, comes in two forms:
from the private sector of the country where the government is providing the aid; and
from the sources from which the recipient purchases goods and services.
Nearly all such foreign aid must be used to purchase goods and services from the private
sector of the country providing the foreign aid financing.
Whilst in the past, export financing was a method for governments to support export programs
through subsidised programs, many Ex-Ims now offer insurance products to support exports of
goods and services to growing economies. As a result, not all Ex-Ims currently offerloans.
Insurance products
Most Ex-Ims offer short-term credit insurance up to and including one year credit terms
and investment insurance products. These enhance a projects creditworthiness, providing
assurance to investors and supplies of capital by managing risks associated with thecountry.
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Loans and guarantees

Export agencies provide support in the form of insurance but may also offer loans and
guarantees. Export-import banks provide a guarantee for the financing that may in turn be
used to support a loan from the regular commercial banking sources of the country.
Supplier credit
In a supplier credit, a loan is made to the supplier, and the supplier quotes financing terms
to the purchaser. Supplier credits usually require the supplier to assume some portion of the
risk of financing, although as a practical matter the suppliers profit margin may exceed the
risk assumed. Not all export-import banks offer these credit facilities.
Buyer credit
In a buyer credit financing, the loan is made to the buyer instead of to the supplier.
The Berne Union

The export agencies of most countries are members of the Berne Union3 and its sister
organisation, the Prague Club, and are committed to operate in a professional manner that
is financially responsible, respectful of the environment and which demonstrates high ethical
values all in the best interest of the long-term success of our industry.
4 Host governments
Host governments will sometimes provide the following direct and indirect assistance:
government equity investment by government investment companies;

investment grants;
government subsidised loans to support new enterprises in depressed areas;
income tax concessions or real estate tax concessions (while these are not a direct infusion
of capital, they have the same effect by reducing cash flow needed for operating expenses);
concessions on royalties;
subsidised energy costs;
subsidised transportation;
subsidised communications;
subsidised employee services such as schools, hospitals and health services; and
local services, roads, water, sewers and police protection.
5 Commercial banks
Commercial banks are the largest funding source for project loans. Commercial banks tend
to limit their commitments to five to 10 years with floating interest rates based on Libor
117

Project Financing
or US prime rate dependent on borrowers, type of loan and market conditions. From time
to time floating rate loans for longer terms may be available, as may be fixed interest rate
loans for five to 10-year maturities or longer. Commercial bank loans for large projects are
typically arranged as syndicated bank loans.
Islamic finance provision is covered separately in this chapter.
6 Institutional lenders
Institutional lenders include life insurance companies, pension plans, profit-sharing plans and
charitable foundations.
In the United States, the institutional debt markets have traditionally provided a substan-
tial source of long-term fixed rate funds. Such institutions can make limited amounts of
loans outside the United States. As an example, insurance companies regulated in the State
of Arizona in the US must limit foreign investments and other asset classes loans to 10% of
their assets. In contrast, in 2007, the Canadian Government removed a restriction of a 30%
ceiling on foreign property by pension funds.4 Local checks on current policy are important
to avoid wasted efforts in attempting to access this source of funding.
7 Money market funds

Money market funds are investment funds that concentrate their investments in short-term
debt, such as certificates of deposit, short-term notes and commercial paper.
8 Commercial finance companies

Large commercial finance companies are another potential source of funds for project
financing. Compared with banks or insurance companies, finance companies do not have
a depositor base of policy-holders as a source of funds. They must buy all their funds in
the debt markets and relend at a spread. Consequently, funds from finance companies tend
to be highly priced. Some large commercial banks now have commercial finance groups or
companies as an adjunct to commercial lending activities.
9 Leasing companies
Leasing companies, that use tax benefits associated with equipment ownership, offer attrac-
tively priced leases for equipment (see Chapters 18 and 19). Independent leasing companies,
and leasing companies owned by banks and finance companies, are an important source of
loans and leases.
10 Private equity providers

Private equity providers may also lend money as additional risk capital in circumstances where
they hold an equity participation through stocks, warrants, earned or other incremental stock
rights, conversions or similar holdings or rights. Some of these companies are owned by
118

banks or insurance companies. Typically, they may limit their investments to around US$5
million. Others are independently owned, and these include some risk capital investment
funds that may invest amounts larger than US$5 million in certain situations.
11 Buy-outs, buy-ins and buy-in management buy-outs funds

The surge in numbers of buy-outs, buy-ins and their combination of new talent or money
with existing management teams in recent years have given rise to the formation of publicly
and privately financed funds to engage in such activities. These funds can be a source of
equity capital for traditional project financings. Lakeland Power Ltd, one of the earliest
private power projects in the UK could have been viewed as a form of buy-in management
buy-out (BIMBO) (see also Chapter 29), though its financial structure went through a number
of subsequent innovative changes.
12 Bond markets
At one time, limited use of debt funding via the issuance of bonds was used by project
companies or by countries to fund infrastructure projects. In recent years, the use of the
bond market as a vehicle for obtaining debt funds has increased. The model structure
for such financing is the industrial development revenue bond commonly employed in
the United States by state and local governments and by their creations. Such bonds are
issued for either project or enterprise financings where the bond issuers pledge to the
bondholders the revenues generated by the operating projects financed. These structures
are described in Chapter 16.
With the adoption of Rule 144A (discussed in the next chapter), greater use can be made
of the private placement market in the US to finance projects throughout the world using
bonds. This also links to the section on ratings agencies in Chapter 8.
13 Wealthy individual investors

Private individual investors are an important source of funds in Europe, including unregis-
tered debt instruments. Eurobonds are attractive investments because they are unregistered
(though in practice they are often registered on the Zurich or Luxembourg exchanges). In
some instances, possession of the physical bond confers ownership (bearer bonds) and this
characteristic can make them attractive to certain investors, coupled with their availability
in small denominations and certain potential tax advantages for some holders.
Private individual investors in the United States are a difficult debt source for a project
financing because public rather than private placements are required to tap this market. This
involves SEC registration, and compliance with state registration laws. Private riskoriented
investors in the United States are more inclined to investment through tax shelter or equity-
related securities than debt securities in an unknown project company.
Private individual investors have invested heavily in tax-shelter oriented investments,
such as limited partnerships, to finance research and development, oil and gas exploration,
and real estate investments. Private individual investors are also an important source of
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Project Financing
funds as end purchasers for industrial development revenue bonds (Chapter 16). Attempts
to replicate the successful tax-based models used in the United States in other jurisdictions
have achieved only limited success.
As traditional sources of long-term debt dry up, greater effort will be made to attract
private individual investors to lend and invest in project financings.
14 Suppliers of a product or raw materials

A supplier seeking a market for a product or a by-product that it produces is sometimes
willing to subsidise construction, or guarantee debt of a facility that will use that product.
This might, for example, be a canning plant supported by farmers in California, or a
steel plant using natural gas in the Middle East. The list of possible suppliers varies with
each project.
15 New product buyers or service users

A corporation requiring a product or a service may be willing to provide financial help in
getting a project built. Generally, this help will come in the form of a long-term take-and-
pay contract, or a through-put contract. Take-or-pay contracts or through-put contracts are
the equivalent of guarantees, and can be used to underwrite loans from other commercial
sources and were discussed in Chapter 2.
Another form of financing sometimes provided by a company that requires a product
or service produced by a project is an advance of capital, repaid from future production or
service provision. This might be repaid in kind, or by providing production or services at a
favourable price until the advance and the interest on the advance are recovered.
Ship operators often use long-term ship charters as the cash flow basis for financing
construction of ships. Under such an arrangement, the chartering party needing the ship
transportation service will enter into a charter of sufficient length to enable the operator to
finance the vessel by undertaking to pay for the use of the ship for a period long enough
to pay back all interest and principal to the bank(s). Such an arrangement is called a full
pay-out charter and the risk taken by the bank is that of the long-term creditworthiness of
the chartering entity, or charter party. Alternatively, lenders may be happy to take some
or all of the market risk and a range of credit risks, by financing ships based on cash flow
arising from shorter charters and a number of different charter parties.
16 Contractors
Contractors, while often enthusiastic about a proposed project financing, are rarely able to
participate significantly in the long-term financing of a project. However, contractors can
provide support in the form of fixed price contracts that are the same as guarantees to build
a project facility at a certain price. Contractors will, on occasion, agree to take a portion
of their fees as an equity interest in a project.
Contractors can sometimes be of great help to their customers by providing advice on
the financing of projects, having had considerable expertise in dealing with lenders, potential
120

sponsors and various government agencies that may be sources of funds for projects. They
may also be able to suggest structures and methods for project financing.
Finally, contractors may often have useful local knowledge about infrastructure projects
in developing countries where they are already active.
17 Trade creditors
Trade creditors wishing to do business with a project company may extend short-term credit
linked to the sale of goods and services that can offer valuable support to a project through
working capital management or short term funding provision.
18 Vendor financing of equipment

Many dealers and manufacturers have extensive financing programs to encourage the sale
of their machinery and equipment. Domestic dealers and manufacturers often compete with
export financing provided by foreign competitors, and credit terms and criteria may, as a
result, be somewhat relaxed. This type of financing has been increasingly available in recent
years, and is an important source of funds for project financing. Long-term warranties of
equipment reliability and performance from manufacturers are helpful in arranging financing
from other sources and in supporting the projects operations and thus cash flow for debt
service post completion.
19 Sponsor loans and advances

Direct loans by a sponsor to a project may not be a very satisfactory method of financing a
project, since the loan is reflected in the balance sheet, and affects the subsequent borrowing
capability of the sponsor. Most project financing tries to avoid this.
Nevertheless, in some circumstances a direct loan or advance by a sponsor is the only
way in which the project can be financed. Such direct loans may also be necessary as a
result of cost overruns or other contingent liabilities that the sponsor has assumed. A loan
is preferable to a capital contribution, since it has a formal repayment schedule and a
priority position. If the project is unconsolidated, the project may receive a tax deduction
for the interest payments on a loan. On the other hand, the interest payments on the loan
made, may be taxable to the sponsor lender, whereas dividend-payments may be subject to
the dividend received credit, possibly at a different tax rate, depending on local tax rules.
A direct loan to a project by a sponsor is also usually at a lower interest rate than might
otherwise be available. Some sponsors prefer to lend directly to a project rather than to
guarantee a loan, because they view the credit exposure as being the same. If a sponsor has
decided to accept exposure to the project risk by offering support, it might prefer to earn
interest on a loan rather than a lower fee (or even no fee) on any guarantees it provides in
support of the project.
Joint venture projects are often financed by loans or advances because of the different
borrowing capabilities of the joint venturers and the inability of the joint venture to borrow
on its own merits (see Chapter 27).
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Project Financing
Subordinated loans by an industrial sponsor to a project are commonly used in lieu of

capital contributions to provide a layer of capital in addition to the project company net worth
to support more senior borrowings and credit arrangements. Senior creditors will generally
treat subordinated loans as equivalent to net worth for the purposes of analysing debt to
net worth ratios and senior debt service ratios (see Chapter 8). The degree of subordination
to various kinds of senior debt must be specifically spelled out to provide the protection
sought by senior lenders. To the extent that such junior subordinated debt can be used to
support borrowing by the project that is non-recourse to the sponsor or off-balance sheet
to the sponsor, a project financing results.
Loans by a sponsor to a project through the sponsors captive finance company (see
Chapter 12) achieve many of the objectives of a project financing. Advances are another
form of loan by a sponsor.
20 Project collateralised bond and loan obligation pools

These structures known as CBOs and CLOs provide a format for securitising the cash
flows from pools of project loans and equity investments. So far these funds or pools have
been closed-end funds in which the loans and equity investments and cash flows were
defined at the offset. However, open-ended funds may be possible in the future. Accepted
debt ratings play an important role in establishing and securitising such funds, but the
recent scandals associated with complex asset bundles may well affect market appetite for
these securities.
21 Insurance provided by private insurance companies

Insurance against trade credit losses is available from a number of private insurance compa-
nies in a similar manner to export agencies mentioned in this chapter under 3 Government
export financing and national interest lenders. Some private insurance companies offer
political risk insurance during construction and during operation. However, the reinsurance
window for political risk insurers is limited and market reinsurance capacity may quickly
be reached with just one project (see Chapter 22).
22 Islamic finance5
Islamic finance is often described as finance without interest, but as the area has developed
over the last 30 years, this description offers a very narrow view of the range of financing
possibilities. Whilst it is almost impossible to summarise a continually growing and changing
repertoire of different financial techniques, in this section we will attempt to summarise some
of the important areas that are useful when considering Islamic finance products that can
be utilised for project financing. In addition, in our coverage of leasing in Chapter 19, we
discuss leasing under Islamic finance conditions. The use of Islamic finance in a transaction
always requires an opinion from an expert in this area who can confirm that the transaction
will fit in with the expectations laid down in the Holy Quran and developed and expanded
through religious opinions and practices.
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The basic principle of Islamic finance is that of supporting trade and forbidding the
collection of interest (Riba) associated with funding that trade. The emphasis is on asset-
backed businesses and transactions representing real sales or transfers of goods or services.
This approach, recognising the idea of sharing the risk in the transaction, fits well within
the principles of traditional project finance. Additionally, Islamic finance avoids transactions
where there is uncertainty resulting from a lack of clarity in the contract or the transaction
(Gharar). We could liken this to issues around asymmetry of information, or ambiguity of
outcome. Finally, the use of Islamic finance is prohibited for certain types of activities such
as gambling.
There are a number of common basic structures that have been developed further.
Mudarabah: in this arrangement, a partnership exists between an entity providing capital

and another entity providing for trading business skills. The capital provider bears the
losses and any surplus or gain is split between the two partners, according to a pre-agreed
ratio enshrined in the contract.
Musharakah: this structure is often used for property or for fixed assets. The duration and
structure of the partnership is either for a pre-specified period of time, or the shareholdings
may alter as the surplus allows the provider of financing to be reimbursed more quickly
as a result of a successful project.
Murabaha-Muajjal: in this approach, the supplier of funds acquires the goods on behalf
of the customer, and then sells them on credit to the entity requiring the funds, who in
turn then sells them at a margin that is used to repay the supplier of funds. Any risks
associated with the damage of the goods or quality issues do not jeopardise the repayment,
which is an irrevocable commitment.
Salam: this approach provides funds against the forward purchase of goods that are
precisely defined (in order to avoid Gharar).
Ijarah: this technique concerns the receipt of payments for the use of an asset and is
therefore more commonly used in leasing transactions. This financing vehicle is discussed
further in Chapter 19 where we cover leasing and where we also provide someexamples.
Istisnaa: in this form of financing, an agent or intermediary contracts to construct or supply
goods or services for future use by an end user, based on an agreed payment schedule.
The intermediary may in turn subcontract the production of the goods or services. The
provider of financing to the intermediary is reimbursed by the end user whose payments
cover the production price and any other marginal costs.
In both Salam and Istisnaa, the margin can also be the subject of a floor through the use
of a put agreement, covered in more detail in Chapter 26.
Whilst collateral can be taken to support these products, liens and mortgages cannot be
enforced if the loss has not resulted from misconduct or negligence on the part of the trading
partner. There are also some restrictions on the ability of a financing institution to generate
liquidity by selling Islamic finance instruments into a secondary market. The underlying spirit
and intent of risk sharing of the original contract must be respected throughout the life of
the transaction and expert advice on Shariah law compliance thoroughly investigated if there
are plans to alter the transaction parties during the duration of the contract.
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Project Financing
We could use the analogy of the assignment of contract rights in other loans. Many
interest bearing loan agreements may permit reassignment or resale of the obligation and
these rights are enshrined in the law governing the loan documentation, but are still explicitly
stated in the documentation, possibly with restrictions about prior consent from all parties.
The issue of reassignment or sale of participations in a syndicated loan (Chapter 7) usually
requires the prior consent of the borrower and banks. So too, in Islamic finance, future
events for the parties to the contract should be discussed and clarified ahead of signature.
The area of Islamic finance is continually developing and the number of transactions using
these approaches continues to rise, especially in areas where adherence to these principles is
paramount. Certification by the appropriate religious authorities of compliance with Shariah
law the transaction is not haram or forbidden can be time-consuming and the reasoning
behind decisions may not always be clear to those outside this financing community. As a
result, it remains of special interest to those economies or entrepreneurial groups where there
is a strong history of trading and deeply held beliefs about adherence to the principles of
the Holy Quran and the unacceptability of the payment of interest.
23 General guidelines when selecting sources of finance

In this chapter we have looked at a number of different sources of funding that are avail-
able for projects. Perhaps the most important message for any financial structure is the
need to try and keep it relatively simple. For every additional layer of financing, another
series of legal documents will need to be constructed, and project financings can go wrong
because of inconsistencies across complex structures. Whilst it is very tempting to try and
meet the needs of every single stakeholder group, the agency costs represented by legal fees
and other advisory fees for each of these groups (not to mention the different timeframes
under a number of sources operate) can lead to delays and frustrations in closing the deal.
Government agencies are not always swift at decision-making and an investigation of the
timeframe from initial approach to final commitment from each supplier of funds at the
design phase can help the project financier manage the project finance to the closure phase
and thereafter to minimise friction costs.
1
The classification we use is by no means universally accepted. Some market observers and compilers of statistical
data on market activity refer to the external market as consisting of the foreign market and the Euromarkets.
2
See the annual World Export Credit Guide Supplements in Trade Finance published by Euromoney Books.
3
For more information on the Berne Union, see: www.berneunion.org.uk/value-statement.html.
4
Institutional investors, global savings and asset allocation, CGFS Paper 27, submitted to the Committee on the
Global Financial System, BIS (2007). Available at: www.bis.org/publ/cgfs27.pdf.
5
Euromoney has a number of publications on Islamic finance that offer more detailed coverage of these topics.
124

Chapter 12
Use of captive insurance and finance

companies
Among the revenue and control enhancing approaches open to sponsoring companies engaged
with multiple projects, two standout developments that have continued to remain important
over time are the use of captive finance companies and the use of captive insurance companies.
In this chapter we will look at how these two approaches can add benefits to a sponsor.
The historical development of captive insurance companies has promoted the extension of
the original forms of captive finance companies to include a wider use of jurisdictions.
1 Captive insurance companies

If we consider a project financing as being a cash flow (that services the debt and equity
associated with developing and maintaining the project, as well as offering returns to those
who invest in it), a collection of assets (that may be real assets or contracts through which
the cash flow arises) and a risk envelope (within which the project exists), then the dynamic
management of that risk envelope is of paramount importance in successful project financing.
In Chapter 22, we discuss the area of risk management and we allude to the role of insur-
ance. This chapter will look at one particular method of insurance that can be beneficial
for sponsoring companies with large collections of projects or worthy of consideration by
smaller projects the captive insurance company.
A captive insurance company (or simply captive) is a separate legal entity, normally
located within a corporate structure and responsible for the insurance of some or all of the
risks associated with that group of business activities. Captives became important as insurance
premia rose for certain specific types of businesses and cover became difficult to purchase.
They also became important when groups of similar activities within a holding company were
being insured externally and the group was unable to benefit from some of the synergies
that might exist. So the captive as an organisational form arose when organisations made
the decision to bring certain or even all of their insurance activities in-house.
There are a number of different forms of captive insurance company that will be discussed
in this chapter, but as with all structures in the book, local regulations are paramount in
assessing whether or not specific corporate or fiscal structures can be implemented and can be
utilised to capture tax or other economic benefits found in other jurisdictions. Many captives
were located in relatively benign fiscal jurisdictions such as Bermuda, Cayman Islands, British
Virgin Islands, Guernsey, Isle of Man and Malta, as well as in some states in the US where
state regulations permit special forms of captives to exist (for example, South Carolina).
In the late 1970s and early 1980s, the setting up of captives was an important activity
for American banks as they internationalised and it was this driver along with American
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Project Financing
companies moving into overseas activities where project finance was widely accepted, such as
oil and gas financing, that caused the explosive growth in this market. Various authors have
suggested that the first captive insurance company was set up in the 1930s and in the early
1960s there were about 100 captive insurance companies in evidence. By 2007, the Captive
Insurance Companies Association suggested that there were over 5,000 around the world.1
If a captive is writing a significant amount of insurance business not related to the parent
(the Harper Group case in the US, which culminated in a series of rulings in 2002 suggested
this should be 30% of the premium volume),2 then it may provide tax benefits inside the
group but local regulations are not universal and expert advice is important.
Different forms of insurance captives

The different forms of insurance captives are:
single parent captive;

association/group captive;
rental captive;
protected cell captives; and
special-purpose financial captives.
The simplest form of captive is the in-house insurance company owned by a single parent
entity, known unsurprisingly as a single parent captive. It is owned and controlled by the
parent company and it will directly underwrite insurance for the parent and the group.
The benefits are the reduction in agency costs and the ability to manage premium income
and control the setting of a level of insurance deduction within the company group before
external reinsurance. There may be associated tax benefits with this activity. There will also
be control issues associated with claims management and the ability to partly insulate the
group of companies from premium loading resulting from claims from other sources, causing
the insurance market to become tight and premia to rise. Qatar Petroleum and the Al-Koot
Insurance and Reinsurance Company are examples.
Just as with a single parent captive, professional associations can form a captive for
managing the insurance of certain specific risks associated with the practice within their
profession. An example might be a captive formed by a trade association of roofers, such
as RCA Indemnity Corp the captive for The Roofing Contractors Association in British
Columbia, Canada.
In the shipping industry, the idea of mutual risk insurance for certain types of risks has
been long established through such entities as protection and indemnity insurance provided
by P&I Clubs, where membership of the club enables insurance coverage to be provided, but
also a mutual liability towards un-reinsured losses. These clubs are professionally managed
and the existence of the coverage that they offer can reassure project lenders, not least when
the club may have been rated by a rating agency. An example is the UK P&I Club also
known as the United Kingdom Mutual Steam Ship Assurance Association (Bermuda) Ltd,
managed by Thomas Miller based in Bermuda and founded in 1869. Amongst other risks,
this entity covers towage liabilities, wreck liabilities and personal injury claims from crew.
126

Use of captive insurance and finance companies
The insurance coverage is specified clearly to all club members who can also select certain
types of coverage that they consider appropriate.
Some captive companies have rented their surplus or unused capacity to other companies,
often smaller, that do not wish to set up their own captive for cost or scale reasons. These
insurance captives are called rental captives.
A more popular version of rental captives used today is the protected cell captive (also
called a segregated-protected cell or sponsored cell) wherein the renting company is able to
ring fence its assets and liabilities from the rent-a captives creditors and shareholders in the
event that the renting entity becomes insolvent.
Also seen in some project financings will be special-purpose financial captives, which
are most commonly created specifically for the securitisation of insurance transactions. So
the entities created would become part of the underlying assets of an asset-backed security.
Other forms of captive insurance company can be found but possibly of less relevance
in project financing.
Why project companies may consider forming a captive

The reasons why project companies may consider this can be summarised under the general
heading of control issues: internal and external.
Internal control
A captive allows the sponsoring company to control pricing because it has access to detailed
internal knowledge and can offer better description and risk assessment for the external
market, as well as better control over internal accounting. This allows for control of premium
income and disbursements within the company group and the ability to harvest any benefits
from timing mismatches between these activities. It can also allow for specification of cover
and through a process of disaggregation, cherry pick the risk cover offered by the external
market as opposed to purchasing a bundled product which may include some redundant
features. From a human resources management point of view, the company can control and
manage the claim, thereby increasing employee satisfaction.
External control
By taking some or all of the insurance in-house, a sponsoring company can reduce reliance on
external providers as it grows and also enters into direct relationships with reinsurers. It can
limit the effects of regulation by selecting the domicile of the captive and it has control over
the selection of underwriters with whom it places its insurance in the market. It can direct
the reinvest of short-term surplus funds into the market and control investment selection so
as to optimise return patterns for its specific groups risk profile, instead of being dependent
on a centralised investment selection policy formed and influenced by the requirements of
other, possibly unrelated activities or parts of an organisation. Sometimes, too, there are
advantages in a smaller size, especially for example, when limited political risk coverage
that is available in the market could not absorb larger amounts proposed by intermediaries.
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Project Financing
Disadvantages of captive insurance companies

Setting up a captive requires a commitment of funding for capitalisation, as well as resources
for negotiating the approval of the captive by the relevant regulatory bodies. As one example,
the state of Vermont requires a minimum capitalisation for a pure captive of $250,000.3
Perhaps, the main disadvantage is the cost associated with acquiring the expertise to manage
a captive insurance company and to cover additional areas such as investment, underwriting
and loss limitation in addition to the more typical insurance claims activity that may be
pre-existing within a sponsoring company. The existence of a captive insurance company
can cause complications for any corporate restructuring because there would need to be an
indemnity to cover future claims and run-offs.
2 Captive finance companies

An in-house or captive finance company can borrow significant funds on the basis of its
own balance sheet; consequently it can be used to provide financing to business activities,
including projects through the benefits from economies of scale that a portfolio of projects
can generate. Finance companies generally enjoy a much higher degree of leverage with their
lenders than industrial companies. This makes it possible to use a captive finance company
to enhance the total borrowing capacity of the parent corporation. Examples of captive
finance companies include Daimler Financial Services and World Omni (South East Toyota),
where the finance company supports the end purchases of goods and services from its group.
Additionally, the equity investment in a leveraged lease by a captive finance company to a
project has a double leverage effect because of the non-recourse debt associated with this
type of lease as explained in Chapter 18.
Since captive finance companies are typically more than 80% owned, a parent company
can claim tax benefits generated by its captive finance company on its consolidated income
tax return. In addition to interest expense deductions, such tax benefits include modified
accelerated cost recovery system (MACRS) depreciation on equipment purchased in connec-
tion with leases written by the captive finance company.
The US case as an historic example

For many years a captive finance company in the United States was not required to be
consolidated with its parent company. This rule was changed in 1987 by FASB Statement No.
94 (Consolidation of All Majority-Owned Subsidiaries), and consolidation is now required.
However, finance companies can still be used advantageously since lenders and rating services
will still de-consolidate them and look at them on a stand-alone basis in many instances.
For a captive finance company to be entitled to treatment as a stand-alone finance
company, so that lenders and rating services will treat the finance company as a separate
entity, the captive finance company must be organised and operated in a manner which
establishes its legal, economic and operating independence.
The finance company should be a separate corporation with its own officers and directors,
who may also be officers and/or directors of the parent company. The company should have
128

Exhibit 12.1
Leverage and debt layers (US$)
1,300
1,200
1,100
1,000
900
800
700 Senior debt (up to 400% of subordinated debt and liquid net worth)
600
US $
500
400
300
200 Senior subordinated debt (up to 50% of junior subordinated debt and net worth)
150
Junior subordinated debt (up to 50% of liquid net worth)
100
50 Liquid net worth

0
some employees whose primary duties are administering the affairs of the finance company.
The relationship between the parent company and the captive finance company should be
spelt out in an operating agreement which sets out the kinds of investments the financing
subsidiary is to make. Since the primary function of most financing subsidiaries is to finance
instalment receivables arising from the sale of the parent companys products, the operating
agreement typically specifies the obligation of the parent company to tender such receivables
to the finance company, and the terms and conditions upon which such receivables are to
be purchased by the finance company.
An existing captive finance company with an operating history and loans in place is in
an ideal position to take on additional loans and investments in projects in which the parent
company is interested, while at the same time continuing the separate nature of borrowings
used to finance such investments.
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Project Financing
Establishing a new captive financing subsidiary which will be used immediately to invest
in the projects in which the parent is interested is more difficult, but may possibly be
accomplished with careful planning. If the parent company has existing customer accounts
receivables which can immediately be transferred to the finance subsidiary, this will help to
establish the nature of the new subsidiary as a true finance subsidiary.
Contributions to the capital of a newly established finance subsidiary can consist of
existing accounts receivables as well as cash. Similar assets, such as the equity in a lever-
aged lease investment, can be contributed to the finance subsidiary by the parent company
as a contribution to capital.
The ability of a finance subsidiary to leverage its equity capital is based upon charac-
teristics which are typical of finance companies, including factors such as high liquidity of
assets, stable earning power and diversity of assets and debtors. Therefore, if the captive
finance company is to achieve high leverage on the basis of typical finance companies, its
portfolio of assets must have similar characteristics. If a large proportion of the captive
finance companys assets are invested in loans to a few projects which are long term and
illiquid in nature, this will have a material effect upon the ability of the captive finance
company to borrow on its own merit. However, the ability of the captive finance company
to borrow from outside sources can be enhanced by keep-well letters and undertakings by
the parent company. Furthermore, the parent may even guarantee the debt of the captive
finance company, although this will, of course, also have some effect on the parents credit
standing. The parent may indirectly support the debt of the finance company if the lease or
loan of the finance company is to a project whose obligations are supported by a take-or-
pay contract from the parent.
The degree of leverage which a captive finance company may achieve is largely a matter
for negotiation between the finance company, its parent and its lenders, taking all the factors
affecting the debt into consideration. Finance companies typically have layers of subordinated
debt and even junior subordinated debt to support senior debt as shown in Exhibit 12.1.
The finance company with an operating history could be structured with layers of junior
subordinated debt of (say) up to 50% of liquid net worth, senior subordinated debt up to
(say) 50% of the total of junior subordinated debt and liquid net worth, and senior debt of
up to (say) 300% to 400% of subordinated debt and liquid net worth. These are exemplar
numbers and each case needs to be viewed on its own merits. The scandals and upheavals
in the financial markets as of this writing mean that current legislation is in a state of flux
and likely to change. Moreover, an increased regulation of financial subsidiaries is expected
to be implemented under the Dodd-Frank Wall Street Reform and Consumer Protection Act
of 2010.
If the captive finance company expects to borrow long-term debt from insurance
companies, it also needs to be compliant with local laws, as well as expectations around
capitalisation and the relationship with the parent of the group.
In any situation in which the sponsor is considering a direct loan to a project, the
possibility of making such a loan through a captive finance subsidiary could be considered
because of the advantageous debt leverage, balance sheet treatment and tax treatment which
may be possible. A captive finance subsidiary can also be useful for making working capital
loans to projects where the primary project financing originates from other sources.
130

The independent character and security of the finance company used to back the borrow-
ings of finance subsidiaries has led some lenders to the conclusion that lending to a finance
subsidiary may be less risky in some instances than lending to the subsidiarys parent company.
Indeed, some lenders regard the bankruptcy of the parent as not necessarily posing a threat
to the finance subsidiary. However, experience with celebrated credit problems, presented by
companies such as Chrysler and Westinghouse, have had a sobering effect on the likelihood
of being able to separate a parents credit problems from those of its finance subsidiary.
Some companies that set out as captive finance entities, such as GE Capital, have become
significant financial players in their own right. In 2011, for example, GE Capital not only
supplied two wind turbines to a French renewable energy project with a 10-year full service
agreement but also provided private equity financing.
1
CICA, Guide to captive insurance, 2008, p. 8: www.cicaworld.com/index.aspx.
2
See www.wmsolutionsnow.com/Captive_Insurance_Tax_Rulings.html. There were three different key US cases on
the deductibility of premiums paid to captives that were ruled upon by the US Tax Court: AMERCO, the Harper
Group, and Republic Western Insurance Co (a subsidiary of Sears, Roebuck & Co).
3
State of Vermont, Department of Banking, Insurance, Securities and Health care Administration: www.bishca.
state.vt.us/captives/captive-laws.
131

Chapter 13
Instruments used in project financing
As project financing techniques have grown in recent years, so has the array of finan-
cial instruments grown to meet the needs of the artful project financier. However, the
choice of financial instruments available to a borrower varies with the type of project
financing involved.
In the idealistic view of project financing, the lenders or investors must be satisfied to
look to the cash flows and assets of an under-capitalised project as the sole source of funds
for repayment. The search for this perfect form of project financing in which lenders will
look only to the cash flows for repayment with little equity underneath them is elusive and
a little like the quest for the Holy Grail. Many people have heard about it, believe in it,
and are searching for it, but thus far, at least, no one has seen it.
As discussed in Chapter 1, a more realistic form of project financing is a transaction
in which lenders and investors will look initially to the cash flows and assets of a project
for repayment. Those cash flows and assets are then backed by indirect guarantees in the
form of such devices as take-or-pay contracts, tolling contracts, put-or-pay contracts and/or
a long-term operating contract coupled with proven underlying assets. These are not invest-
ment grade credits. However, banks, lessors and other lenders with the technical expertise
to understand and appraise the risks involved can aid in structuring the undertakings of the
interested parties so that taken together they constitute an equivalent to adequate guaran-
tees. If satisfied with the arrangement, such banks, lessors and lenders will advance funds
or provide standby credit facilities on that basis.
Another category of project financing with a much broader array of available financing
methods is one which is off-balance sheet and without recourse to the sponsor while at
the same time constituting a clear liability of one or more third parties who are interested
in getting the project built for one reason or another, such as companies with a need for
the product to be produced or the service to be provided. Obviously, projects with strong
undertakings and guarantees by investment grade third parties have a much broader array
of financial products available than a highly geared project based upon indirect, contingent
and/or implied guarantees for credit support.
Past shortages of medium- and long-term capital for project financing and for conven-
tional financing have resulted in a variety of debt instruments containing unusual features,
either to attract investors or to deter risk. Many of these are private debt issues which may
be arranged through a commercial bank or investment bank, and most can be adapted to
project financing.
Some of the possible instruments and sources of funds for project financing are discussed
below. Not all of these instruments have been used in project financing. However, they have
features and characteristics which give them promise for the future where investors can be
satisfied that equivalent to investment grade risks exist.
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With proper structuring of the underlying credit risks, the artful project financier has a
variety of methods and instruments from which to choose.
In addition to the instruments discussed in this chapter, there are derivative instruments
(that is, futures, forwards, swaps, options, caps and floors) that can be used to modify the
risk exposure or lower the funding cost. Derivative instruments are discussed in Chapters
24, 25 and 26.
1 Commercial bank loans

Commercial banks remain the most popular and largest source of project financing because
of the ability of banks to understand and appraise the credit risk exposures involved in
unusual loan transactions. Many of the large international commercial banks employ staffs
of engineers to assist in the structuring of project financings which involve mining or petro-
leum projects. They have expert staff often organised into specialist lending groups and
including equipment experts and real estate professionals to assist in asset-based financing.
These banks also have experienced and professional loan officers with expertise as to the
acceptable practices and risks of particular industries.
Bank loans may take the form of secured or unsecured loans. Commercial bank loans
may involve a single lender, several lenders or be syndicated. They may be in the form
of construction loans, term loans, bridge loans, mortgage loans or working capital loans.
Commercial banks tend to limit their commitments to 5 to 10 years with floating interest rates
based on the London interbank offered rate (Libor) (or equivalent financial centre funding
basis) or the US prime rate. Periodically, loans for longer terms are available. However, at
the time of writing, the markets are difficult for project lending. Fixed-rate loans for five to
10 year maturities or longer are sometimes available.
Equally as important as loans are standby credit facilities provided by banks with the
expertise to understand and appraise the credit risks of a financing. Such standby facilities
are the key to accessing the private and public markets for project financing. This can be
attractive business for banks if priced correctly.
Commercial bank loans and standby facilities for large projects are typically arranged
on a syndicated basis by a group of banks.
Documentation for commercial bank loans consists of the loan agreement, promissory
notes (in the United States), guarantees and security documents.
Some of the key and obvious points to be covered in a loan agreement include
the following.
1 The amount which may be borrowed.

2 Commitment fees for unused amounts under the commitment.
3 The term of the loan and repayment schedule.
4 The interest rate on the outstanding balance.
5 The procedure for drawdowns or take-down and conditions precedent for thedrawdown.
6 Representations and warranties of the borrower including:
use of proceeds;
financial conditions;
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Project Financing
title to assets;

material litigation;

contingent liabilities;
establishment and organisation; and
authority to enter into the loan agreement.
7 Legal opinions which will be required at the closing of the loan agreement, at the time
of take-downs, and periodically during the loan agreement.
8 Affirmative covenants, such as:
compliance with laws;
payment of taxes;
maintenance of equipment and facilities;
obtaining requisite government approval;
maintenance of insurance;
furnishing periodic financial reports;
non-encumbrance of assets; and
limitations on mergers, dividends and sale of assets.
9 Financial covenants, such as:

limitations on indebtedness; and
maintenance of financial ratios.
10 Responsibility for any withholding tax on interest.

11 Enforceability of the rights of the lender:
events of default and opportunities to cure a default;
remedies in case of default;
cross-default clauses; and
insurance proceeds.
2 Supplier financing and captive finance companies

Companies anxious to supply goods and equipment to a project are an excellent source of
funds for project financing. Most manufacturers of large items of capital equipment have set up
captive finance companies or units to assist in arranging financing for their products. Usually
these captive financing companies are specifically designed to generate incremental sales by
dealing with less than investment grade credits. Competition often forces such companies to
offer very competitive rates and terms which are not otherwise available in the marketplace.
Instruments used by suppliers will include secured and unsecured term loans and instal-
ment loans and leases. While supplier financing is not itself an instrument, the service is so
important that it requires mention as a separate category (see also Chapter 12).
3 Export credit financing

Government export credit financing can be especially attractive for eligible projects. This type
of loan or guarantee of commercial bank credit may be available for a longer term than
traditional commercial bank loan funding. Further, the loan interest rate may be subsidised
and be offered at a fixed interest rate.
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Where potential suppliers of equipment and services from different countries are competing
to supply a particular project, the bidding (in the form of export credit terms) can become
quite spirited.
Export financing or guarantees may be available even though the goods or equipment
contain foreign content parts. The US Eximbank, for example, will finance or guarantee up
to 100% of US content of capital goods or equipment where up to 50% of the value of
the finished product constitutes foreign content, but local and current regulations should
always be checked.
Commercial banks and investment banks with experience in project financing and export
credit agency financing can be especially helpful to a project in selecting and negotiating
favourable terms and conditions for such financing. Large suppliers and contractors can also
be helpful in this regard.
4 Buyer credits supported by an export credit agency

In a buyer credit, an export credit agency provides guarantees to the buyers commercial banks
which then advance funds toward purchases of equipment to be financed. The funds are the
same as a loan to the buyer and will give the buyer the advantage of a cash transaction in
dealing with the various suppliers. This type of an arrangement is especially well suited for
a project financing. The key document in a buyer credit arrangement is a loan agreement
between the bank acting as the lender and buyer or the central bank in the buyers country
which is acting as the borrower. The contract price for the equipment includes the cost of
the export credit agency premium payable by the exporting company.
5 National and international development bank loans

Long-term fixed rate loans at attractive rates may be available for certain projects from
national and international development banks. The difficulty with arranging such loans for
an eligible project is the lengthy approval process which may delay a project for months
or years. Procedural requirements such as competitive bids for construction contracts and
equipment purchases are another drawback. Also, the funds provided may be in a currency
difficult to hedge.
6 Co-financing and complementary financing

Co-financing and complementary financing is used in connection with international develop-
ment bank loans, World Bank loans, IFC loans and EBRD loans. The idea is for the agency
to provide seed money for the project and to intertwine its loan with loans from the private
sector so that a default on the private sector loan will also constitute a default on the
international agency loan. The theory of this arrangement is that the borrower and the host
country for the project will be less inclined to permit the loan to default by reason of the
World Bank or agencys involvement. The World Bank and EBRD encourage and promote
co-financing arrangements. This is also discussed in Chapter 11.
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Project Financing
7 Syndicated credit facility

A syndicated credit facility is one in which a number of banks undertake to provide a loan
or other support facility to a customer on a pro rata basis under identical terms and condi-
tions evidenced by a single credit agreement. These facilities are generally floating rate in
nature, with or without amortisation, and the pricing will normally consist of a fixed spread
over a short-term base rate (which base rate is adjusted periodically during the life of the
loan), with commitment fees, agency fees, management fees, offsetting balances, security and
so on, often included as well. Tenors may range from one to 12 years.
Syndicated credit facilities may be structured as conventional revolvers and club loans to
multi-option or highly single-purpose facilities. They may consist of revolving or term bank
lines, commercial paper liquidity (back-up) lines, standby letter of credits (for commercial
paper, private placements, IRBs, Eurobonds and so on), bankers acceptances, receivable
financings and so on. Pricing is generally based on prime, Libor, certificates of deposit, or
bankers acceptances, in varying combinations, for funding periods ranging from days to one,
two, three, six or 12 months. Participants include all types of financial institutions, but are
primarily major international banks. The lead or agent bank oversees the structure, pricing,
syndicate configuration, construction of a timetable, selling, documentation and closing of
the transactions, as well as administering the facility until final maturity.
The following are general advantages of the syndicated loan market.
1 Large amounts of debt can be raised. The syndicated loan market is the largest source
of international capital.
2 Loans may be made in any of several currencies.
3 The number of participants can be substantial.
4 Banks participating in syndicated loans are sophisticated and able to understand and
participate in complex credit risks presented by project financing.
5 Drawdowns can be flexible.
6 Prepayment is customarily permitted.
Syndicated loans are generally used by governments and government agencies. However,
strong corporate credits, utilities and energy projects have used this market to raise funds.
A major advantage of syndicated loans for borrowers is the large amounts of financing
available, their flexibility, and the fact that they are relatively quick and cheap to arrange.
Syndicated loans are usually structured as term loans. The major disadvantage of the
syndicated loan market is that the interest rate is usually floating, and is usually based on
Libor, which may be high cost relative to other market rates. In the Far East, the local
inter-bank rate would be used for setting the interest rate. Since interest rate is floating,
the lender ordinarily protects itself by a matching deposit in the London inter-bank market
in the same amount and term, which is renewed each interest period. Syndicated loans are
usually amortised according to a fixed schedule, and repayment begins after a term of years
known as a grace period, which is usually not longer than five or six years. Maturities are
as long as 10 years, and sometimes longer. Syndicated loans can be repaid without penalty.
Syndicated loans are arranged by a manager or lead manager using the process discussed
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in Chapter 7. Terms and conditions are negotiated by the manager. The manager could be
a commercial bank providing loan funds, or either a merchant bank or a commercial bank
which acts solely as the arranger of the loan. The manager in a syndicated loan transaction
monitors a borrowers financial condition during the term of the loan. Such loans contain
numerous covenants and default provisions. Most syndicated loans are unsecured but they
may be protected by a negative pledge of the project companys assets. Syndicated loans are
usually non-negotiable and remain on the banks books until maturity (though asset sales do
take place). The member banks will try to retain the right to assign participations to their
branches or to other banks, but this is often granted conditional upon prior approval from
the borrower, sponsoring companies and/or the lead manager and majority of thesyndicate.
Many syndicated loans are denominated in US dollars, but may also be denominated in
other currencies including Sterling, Euros, Swiss francs, or Japanese yen. Central banks often
prefer loans in their country to be led by one of their domestic banks. Syndicated loans are
made to developing countries, whereas bond issues are normally restricted to industrialised
nations. For many sovereign states, the syndicated loan market is one of the few international
financing options available.
8 Production payment loans and advances

Production payment loans and advances are widely used for both off-balance sheet and
on-balance sheet financing of oil and gas properties. They are also beginning to be used for
coal and other minerals. In a pure production payment loan, the obligation is to be repaid
from proceeds of oil or gas production. These loans are typically provided by banks and
bank syndicated credits. The skill and reputation of the operator is an important factor in
appraising the creditworthiness of the transaction. Production payment loans have been used
extensively in financing development of the North Sea gas and oil fields, as well as in the
United States. These are discussed further in Chapter 28.
9 Short-term financing vehicles

Commercial paper is a particular form of short-term roll-over note and is widely used
by established companies as a reliable source of short-term financing which can be rolled
over to provide working capital or very short-term finance as part of a financing package.
Normally unsecured, less established or less well-known companies to this market would
use a back-up letter of credit or line of credit from a commercial bank to support their
program. The all-in cost of commercial paper can be attractive compared with other
methods of financing one of the attractions of the commercial paper market is that
a detailed (and thence expensive) securities registration process need not be followed.
However, in order to protect investors, there are limitations placed on commercial paper
programs. They may not be used for fixed asset financing (and thence would only be
useful for working capital financing). The notes usually have a life of up to 270 days in
the US though this can be longer outside the US (for example, AG issued its 10 billion
multicurrency commercial paper program in 2009 for periods of up to two years less one
day). A key feature of these programs is that the rollover of the paper is not automatic.
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Project Financing
Commercial paper and back-up credit facilities used in connection with commercial paper
are discussed in Chapter 17. The issuing program is set up and then the paper is issued
as and when required.
Short-term roll-over notes should only be used with back-up credit lines for long-term
financings, and the projected interest cost of the notes should include fees for the back-up
credit lines. Without a back-up facility, the risk is that the note fails to roll over, becomes
due and payable and non payment could trigger a default. A commercial paper program can
be for domestic use or use offshore currencies, a so-called Euro-commercial paper (ECP),
and a short-term note program can be a Euro note program.
ECP had its beginnings as Euro notes with maturities of one week, one month, three
months, six months or one year. Euro notes are negotiable bearer instruments, usually
denominated in dollars but also denominated in sterling, Euros and several other currencies.
Euro notes are usually issued through note issuance facilities (NlFs) consisting of medium-
term standby facilities provided by a group of banks. Distribution under a NIF takes place
through a tender panel of syndicate banks who are invited to bid for each issue. Revolving
underwriting facilities (RUFs), which may be collateralised (CRUF) or transferable (TRUF)
can also be used as support mechanisms for issuance of these notes. NIFs and RUFs will
count as contingent liabilities of the entities participating in them.
As the market for Euro notes matured, some issuers began to issue Euro notes without
a standby facility, thus giving rise to ECP programs. Both short-term note programs and
commercial paper programs have become more mainstream as an example, the Japanese
commercial paper program mentioned as a novel idea in a previous edition of this book is
now a well-developed market and commercial paper programs exist in other newer markets
such as Turkey and India.
10 Bond financing
As explained in Chapter 11, greater use is being made and contemplated for raising funds
for a project via the bond market.
Eurobond market
The Euro market was described in Chapter 11. The distinguishing features of the securities in
this market are that: (i) they are underwritten by an international syndicate; (ii) at issuance
they are offered simultaneously to investors in a number of countries; (iii) they are issued
outside the jurisdiction of any single country; and (iv) they are in unregistered form. The
sector of the Euro market in which bonds are traded is called the Eurobond market and the
bonds traded are called Eurobonds.
The maturity of Eurobonds typically ranges from five to 10 years, or even longer in
certain markets. Interest is payable annually at a fixed rate or floating rate, and is paid
free and clear of withholding taxes. Investors have call protection of three to four years,
and some premium may be charged in the event of a call. Eurobonds contain few default
clauses other than for non-payment of principal or interest. However, they do contain nega-
tive pledge clauses.
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Eurobonds include zero coupon bonds, floating rate bonds, stock convertibles, bonds
with warrants to purchase stock and bonds with warrants to purchase more bonds at a
set price.
Many international banks participate in the Eurobond market. Individual investors are
attracted to Eurobond investments because of the obvious tax advantages. They are under-
written usually by a group of underwriters, with one or more managing underwriters.
In pre-priced issues (also called bought deals) the underwriter guarantees a price and
an interest rate to the seller in advance of the sale. The market risk is thus transferred to
the underwriter (or lead manager) who in turn shares the risk (or attempts to do so) with
members of a syndicate. Competition has forced underwriters to engage in this practice,
which involves considerable risk. New entrants with no customer following have used the
bought deal as a means of competing for business.
Eurobonds can be denominated in several major currencies. Eurobonds are referred
to by the currency in which the issuer agrees to denominate the payments. For example,
US dollar-denominated bonds are called Eurodollar bonds and Japanese yen-denominated
bonds are called Euroyen bonds. The largest share of the Eurobond market remains the
Eurodollar bond, but the number of currencies continues to grow to include Euro roubles
and Euro renminbi. Eurobonds denominated in Euros were also popular until the current
Euro crisis.
The advantages of borrowing in the Eurobond market are:
1 the potential for lower cost funding under certain market conditions, particularly with
the use of swaps (as explained in Chapter 25);
2 access to a large diversified group of individual lenders not otherwise available; and
3 rapid access to the market to take advantage of current market conditions.
US bond market
The US bond market accounts for around 40% of the international bond markets as of
mid 2011. A lengthy discussion of the public debt markets is beyond the scope of this
chapter, but the US market is chosen as an exemplar. Access to the public debt markets in
the United States requires compliance with the federal and state securities laws, which raises
special problems for most project financing. While the potential exists for registration and
rating of such debt for a project financing, and undisclosed ratings have been solicited for
some projects as a guide to the future marketability of the securities, access to public debt
markets may be very difficult for projects located outside the US. Sponsors and guarantors
with established credit may access the public debt markets.
In recent years in the United States, the introduction and acceptance of so-called
junk bonds (which by their nature are less than investment grade and were discussed
in Chapter 8) as part of investment portfolios, has revolutionised the financing of lever-
aged buyouts. Such bonds are attractive to issuers because they have few covenants and
often are not convertible, so are sold without stock warrants or options. While they pay
higher interest, this is still a less expensive form of finance where such bonds are used
as a substitute for equity. They are usually subordinated to senior debt. These types of
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Project Financing
bonds certainly have the potential for wide use in project financing as long as there is
investor appetite.
Rule 415
Securities Act Rule 415, which was originally adopted by the Securities and Exchange
Commission (SEC) on 24 February 1982, and subsequently refreshed, expands the avail-
ability of shelf registration statements and the distribution techniques which may be covered
thereby. Its provisions permit easier, quicker and more flexible access to the debt markets
than in the past. (This used to be a major drawback of US debt offerings as compared with
Eurobond offerings.)
Under Rule 415, a company is permitted to register the amount of debt and equity
securities which it reasonably expects to sell within three years of the effective date of the
registration statement. Although the securities can then be sold and distributed in any manner,
it is important to also read the interpretation notes provided by the SEC as they relate to
specific cases and classes of securities, especially more complex debt types.
A company can register debt and equity securities in advance and, when market condi-
tions warrant, reach definitive agreement with the managing underwriter(s) as to the type
and terms of securities to be offered. Terms can be negotiated within a matter of minutes,
sales can be orally confirmed immediately, and the underwriters can have a prospectus to
deliver to customers with written confirmations within a few hours.
Form S-3
The SEC has adopted registration form S-3, which relies almost entirely on incorporation by
reference to Exchange Act reports, and contemplates a barebones (basic) prospectus.
Form S-3 will be available to any US company (or foreign company filing the same reports
under the Exchange Act as a US company) which has not had a serious default under its
long-term debt or preferred stock since the end of its last fiscal year, and which has been a
reporting company for three years and has made a timely Exchange Act filing in the most
recent 12 months. Form S-3 may be used: (i) for primary and secondary offerings of any
security of a company which has (a) US$150 million in market value of voting stock held
by non-affiliates, or (b) US$100 million in market value of such stock and an annual trading
volume of at least three million shares; and (ii) for primary offerings of investment grade
non-convertible debt and preferred stock. A firm commitment underwriting is not required
as a condition of the use of Form S-3.
In the typical case, an issuer using Form S-3 for a shelf offering would file a registration
statement containing a barebones prospectus. This would include a description of possible
debt securities, or of the common stock which might be issued, as well as a description in
general terms of the various possible methods of distribution. At the time of pricing, the
basic prospectus, supplemented with a wrap-around reflecting the actual terms and method
of distribution (supplemented prospectus), would be sent to purchasers with the confirma-
tions. The supplemented prospectus is mailed to the SEC but no action on the part of the
SEC is required.
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Yankee bonds
Foreign borrowers seeking to gain access to US capital markets organise and issue bond
issues in the United States similar to US domestic issues. These bonds are called Yankee
bonds and they often end up being sold in Europe.
Where foreign credit support is relied upon to support a project financing, the foreign
credit must be of the highest quality. However, a less than high quality credit can be
made marketable in the United States by obtaining letter of credit backing for the loan.
Large commercial banks and some insurance companies can provide such letter of credit
support to enable a borrower to gain access to the US private placement market. (See
Chapters 17 and 23 for a more detailed discussion of letters of credit and back-up lines
of credit.)
Private placement debt

Private placements differ from public offerings in that private placements do not require
regulatory approval, do not require public disclosure, and are arranged with a limited number
of institutional sophisticated investors (accredited investors). The private placement market
may be accessed directly or more usually through a commercial bank or investment bank.
The private placement market has several advantages.
1 Private placements do not require registration under the securities laws (but may require
registration in certain US states).
2 The borrower can retain absolute control of when it wishes to enter the market. That
entry does not have to be at the end of a registration period, as with a public offering.
Thus, the borrower can have its papers ready, and wait until market conditions are
to its liking.
3 The interest is usually at a fixed rate. Pricing (and hence the coupon interest rates) of
privately placed debt closely follows the market for publicly traded bonds. While public
bonds are priced continuously in the secondary market throughout each trading day, the
rates for new private placements are set within each institution by finance committees
which usually meet once a week. Thus, movements in private rates typically lag behind
public rates, although both are affected by general economic conditions. This lag can be
used to advantage.
4 Buyers in the private placement market have the sophistication to understand a project
company with a complicated credit or financing structure to explain.
5 A private placement is a good way to establish useful long-term investor relationships
which a borrower can call on for future financings.
6 No public disclosure of sensitive information is required.
7 There are longer maturity alternatives available under a private placement.
8 The all-in cost of a private placement is not expensive. Both US and Euro public offer-
ings involve substantial legal and printing expenses, whereas a private placement requires
virtually no printing and fewer legal expenses. In addition, the underwriters/managers
spread on a public issue is greater than the fee to a private placement adviser.
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Project Financing
A disadvantage of the private placements market is that interest rates may be higher than
the public US market or the Eurodollar market for similar rated debt. Foreign borrowers in
the United States will find the marketplace for private placements somewhat limited. Only
the larger institutional investors have the sophistication to analyse foreign credit arrange-
ments, and their total investment in foreign loans is limited to 5% of their assets. There are
approximately 50 insurance companies and institutions in the United States who are buyers
of private placements, and about 20 of these are regularly in the market.
Private placement funds are available outside the United States in Eurodollars, sterling,
Euros, yen, Swiss franc and other currencies and are discussed further in Chapter 15.
Rule 144A
In the United States, one restriction imposed on buyers of privately placed securities was that
they could not be resold for two years after acquisition. Thus, there was no liquidity in the
market for that time period. Buyers of privately placed securities must be compensated for
the lack of liquidity which raises the cost to the issuer of such securities.
In April 1990, however, Securities Act Rule 144A became effective. This rule reduces the
two-year holding period prior to resale by qualified institutional buyers (QIBs) (which need
to provide certification that they meet the criteria laid out in the Act before participating
in these offerings and which are normally large institutions) to trade securities acquired in
a private placement among themselves without having to register these securities with the
SEC. Private placements are now classified as Rule 144A offerings or non-Rule 144A offer-
ings. The latter are more commonly referred to as traditional private placements. Rule 144A
offerings are underwritten by investment bankers.
Rule 144A encourages non-US corporations to issue securities in the US private place-
ment market for two reasons. First, it attracts new large institutional investors into the
market that were unwilling previously to buy private placements because of the require-
ment to hold the securities for a period. Second, foreign entities had been unwilling to
raise funds in the US prior to establishment of Rule 144A because they had to register
their securities and furnish the necessary disclosure set forth by US securities laws. Private
placement requires less disclosure. Rule 144A also improves liquidity, reducing the cost
of raising funds.
The distinction between public offerings and private placements has been reduced as a
result of Rule 415 and Rule 144A including more recent changes.
Industrial development revenue bonds

Industrial development revenue bonds (IDR bonds also known as industrial revenue
bonds) are issued in connection with the development or purchase of industrial facilities. As
explained in Chapter 16, the variety of IDR bonds available for use in the United States
is limited. The main attraction to borrowers of IDR bonds is their attractive interest rates
due to the fact the interest paid on the bonds is free from income tax. Their use may
also result in a reduction or elimination of state real estate or property tax. True leases
of equipment can be used to keep projects within statutory capital expenditure limits.
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IDR bonds can be issued as either public or private placements and may be priced in a
fixed or floating basis.
Bond structures
There are a wide range of bond structures. The more popular structures in the US and
Eurobond markets are reviewed in the following sections.
Floating-rate notes
A floating-rate note (FRN) is a security with a coupon rate that changes based on some
reference interest rate. Domestic markets of many countries permit the issuance of an FRN.
In the Eurobond market there is a wide variety of floating rate bonds.
In the Eurobond market, almost all floating rate issues are denominated in US dollars.
The coupon rate on a Eurodollar FRN is some stated spread over Libor, the bid on Libor
(referred to as Libid), or the arithmetic average Libor and Libid (referred to as Limean).
The size of the spread reflects the perceived credit risk of the issuer, spreads available in the
syndicated loan market and the liquidity of the issue. Typical reset periods for the coupon
rate are either every six months or every quarter, with the rate tied to a six-month or three-
month Libor, respectively. That is, the length of the reset period and the maturity of the
index used to establish the rate for the period are matched.
Many issues have either a minimum coupon rate (or floor) that the coupon rate cannot
fall below and a maximum coupon rate (or cap) that the coupon rate cannot rise above. An
issue that has both a floor and a cap is said to be collared. Some issues grant the borrower
the right to convert the floating coupon rate into a fixed coupon rate at some time. Some
issues, referred to as drop-lock bonds, automatically change the floating coupon rate into a
fixed coupon rate under certain circumstances.
A floating rate issue either has a stated maturity date, or it may be a perpetual,
also called undated, issue (that is, with no stated maturity date). For floating rate issues
that do mature, the term is usually more than five years, with the typical maturity being
between seven and 12 years. There are callable and puttable FRNs; some issues are both
callable and puttable.
The typical FRN has a coupon rate that increases with Libor. However, FRNs have been
issued where the coupon rate varies inversely with the reference rate. FRNs with this coupon
structure are referred to as inverse floaters. They are issued as structured notes which we shall
describe later. The issuer is not making a bet about interest rates. Instead, the issuer will be
swapped out of the risk using an interest rate swap. The issuer does face counterparty risk
with respect to the swap counterparty. (Swaps are covered in more detail in Chapter 25.)
Zero-coupon bonds
All bonds make periodic coupon payments, except for one type that makes none, that is, only
a single payment. These bonds, called zero coupon bonds, made their debut in the US bond
market in the early 1980s. The holder of a zero coupon bond realises interest by buying the
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Project Financing
bond substantially below its principal value. Interest then is paid at the maturity date, with the
exact amount being the difference between the principal value and the price paid for thebond.
As an example, suppose that a project company issues a five-year zero-coupon bond in
the Eurobond market with a maturity value of US$40 million and a yield of 7%. The issuer
would sell the bond for US$28,519,447. The difference between the US$40 million maturity
value and the price at which the bonds are issued represents the accrued interest that the
investor receives if the bond is held five years to the maturity date. It is US$11,480,553 in
our example.
An advantage of a zero-coupon bond to issuers is that interest may be deducted annually
even though the issuer does not make a cash payment to bondholders.
Investors find zero coupon bonds attractive during periods of declining interest rates
because a zero coupon issue locks in a yield for the investor. Also, investors in some countries
are granted favourable tax treatment for realised capital gains. The favourable tax treatment
means a lower tax rate than applied to other income and, in some instances, may mean
no tax at all on the capital gain. This favourable tax treatment is sometimes applied to the
capital gain realised by buying a zero coupon bond and holding it until maturity.
Deferred coupon bonds

Deferred coupon bonds postpone the payment of interest to some date prior to maturity. For
example, a Eurodollar US$40 million five-year deferred coupon bond with a coupon rate of
7% may have the following structure. Rather than paying coupon interest of US$2.8 million
per year for five years as with a Eurostraight bond, the coupon payments can be structured as
follows: no coupon payments for years one, two and three; US$11.2 million (US$2.8 million
times four) in year four; and US$2.8 million in year five. The deferred coupon structure is
tax motivated. Investors in some countries can purchase this bond and sell it before the first
coupon payout year four in our example. The market price just before the pay-out in year
four will reflect the accrued interest. The capital gain realised by selling the issue prior to
maturity is granted favourable tax treatment despite the fact that the capital gain represents
accrued interest. Because of this tax advantage to the investor, an issuer can benefit through
a lower coupon rate on the issue compared with a Eurostraight issue.
Finally, for some bond structures, the issuer pays a fixed coupon payment, but two
tranches are created so that the principal payment at maturity is indexed to some financial
or commodity benchmark. Examples are Euro yen bonds called bull and bear bonds. With
these bonds, one bond tranche, called the bull tranche, has a maturity value that rises in
value if the Nikkei Dow Index of stocks in Japan rises. The bear tranche has a maturity
value that declines in value if the same index declines. The issuer of this type of bond is
hedged against the movement of the index since the change in maturity value of one tranche
has the exact change for the other tranche.
Convertible bonds
A convertible bond grants the bondholder the right to convert the bond to a predetermined
number of shares of common stock of the issuer. The number of shares of common stock
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that the bondholder receives from exercising the option of a convertible bond is called the
conversion ratio. The conversion privilege may be permitted for all or only some portion of
the bonds life, and the conversion ratio may decline over time.
Convertible issues are callable by the issuer. This is a valuable feature for the issuer,
because an important reason for using convertibles is that a firm seeking to raise additional
capital would prefer to raise equity funds but deems the current market price of its stock
too undervalued so that selling stock would dilute the equity of current stockholders. So it
issues a convertible, setting the conversion ratio on the basis of a price it regards as accept-
able. Once the market price reaches the conversion point the issuing entity wants to see the
conversion occur in view of the risk that the price may decline again. It has, therefore, an
interest in forcing conversion, even though this is not in the interest of the owners of the
security because its price is likely to be adversely affected by the call.
If a convertible bond is used as part of a project financing, the conversion feature gives
the lender upside potential in the project. The equity kicker encourages the lender to provide
terms or take risks which it would not otherwise be inclined to take.
A special type of convertible was developed by Merrill Lynch. This is a zero coupon
convertible note. The issue is callable and puttable. However, the put feature makes it
unattractive for project financing since the holder can force the project company to repay
the issue at specified dates.
An exchangeable bond grants the security holder the right to exchange the security
for the common stock of a firm other than the issuer of the security. For example, some
Ford Motor Credit convertible bonds are exchangeable for the common stock of the parent
company, Ford Motor Company.
Bonds with warrants

Warrants are sometimes issued as part of a bond offering. A warrant grants the warrant
owner the right to enter into another financial transaction with the issuer. Most warrants
are detachable from the host bond; that is, the bondholder may detach the warrant from
the bond and sell it.
Several types of warrants have been issued as part of a Eurobond offering: equity
warrants, debt warrants, currency warrants and commodity warrants.
An equity warrant permits the warrant owner to buy the issuers common stock at a
specified price.
A debt warrant entitles the warrant owner to buy additional bonds from the issuer at
the same price and yield as the host bond. The debt warrant owner will benefit if interest
rates decline because a bond with a higher coupon can be purchased from the same issuer.
A currency warrant permits the warrant owner to exchange one currency for another
at a set price (that is, a fixed exchange rate). This feature protects the bondholder against a
depreciation of the currency in which the bonds cash flows are denominated.
A commodity warrant permits the warrant owner to buy a certain amount of some
specific commodity at a fixed price. The typical commodities that have been used in the
Eurobond market are gold and oil.
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Dual-currency bonds
Some fixed rate coupon issues pay coupon interest in one currency and pay the principal in
a different currency. Such issues are called dual-currency bonds. For example, the coupon
payments can be made annually in Swiss francs while the principal can be paid at maturity
in US dollars. There are three types of dual-currency bonds.
The first type is one in which the exchange rate at which the principal and coupon are
repaid is fixed at the time of issue. The second type differs from the first in that the exchange
rate is the rate that prevails at the time a cash flow is made (that is, at the spot exchange
rate at the time a payment is made).
The third type offers either the investor or the issuer the choice of currency in which a
cash flow can be denominated at the time the payment is made. These bonds are commonly
referred to as currency option bonds. Effectively, this third type of dual-currency bond grants
either the issuer or the bondholder an option to take advantage of a favourable exchange
rate movement.
Commodity-linked notes
Commodity-linked notes allow the investor to share the risk in upside potential of future
commodity prices with the issuer. Petrobonds, silver bonds, gold bonds and coal bonds have
been issued.
In a commodity-linked note, investors are paid interest in currency but paid the principal
amount at maturity based upon the then current value of the related commodity. A petro-
bond, for example, might carry a fixed interest rate coupon with a part of the face value of
the bonds denominated in barrels of oil. A coal bond, for example, might carry a royalty
payment per ton of coal mined, in addition to an interest coupon rate. There is a floor in
the face value of the bonds. The interest coupon will be less than the oil company or coal
company would otherwise have had to pay. If inflation increases, so does the value of the
commodity and bond. If the price is lower at maturity, the investor receives full face value.
In that case, the issuer obtains money at a lower cost than if it had done a conventional
bond financing.
Another variation of commodity notes which is used to lower the cost of debt is to issue
along with debt, warrants to purchase some amount of the commodity at a set price at some
point in the future. The warrants can be separated from the debt for secondary trading.
Credit-linked notes
A credit-linked note is a form of credit derivative that has a maturity typically between one
and three years. The note is a standard bond offering with one exception: the maturity value
depends on the credit of a reference issuer. The reference issuer could be a project company
or a pool of assets. In the basic credit-linked note, the prospectus calls for a reduction in
the maturity value if a credit event occurs with respect to the reference issuer. The amount
of the reduction is specified in the prospectus as well as the definition of what constitutes a
credit event. For example, a downgrade of the reference issuer would be a credit event and
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the number of notches by which the reference issuer is downgraded would determine how
much the maturity value is reduced.
Inflation-indexed bonds
Bonds indexed to some inflation rate have proved popular for project financings reliant on
revenues escalating by inflation, such as hospitals, prisons, tollroads, gas pipelines and water
distribution systems. Bonds indexed to some inflation index, such as a countrys consumer
price index (CPI), are referred to as inflation-indexed bonds or simply linkers. Offerings of
linkers have been made by governments, corporations and supranationals.1
There are two structural variations of inflation-indexed bonds. In the first, the coupon
only is indexed to the CPI. In the second, and more common type, the principal is also
indexed to an inflation index. Naturally both varieties attract low interest rates in realterms.
11 Medium-term notes
A medium-term note (MTN) is a debt instrument with the unique characteristic that notes
are offered continuously to investors by an agent of the issuer. Investors can select from
several maturity ranges: nine months to one year, more than one year to 18 months, more
than 18 months to two years and so on, up to 30 years. In the United States, MTNs
are registered with the Securities and Exchange Commission under Rule 415 (the shelf
registration rule) which gives a corporation the maximum flexibility for issuing securities
on a continuous basis.
The label medium-term note to describe this corporate debt instrument is misleading.
Traditionally, the term note or medium-term was used to refer to debt issues with a
maturity greater than one year but less than 15 years. The purpose of the MTN was to fill
the funding gap between commercial paper and long-term bonds. It is for this reason that
they are referred to as medium term.
Borrowers have flexibility in designing MTNs to satisfy their own needs. They can issue
fixed or floating rate debt. The coupon payments can be denominated in US dollars or in
a national currency.
A project company that has a choice between a bond or MTN offering should consider
the following two factors in deciding which to use as a financing instrument. The most
obvious is the cost of the funds raised after consideration of registration and distribution
costs. The second is the flexibility afforded to the issuer in structuring the offering. The
attraction of the MTN market is evidence of the relative advantage of MTNs with respect
to cost and flexibility for some offerings. However, the fact that there are borrowers that
raise funds by issuing both bonds and MTNs is evidence that there is no absolute advantage
in all instances and market environments. One route that can allow for economies of scale
in terms of the issuance costs is to raise MTNs for a program. An example would be the
Rural Electrification Program in India where a MTN issue was proposed by the program on
behalf of the Power Finance Corporation (PFC) for funding infrastructure projects.2
MTNs differ from bonds in the manner in which they are distributed to investors when
they are initially sold. Although some investment grade corporate bond issues are sold on
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Project Financing
a best-efforts basis, typically they are underwritten by investment bankers. MTNs have
traditionally been distributed on a best-efforts basis by either an investment banking firm or
other broker/dealers acting as agents. Another difference between bonds and MTNs when
they are offered is that MTNs are usually sold in relatively small amounts on a continuous
or an intermittent basis while corporate bonds are sold in large, discrete offerings.
In the United States, a borrower that wants to set up an MTN program will file a shelf
registration with the SEC for the offering of securities. While the SEC registration for MTN
offerings are between US$100 million and US$1 billion, once the total is sold, the issuer can
file another shelf registration. The registration will include a list of the investment banking
firms, usually two to four, that the borrower has arranged to act as agents to distribute
the MTNs.
The issuer then posts rates over a range of maturities: for example, nine months to
one year, one year to 18 months, 18 months to two years and annually thereafter. Usually,
an issuer will post rates as a spread over a Treasury security of comparable maturity. For
example, in the two to three year maturity range, the offering rate might be 35 basis points
over the two-year Treasury. Rates will not be posted for maturity ranges that the issuer
does not desire to sell. The minimum size that an investor can purchase of an MTN offering
typically ranges from US$1 million to US$25 million.
The rate offering schedule can be changed at any time by the issuer either in response
to changing market conditions or because the issuer has raised the desired amount of funds
at a given maturity. In the latter case, the issuer can either not post a rate for that maturity
range or lower the rate.
At one time the typical MTN was a fixed rate debenture that was non-callable. It
is common today for issuers of MTNs to couple their offerings with transactions in the
derivative markets (options, futures/forwards, swaps, caps and floors) so as to create debt
obligations with more interesting risk/return features than are available in the bond market.
Specifically, an issue can be floating rate over all or part of the life of the security and the
coupon reset formula can be based on a benchmark interest rate, equity index or individual
stock price, a foreign exchange rate, or a commodity index.
MTNs created when the issuer simultaneously transacts in the derivative markets are
called structured notes. The most common derivative instrument used in creating structured
notes is a swap (see Chapter 25 for a discussion on swaps).
By using the derivative markets in combination with an offering, borrowers are able to
create investment vehicles that are more customised for institutional investors to satisfy their
investment objectives. Moreover, it allows institutional investors who are restricted to investing
in investment grade debt issues the opportunity to participate in other asset classes to make
a market play. For example, an investor who buys an MTN with a coupon rate tied to the
performance of the S&P 500 is participating in the equity market without owning common
stock. If the coupon rate is tied to a foreign stock index, the investor is participating in the
equity market of a foreign country without owning foreign common stock. In exchange for
creating a structured note product, borrowers can reduce their funding costs but, as explained
in Chapter 24, this is exposed to counterparty risk.
Examples of structured notes are step-up notes, range notes, Himalayan options and the
inverse floaters (discussed earlier).
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Step-up notes are fixed income instruments with a coupon rate that is increased (that
is, stepped up) at designated times and is callable. When the coupon rate is increased only
once over the securitys life, it is said to be a single step-up callable note. A multiple step-up
callable note is a step-up callable note whose coupon is increased more than one time over
the life of the security.
A range note is a security that pays the reference rate with no spread if the reference
rate is within a band. If the reference rate falls outside of the band (lower or upper), the
coupon rate is zero. Himalayan options are notes supported by a basket of stocks or indices,
where the highest performing component is used for the periodic return calculations and then
removed from the basket to leave a single index or underlying stock at maturity.
12 Asset-backed securities
Asset-backed securities are notes or bonds collateralised by a pool of assets. The process
of creating securities backed by assets is referred to as asset securitisation. The assets
that have been securitised include residential home mortgages, commercial property mort-
gages, consumer receivables and commercial receivables. For a project company, the use
of project receivables as collateral for a securitisation is possible. However, as explained
in Chapter 22, the receivables that can serve as collateral can either be existing receiv-
ables or future receivables. Securitisations using the latter collateral are referred to as
future flow securitisations and such securitisations do not provide the true benefits to
issuers and investors associated with securitisations. So it is likely that securitisation
offers the greatest potential for a project company when it is operational and thereby
generating receivables.
The securitisation process involves pooling of assets (such as receivables) and creating
different bond classes (referred to as tranches) with different priorities on the cash flows of
the pool of assets. The higher the priority of a bond class, the higher the credit rating. Via
a securitisation, a project company can create bond classes for a wide range of investors
willing to accept different degrees of credit risk.
In the United States, the most common assets backing an asset-backed security are
automobile receivables and credit card receivables. However, other types of assets have been
securitised in the US and other countries.
One motivation for segregating assets and using them as collateral for a security offering
is that it can result in lower funding costs. This is because investors look to the credit quality
of the underlying pool of assets rather than the credit quality of the issuer of the asset-
backed securities. The following example illustrates this. The first asset-backed security was
issued by Sperry Lease Financial Corporation and was backed by lease receivables. Because
the issue was structured so that the cash flow from the underlying leases would be sufficient
to satisfy the interest and principal payments, the security received a triple-A rating. At the
time, Sperry Lease Financial Corporation had a lower credit rating.
Apart from offering opportunities for project financing, asset-backed securities have the
potential to increase the ability of bank lenders to provide project financing. However, it is
unlikely that an individual bank will be able to securitise a project finance loan. While commer-
cial loans have been securitised in the US, typically the loans are somewhat homogeneous.
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Project Financing
This is not likely to be the case for the project finance loans held by an individual bank. In
contrast, the IFC has securitised its Latin American and Asian loans.
The US Eximbank has used the securitisation mechanism to support sales in both US
dollar and non-dollar currencies. For example, in 1994 the Eximbank used securitisation to
support Alitalias purchase of US manufactured aircraft. The asset backing the transaction is
Alitalias revenues. The deal was for lira 350 billion (US$175 million) with a final maturity
of 12 years and repayment in 47 equal quarterly instalments. The payments are guaranteed
by a special purpose fund, US Guaranteed Finance Corporation. The guarantee is effectively
the guarantee of the US government.
13 Leases
Tax-oriented true leases and non-tax oriented finance leases constitute an excellent source
of both on-balance sheet and off-balance sheet financing, and are discussed separately in
Chapters 18 and 19.
In a tax-oriented lease, the lessor claims and retains the tax benefits associated with
equipment ownership and passes most of those tax benefits to the lessee in the form of
reduced rental payments. Since project companies do not typically generate sufficient earn-
ings to cause income tax liability during their formative years, tax-oriented leasing offers the
opportunity to indirectly obtain tax benefits associated with equipment ownership, which
would not be available if the equipment was purchased.
Tax leases are often structured in the United States as leveraged leases in which the equity
investor furnishes a portion of the funds (20% to 25%) and lenders provide the balance
of the funds (75% to 80%) needed to acquire the asset being leased. The lenders security
interest in the leased asset is senior to the equity. However, the equity holder enhances its
tax benefits by claiming tax deductions and tax credits, if applicable, upon the entire cost
of the asset.
Tax-oriented leasing is mainly confined to a leasing companys domestic market since
tax authorities tend to frown on exporting tax benefits. However, this is not always the
case, particularly where the lease is used to promote an export, as has been the case in
aircraft leasing.
14 Preferred stock
Preferred stock is a class of stock, not a debt instrument, but it shares characteristics of
both common stock and debt. Indeed, preferred stocks can offer a very versatile form of
finance for project structures.3 Like the holder of common stock, the preferred stockholder
is entitled to dividends. Unlike those on common stock, however, dividends are a specified
percentage of par or face value. The percentage is called the dividend rate; it need not be
fixed, but may float over the life of the issue.
Unlike debt, failure to make preferred stock dividend payments cannot force the issuer
into bankruptcy. Should the issuer not make the preferred stock dividend payment, usually
made quarterly, one of two things can happen, depending on the terms of the issue. The
dividend payment can accrue until it is fully paid. Preferred stock with this feature is called
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cumulative preferred stock. If a dividend payment is missed and the security holder must
forgo the payment, the preferred stock is said to be non-cumulative preferred stock. Failure
to make dividend payments may result in imposition of certain restrictions on management.
For example, if dividend payments are in arrears, preferred stockholders might be granted
voting rights. Preferred stock with a dividend holiday refers to stock on which the issuer
need not pay dividends for a specified period after issuance. This of course helps the issuers
cash flow in the early days of the project.
Preferred stock has some important similarities with debt, particularly in the case of
cumulative preferred stock: (i) the returns to preferred stockholders promised by the issuer
are fixed; and (ii) preferred stockholders have priority over common stockholders with respect
to dividend payments and distribution of assets in the case of bankruptcy. (The position of
non-cumulative preferred stock is considerably weaker.) It is because of this second feature
that preferred stock is called a senior security. It is senior to common stock. On a balance
sheet, preferred stock is classified as equity.
Almost all preferred stock has a sinking fund provision, and some preferred stock is
convertible into common stock. Preferred stock may be issued without a maturity date. This
is called perpetual preferred stock.
A cross-border preferred stock is structured so as to qualify as debt in the issuers country
(thus being eligible for interest deductions for tax purposes) and as preferred stock in the
purchasers country, thus being eligible for dividend-received credit.
As with bonds, preferred stock may be rated. The nationally recognised commercial
rating companies that rate bonds also rate preferred stock.
15 Master limited partnerships

In the past, one of the most attractive investments for individuals seeking to shelter income
tax liability in the United States was a real estate limited partnership which permitted an
individual investor to claim depreciation deductions against income generated from other
sources, including salaries and dividends. The US tax law passed in 1986 limits the use of
passive losses, which would include those generated by the formerly popular limited partner-
ships, to be offset against only passive income, so it is ring fenced or limited in any offsets,
but note that taxation of the proceeds arising from the sale of a master limited partnership
(MLP) interest may also extend to any perceived carried interests. Currently MLPs offer
higher returns than bonds and as such are in the spotlight once more.4
MLPs have been formed as devices to generate passive income. Such master limited
partnerships are often, in effect, project financing entities. Under a MLP a corporation
might spin off certain assets into a new partnership entity which would then sell units in
the partnership to investors. The units in some instances are listed on a stock exchange and
traded as if they were corporate shares. In many instances, the corporation spinning off the
assets or forming the partnership manages the assets of the limited partnership for a fee.
Some examples of MLP structures would include coal projects, oil and gas projects, a group
of restaurants or fast food locations, hotels, or a gas transmission pipeline. Some MLPs are
publicly traded, for example, Plains all America Pipeline. Although MLPs have been popular
with investors, there are rumours once more that the US Department of the Treasury may
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Project Financing
seek to curb a characterisation of income from MLPs qualifying as passive income. However,
MLPs may also be a useful future structure for developing renewable energyprojects.
16 Research and development limited partnership

An R&D limited partnership in the United States is one that finances corporate research
and development, claims R&D tax deductions and shares in the revenues, if any, of the
products developed and sold.
17 Equity funding via depositary receipts

When a corporation issues equity outside of its domestic market and the equity issue is
subsequently traded in the foreign market, it is typically in the form of an international
depositary receipt (IDR). Banks issue IDRs as evidence of ownership of the underlying stock
of a foreign corporation that the bank holds in trust. Each IDR may represent ownership of
one or more shares of common stock of a corporation. The advantage of the IDR structure
is that the corporation does not have to comply with all the regulatory issuing requirements
of the foreign country where the stock is to be traded. IDRs are typically sponsored by the
issuing corporation. That is, the issuing corporation works with a bank to offer its common
stock in a foreign country via the sale of IDRs.
As an example, consider the United States version of the IDR, the American depositary
receipt (ADR). The success of the ADR structure resulted in the rise of IDRs throughout
the world. ADRs are denominated in US dollars and pay dividends in them. The holder of
an ADR does not have voting or pre-emptive rights.
ADRs can arise in one of two ways. First, one or more banks or security firms can
assemble a large block of the shares of a foreign corporation and issue ADRs without the
participation of that foreign corporation. More typically, the foreign corporation that seeks
to have its stock traded in the United States sponsors the ADRs. In these instances, only one
depositary bank issues them. A sponsored ADR is commonly referred to as an American
depositary share (ADS). Periodic financial reports are provided in English to the holder of
an ADS. ADSs can either be traded on one of the two major organised exchanges (the New
York Stock Exchange and the American Stock Exchange), traded in the over-the-counter
market, or privately placed with institutional investors. The non-sponsored ADR is typically
traded in the over-the-counter market.
In the British Telecom initial public offering, the offering in the United States was an ADS
(since it was sponsored by British Telecom) and listed on the New York Stock Exchange.
Each ADS represented 10 shares of British Telecom.
18 Islamic lending
As discussed in Chapter 11, various forms of Islamic lending have been extended for project
financings including leasing, repurchase agreements, discount purchase/sell back and joint
operating arrangements. Interest is forbidden to be paid to Islamic lenders. The main thrust
is towards participation in the profit or capital of the enterprise to be project financed.
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19 Credit enhancement
Structures which use the balance sheet of special funds, insurance companies, or banks have
been developed either to stand behind the completion risk attached to a project or to backstop
the project-finance loan repayments in their entirety. Usually this form of credit enhancement
allows the guarantor or wrap party to charge a higher fee for accepting the risk(s).
1
For a detailed discussion of inflation-indexed bonds, see Garcia, JA, and van Rixtel, A, Inflation-linked bonds
from a central bank perspective, Occasional Paper Series No. 62, European Central Bank, June 2007.
2
www.eai.in/club/users/Shweta/blogs/7993. Accessed 4 November 2011.
3
Care must be taken, when arranging a financing transaction in any jurisdiction, to comply with national and
local securities regulations. As one example, in the US, the Securities Act of 1933 makes it unlawful to sell or
offer to sell or solicit offers to buy securities, unless either a registration statement is in effect with respect to the
securities or an exemption from registration exists. Bank loans, private placements, commercial paper and foreign
issues do not ordinarily present a problem. However, the term security is broadly defined by the Securities Act
to include many types of debt instruments and participations as well as shares of stock in corporate entities.
An exemption from registration exists under Section 4(2) of the Securities Act for transactions by an issuer not
involving any public offering. Because of the greater expense, time and effort involved in registration, borrowers
usually seek to structure their offerings within the scope of this exemption. Rule 146T, while not exclusive, offers
a safe harbour exemption if specific conditions are met and legal advice should be sought on the currentsituation.
4
www.forbes.com/sites/johndobosz/2011/10/03/pump-up-yields-in-master-limited-partnerships/. Accessed 4 November
2011.
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Chapter 14
Construction financing
The objectives and considerations of project sponsors or a project company in connection

with any construction financing, independent of the type of permanent financing to be used,
are generally:
1 to obtain financing at the lowest effective interest cost;

2 to make the best use of any and all construction period tax deductions or credits;
3 to optimise the allowed revenue effects resulting from the regulatory treatment of the
transaction;
4 to achieve the targeted balance sheet and financial reporting treatment;
5 to obtain financing with minimum adverse impact vis--vis covenants contained in debt
agreements;
6 to maintain flexibility regarding the type of permanent financing ultimately employed; and
7 to accommodate the amount and timing of differing types of construction period borrowing
instruments (for example, tax exempt, commercial paper, early take-down of long-term
funds, bank lines).
Each construction financing is different, and involves establishing priorities for these objectives.
This discussion has particular application to the United States where typically construction
financing is provided by one set of lenders and long-term financing is provided by another
set of lenders. However, the same principles apply in other countries.
A key factor in construction financing is the types of guarantees and bonds used to guar-
antee completion and performance under construction contracts. These include bid bonds,
performance bonds, advance payment guarantees or bonds, retention money guarantees or
bonds and maintenance bonds. We postpone a discussion of these until Chapter 23.
1 Estimation of funding needs

Construction financing begins with an estimation of the costs associated with the initial
establishment of the project and then the procurement of the funds of the estimated amount
at the lowest funding cost that does not jeopardise the projects completion and satisfies the
other sponsor objectives enumerated at the outset of this chapter.
The non-financing costs that must be taken into account in estimating financing needs
are those associated with:
land acquisition;
improvement/preparation of the site;
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building permits;
architectural design;
engineering design;
construction costs;
feasibility studies;
insurance during the construction phase;
taxes during the construction phase; and
inspection tests.
In infrastructure projects, the major non-financing cost is typically the construction cost.
Consequently, cost estimation for this component is critical. Of course, the decision to
proceed with a project will have been based on cost estimates for aspects of the project
design. These estimates are either provided by the project sponsors engineering team or by
a firm specialising in cost estimation that is retained by the sponsor. The degree of accuracy
of these cost estimates will vary based on the stage of construction and are expected to be
more accurate than in the initial planning stage. Moreover, typically there is a cost estimator
who specialises in each design phase.
In estimating each of the cost components above, an estimate must be made for unexpected
costs that might arise during the construction phase. For example, when site preparation
begins, it may be determined that the conditions were not as expected, resulting in addi-
tional costs. The projects design may have to be altered for some reasons. If a project
is undertaken in an economic environment where employment is high, this may result in
higher construction costs because of the need to pay a more competitive wage rate to attract
workers. When costs are to be incurred in a foreign currency, if exchange-rate risks are not
hedged, then estimates of the impact of adverse currency movements must be incorporated
into the estimated costs.
In the United States, for example, the recommended practice for estimating costs has been
codified by AACE International, Inc, a professional association for cost and management
professionals that offers several specialised certification programs such as cost estimation, plan-
ning and scheduling and project controls.1 In addition to base estimates provided, estimates
are provided for specific project risks classified as contingencies, allowances and reserves. As
described in the primer for the certified cost technician, one of the certifications awarded by
AACE International, these are defined as follows.2
Contingency is defined as:
An amount added to an estimate to allow for items, conditions, or events for which
the state, occurrence, or effect is uncertain and that experience shows will likely result,
in aggregate, in adding costs. Typically estimated using statistical analysis or judgment
based on past asset or project experience
To an estimator, contingency is an amount used in the estimate to deal with the
uncertainties inherent in the estimating process. The estimator regards contingency as
the funds added to the originally derived point estimate to achieve a given probability
of not overrunning the estimate (given relative stability of the project scope and the
assumptions upon which the estimate is based).
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An allowance is defined as:
Resources included in estimates to cover the cost of known but undefined requirements
for an individual activity, work item, account or sub-account
Allowances are often included in an estimate to account for the predictable but
indefinable costs associated with project scope. Allowances are most often used when
preparing deterministic or detailed estimates. Even for this class of estimate, the level
of project definition may not enable certain costs to be estimated definitively.
Finally, a reserve is defined as:
An amount added to an estimate to allow for discretionary management purposes outside

of the defined scope of the project, as otherwise estimated. Use of management reserve
requires a change to the project scope and the cost baseline, while the use of contin-
gency reserve funds is within the projects approved budget and schedule baseline
Construction financing falls into two general categories.
Separate entity project financing, in which construction projects are domiciled in special
purpose entities (SPEs) established by the project sponsor(s) referred to as construction
intermediaries whose borrowing is based upon direct or indirect credit support provided
by the project sponsor.
Direct financing by the sponsor using corporate funds available from the various direct
borrowing facilities that the project sponsor has arranged, including new facilities that
may be specifically related to (and drawdowns or take-downs thereunder timed with)
construction expenditures.
Special purpose entity project financing

Special purpose entity financing, or project financing construction intermediaries, include
both corporate and trust vehicles with degrees of ownership and/or control on the part of
the sponsor ranging from none to full control. Typically, the sponsor will assign its interest
in the project and other contract rights to the construction intermediary. The construction
intermediary then has the right to obtain the necessary funding. With the project economi-
cally isolated in the construction intermediary, a wide variety of borrowing alternatives are
available to the project entity, including bank lines (which include revolving and term credits),
commercial paper and early take-down or drawdown of permanent financing monies.
Although in part credit support for debt financing obtained by the construction inter-
mediary is guaranteed by the work in progress for the project, there is typically sponsor
credit support in the form of an obligation that under certain circumstances requires that the
sponsor purchase at the completion, the project or the notes representing the projects debt.
Sponsor credit support in the form of an unconditional take-or-pay contract may, in turn,
support a take out by long-term lenders or a lessor. The necessity of an equity investment
by the sponsor in the project entity is a function of the collateral and the nature of credit
156

support. Interest rates should approximate those available to the sponsor directly, unless the
sponsors credit support is conditional or ambiguously indirect.
As explained earlier, funding needs based on estimated construction costs are just that:
estimates. During the construction process, there can be shortfalls due to an underestimate of
the construction costs or other contingencies that increase construction costs. In such cases,
the sponsor may be required to supply the shortfall. In the favourable scenario where there
are excess funds that cannot be prepaid to the lender, those excess funds may be loaned by
the construction intermediary to the sponsor.
Using a construction intermediary approach to construction financing in the case of the
United States may facilitate efficient use of construction period tax benefits from interest
deductions, either through transfer to a third party or through capitalisation of expenses,
with depreciation tax deductions ultimately available on such capitalised expenses as a
component of plant cost. The use of asset-oriented tax benefits is of primary concern to
project companies considering a leveraged lease3 as the form of permanent financing, and
particularly to those sponsors and/or project companies experiencing a very low declining
federal income tax liability as a result of new plant acquisition.
Accounting and tax treatment from the sponsors standpoint varies according to the
nature of its ownership, control and contingent obligation to support the credit. Interest
during construction can be capitalised, and off-balance sheet financing may be possible in
some instances. However, SEC Accounting Rules, Topic 5-L, states that in the case of utili-
ties, the intermediaries work in process should be shown in the appropriate caption under
utility plant, and that related debt should be included in long-term liabilities and disclosed
either on the balance sheet or in a footnote.4
For a project in which rate-making is important, the construction intermediary approach
may facilitate allocations of interest expense to current expenses or to rate base as a capital-
ised cost. Advantages may sometimes be obtained from differentials between actual interest
rates and the rates used in computing the allowance for funds used during construction.
Exhibits 14.1 and 14.2 show two examples of construction intermediary trusts. In Exhibit
14.1, the arrangement clearly falls within the scope of SEC Topic 5-L because the lenders rely
primarily upon the credit of utility for take out. The example in Exhibit 14.2 attempts to shift
the obligation off the balance sheet, or at most to a footnote, by casting the transaction as
equivalent to a purchase of equipment that does not become an obligation until delivery of the
facility built to specifications. During construction, the lenders look primarily to the credit of the
contractor and to the bonding company for assurance that a facility will be built tospecification.
Direct construction financing

When arranging construction financing without the use of a construction intermediary or
double A rated project company, all borrowing avenues usually available to the sponsor can
be used to fund the construction.
However, a primary concern when considering permanent financing alternatives is the
security interest which under such circumstances may automatically attach for the benefit
of existing secured lenders under open-ended indentures. Such a situation may ultimately
require substitute collateral, such as cash or other property, to release the property being
157

Exhibit 14.1
Financing of construction of a utility by a construction intermediary in which creditors
rely primarily upon the credit of the utility
Utility
2 Contract to
4 Purchase
1 Assignment purchase facility upon
4 Title to price settlement
of interest in the completion and assume or
facility of construction
property settle construction
loan
loan
Financing
intermediary
3 Assignment
3 Construction
of contract rights
loan
with utilities
Bank
Continued

Summary
1 A utility assigns its interest in the construction site and other construction rights to a construction
financing intermediarytrust.
2 The utility contracts with the intermediary to purchase the facility upon completion, and agrees to assume
or settle construction loans that the intermediary is authorised to borrow during construction, and to pay
interest on the constructionloan.
3 The construction intermediary borrows from banks on the basis of a lien on the work in process and the
agreements of the utility to assume or settle construction loans oncompletion.
4 The facility is completed, the utility purchases the facility, and settles or assumes liability for the
constructionloans.
financed to the permanent secured parties under a leveraged lease or secured debt. If a lease
is contemplated as the permanent financing, this problem may be solved by having the lessor
take title to the facility during the early stages of construction. Under such circumstances,
the leasing company can either claim tax benefits from deductions for interest paid during
construction, or capitalise interest and claim tax depreciation deductions on such expense
as part of the component plant cost, with most of such tax benefits passed through to the
project company in the form of reduced rentals.
2 Construction financing using leveraged leasing

As explained in Chapter 18, while it is possible to arrange a facility lease in a fairly short
time, the financial planning for a large facility is complex and may involve a typical lead
time extending over several months.
A leveraged lease financing structure can be used in construction financing. The participa-
tion agreement and the lease agreement may contemplate that the title to the property to be
leased will be transferred to the owner trustee (lessor) while the facility is still in the early
stages of construction. In this situation, the construction contract is assigned by the lessee
to the owner trustee and construction financing is arranged.
Although the facility will usually be constructed by a third-party contractor, the sponsor
may wish to supervise the performance of the construction contract with the third-party
contractor. In this situation, a construction supervision agreement is entered into between
the lessee and the owner trustee. The purpose of this agreement is to arrange for and require
the owner trustee to use the services of the project in the capacity of construction supervisor
to oversee the construction testing, delivery and acceptance of the facility.
To the extent that a project financing is to be accomplished through a leveraged lease,
the mechanics include a sale by the sponsor of the project to the owner trustee for lease-
back. The sale price to the lessor may include capitalised costs that are related to the utilitys
overhead and financing costs during construction. However, where the construction period
extends over a considerable time, the contractor may require progress payments during
construction. In such a situation, the parties may agree that the owner trustee will take title
to the facility during construction, so that the lease involves an interim lease term during
159

Exhibit 14.2
Construction financed through construction trust which relies on the credit of
the contractor
5 Guarantee
and assignment of Bonding
Contractor
construction company
contract
6 Guarantee of
2 Contract to 7 Progress
performance of
build facility payments
contractor
7 Loan funds
Construction
3 Loan Construction
trust or
agreement lenders
corporation X
4 Security interest
in construction
1 Agreement to
purchase facility for
a certain amount when 8 Title
completed to certain
specifications
8 Payment of
construction
loan with
capitalised costs
Sponsor
8 Loan
8 Security 8 Long-term
agreement or
agreement loan funds
lease
Permanent
lenders or
lessors Continued

Summary
1 The sponsor agrees with the construction intermediary trust to purchase a facility built to certain
specifications. The purchase price and time frame for delivery areestablished.
2 The contractor agrees to build the facility at a price and on terms consistent with the contract between
the sponsor and the constructiontrust.
3 A loan agreement is entered into between the construction intermediary trust and the
constructionlenders.
4 The construction trust assigns a security interest in its assets to the constructionlenders.
5 The contractor enters into an agreement with a bonding company to provide a bond sufficient to
guarantee performance, and provides the bonding company with a guarantee and an assignment of its
rights under the construction contract assecurity.
6 The bonding company provides a guarantee. (A bonding company guarantee may not be available at
a reasonable price, in which case the lender must look to the financial resources and reputation of the
contractor.)
7 Construction loan funds are advanced as needed and progress payments are made to thecontractor.
8 The facility is completed to the specifications called for in the contract, the permanent financing is
arranged by the sponsor, the construction loan is repaid, title passes to the sponsor, and a security
interest passes to the permanent lenders orlessors.
construction that precedes the base lease term. Where this type of arrangement is made, a
separate interim loan (construction loan) agreement is entered into by the lessee, the owner
trustee (the entity named to hold title to the equipment and represent the owners or equity
participants), and the construction lenders (who are usually not loan participants during the
base term lease). The lessors equity investment and short-term construction loan financing
is used until the completion of construction, acceptance by the lessee, drawdown of the
long-term financing (leveraged debt), and commencement of the base lease term. The lessee
pays interim rents to the owner trustee in an amount sufficient to cover both the interest
cost of the construction loan and provide an adequate return to the equity participants. In
the alternative, construction loan interest may be capitalised into the cost of the facility and
included in the total cost of the facility which is to be financed by the lease.
Construction financing is usually provided by commercial banks. Such financing is secured
by an assignment of interim rents and by the lessees obligation to pay off the principal of the
loan if the long-term lenders fail to provide the financing or if the facility is not constructed
or completed by a certain date. In such a situation, the equity participants will also look to
the lessees guarantee to recover their investments plus an adequate return. All of the lessees
guarantees of construction loans are eliminated on or before completion and acceptance of
the leased equipment and commencement of the base term of the lease. Eliminating lessee
guarantees of the owner trust debt obligations may also be necessary in order to comply
with the local tax rules.
Construction supervision agreement

The construction supervision agreement is between the utility lessee and the partnership.
The participation agreement contemplates that the title to the property to be leased will be
161

Project Financing
transferred to the owner agent (lessor) while the plant is still in early stages of construc-
tion. Although the facility is being constructed by a third party contractor, the utility lessee
has been supervising and wishes to continue to supervise the performance of a construction
contract with the third party contractor.
Therefore, the purpose of this agreement is for the partnership to use services of the
utility in its capacity as construction supervisor to oversee the construction testing, delivery
and acceptance of the facility.
Construction contract assignment

The participation agreement and the lease agreement contemplate that the partnership (lessor)
will take possession of the facility during the early stages of construction. The construction
contract must be assigned by the utility lessee to the partnership.
1
The certifications awarded by AACE International include, for example, the certified cost consultant (CCC), the
certified cost technician (CCT), and the certified cost engineer (CCE).
2
These definitions are taken from Supporting Skills and Knowledge of Cost Engineering CCT Primer, AACE
International, Inc, pp. 2122.
3
Leveraged leases are discussed in Chapter 18.
4
www.sec.gov/interps/account/sabcodet10.htm.
162

Chapter 15
Term loans and private placements
As noted at the beginning of this book in the definition of project finance, a project
financing contemplates an extension of credit in which lenders will be willing to look
initially to the cash flows of the project as the source of funds from which the loan will
be repaid whilst recognising the risk environment. Obviously this arrangement contemplates
a loan which must be repaid over a term of years. The complexities of project financing
and lack of operating history or performance pretty much limit the public markets appetite
for providing such debt financing. Consequently the main source of term project financing
has been in the form of privately placed loans to banks, insurance companies and other
institutional investors.
1 Commercial bank loans

Commercial bank loans are the most important source of senior debt for project financing.
They may take the form of secured or unsecured loans. Commercial bank loans may involve
a single lender, several lenders or be syndicated. They may be in the form of construction
loans, term loans or working capital loans.
Documentation for commercial bank loans consists of the loan agreement, promissory
notes (in the United States), guarantees and security documents.
Some of the key and obvious points to be covered in a loan agreement include
the following.
1 The amount which may be borrowed.

2 Commitment fees for unused amounts under the commitment.
3 The term of the loan and repayment schedule.
4 The interest rate on the outstanding balance.
5 Procedure for drawdown or take-downs and conditions precedent for the take-down.
6 Representations and warranties of the borrower including:
use of proceeds;
financial conditions;
title to assets;
material litigation;
contingent liabilities;
establishment and organisation; and
authority to enter into the loan agreement.
7 Legal opinions which will be required at the closing of the loan agreement, at the time
of drawdown or downs and periodically during the loan agreement.
8 Affirmative covenants, such as:
163

Project Financing
compliance with laws;

payment of taxes;

maintenance of equipment and facilities, and any assets or security offered to support
the loan;
obtaining requisite government approval;
maintenance of insurance;
furnishing periodic financial reports;
non-encumbrance of assets; and
limitations on mergers, dividends and sale of assets.
9 Financial covenants, such as:

limitations on indebtedness; and
maintenance of financial ratios.
10 Responsibility for any withholding tax on interest.

11 Enforceability of the rights of the lender:
events of default and opportunities to cure a default;
remedies in case of default;
cross-default clauses; and
procedure for capture of the cash flow.
12 Governing law.
Term bank loans

Commercial banks have been the traditional providers of unsecured short-term business
working capital loans, made either under a line of credit or on a transaction basis. Other
financial institutions and the public capital markets have been regarded as the primary source
for intermediate and long-term business financing.
Loans to acquire the permanent operating assets of a project company which are intended
for long-term use cannot be repaid in the traditional manner of unsecured short-term loans.
Rather, it is necessary to repay the financing of these assets over time from the profits and
cash flow generated by their use and support the loan with a lien, mortgage or other security
interest in the asset financed.
Acquisition of machinery and equipment for a project company provides either a revenue
stream or a reduction in operating costs, thereby producing a flow of cash with which to
repay the loan over a period of time. Term lending to finance the acquisition of such assets
is merely an extension of the historic commercial banking self-liquidating loan concept over
a longer period of time than the seasonal expansion and contraction of trading assets that
are associated with traditional bank lending activities.
Project companies typically did not enjoy broad private or public markets for their
long-term bonds or debentures, though this has changed in recent years as project securities
have been rated by rating agencies. The national and international public capital markets
are not often a viable source of financing for them, since the specialist knowledge to make
an informed investment selection choice by financial institutions may be less widespread
outside the major capital centres, although as noted in previous chapters, there is likely
to be increased use of bond financing. Consequently, project companies must look to
164

other financial sources for intermediate and long-term financing. Their primary suppliers
of resources and financial services have historically been commercial banks familiar with
project finance.
Commercial banks have become sources of term loans with maturities of two to 10 years
or longer for project financing, depending on the market and the perceived risk. The loans
may be floating or fixed rate. Commercial banks can prudently make floating rate loans for
longer terms than fixed rate loans because the rate earned will fluctuate with the cost of
funds from traditional funding sources.
With a floating rate loan, the borrower takes the risk that the borrowing rate can
rise significantly and, as a result, potentially lead to financial difficulties. Provision can be
included in a loan agreement to hedge the risk that the borrowing rate will rise above a
predetermined rate the cap rate. The inclusion of a cap in the loan agreement is basically
an option granted by the bank to the borrower. As a result, it increases the interest rate
risk to the bank. The borrower pays for this through a higher spread to the benchmark
rate. To reduce the borrowing spread, the borrower can agree to have a floor included in
the loan agreement. The floor agreement specifies that if the borrowing rate falls below a
predetermined level, the borrower agrees to pay the floor rate. The inclusion of a cap and
a floor in a loan agreement results in a collar for the interest rate. Exhibits 15.1, 15.2, 15.3
and 15.4 show the borrowing cost with a cap and a collar. (More on caps and floors is
provided in Chapter 26.)
The typical term loan is repaid in instalments so as to match the projected revenue
stream. Such instalments may be paid monthly, quarterly, semi-annually, or even annually.
The repayment schedule for a term loan to a project company may include a recapture
clause, which provides that some percentage of earnings or cash flow above an agreed
upon base level will be applied annually as extra principal payments in the inverse order of
scheduled maturity. This protects the lender against windfall profits being dissipated prior
to the scheduled term loan payments.
Revolving bank loans

Revolving credit agreements (sometimes called revolvers) resemble term loans since they are
made for a period of years. However, they differ from term loans in that principal payments
are not usually required during the life of the facility provided any underlying security main-
tains or increases its value. The cut off point is often prudently set well in excess of 100% of
the revolver amount to allow for underlying security value fluctuations and recognise poten-
tial repossession and distress sale costs should the worst case scenario occur. The borrower
may borrow, repay and re-borrow so that the balance outstanding under a revolving credit
agreement fluctuates up and down in accordance with the borrowers needs.
Revolving credit agreements were originally designed to finance trading assets over a
period of years. A revolving credit that is regularly renewed and extended prior to its matu-
rity so that it never becomes a current liability is known as an evergreen revolving credit.
Since revolving credit agreements mature beyond one year, revolving credits are carried
as long-term liabilities on the borrowers balance sheet. Consequently, revolvers may serve
to enhance working capital.
165

Project Financing
Exhibit 15.1
Borrowing cost under a loan agreement with an interest of 12%
18
16
14
Cost of borrowing (%)
12
10
4
4 6 8 10 12 14 16 18
Market interest rates available to borrower (%)
Unhedged cost of borrowing

Cost of borrowing under cap agreement
However, revolving credit agreements can also be used for the acquisition of fixed assets
under an arrangement whereby the loan is converted to a term loan when the project to
be financed is completed and the amount to be funded over time is determinable. This has
been a classic oil and gas financing approach.
Revolving credit agreements and term loans are sometimes used together under an
arrangement whereby the revolving credit agreement contains a right of the borrower to
convert the outstanding balance to an amortising term loan. This right is usually irrevocable
to the borrower as long as he is in compliance with the terms of the governing agreement.
Term or revolving credits may be either unsecured but in project finance contexts are
more usually secured by the pledge of specific assets. A blanket lien or charge may be taken
on all assets to secure term or revolving credit debt. As in any other type of secured loan,
the collateral may be used in the event of default to provide a secondary source of repay-
ment or to limit the total credit available to the borrower from other sources. Sometimes
the limitation on leverage may be accomplished by a negative pledge whereby the borrower
166

Exhibit 15.2
Borrowing cost under a loan agreement with a capped interest rate of 12%
18
16
Interest rate borrowing cost (%)
14
Capped cost of borrowing

12
10
4
0 1 2 3 4 5 6 7 8
Years
Market rate
Borrowing cost under capped loan agreement
agrees not to pledge its assets to any other lender, but this carries risks to lenders in a
default situation. From the standpoint of the lender, a negative pledge serves the purpose of
limiting the borrowers overall leverage, but does not provide any direct secondary protec-
tion for repayment.
Syndicated credits, including Eurocurrency loans

Large international bank loans are made by syndicates or groups of international commercial
banks. The general advantages of the syndicated loan market are:
1 large amounts of debt can be raised. The syndicated loan market is the largest source of
international capital;
2 loans may be made in any of several currencies;
3 the number of participants can be substantial;
167

Project Financing
Exhibit 15.3
Borrowing cost under a loan agreement with a collared interest rate of 12%
18
Cost of borrowing with collar

16
Risk assumed by lender
Interest rate borrowing cost (%)
14 or seller of collar
Upper collar rate

12
Cost of borrowing without collar agreement
10
Lower collar rate

6
4
0 1 2 3 4 5 6 7 8
Years
4 banks participating in syndicated loans are believed to be sophisticated and more able to
understand and participate in complex credit risks presented by project financing;
5 drawdowns can be flexible; and
6 prepayment is customarily permitted.
Syndicated loans are essentially large term loans or even revolvers where the funding is
shared between a group of lenders with co-ordinating documentation and the same principles
apply. Club loans are essentially a pre-agreed syndicate of banks making a loan together
to a borrower.
Syndicated loans were generally used by governments and government agencies. However,
strong corporate credits, utilities and energy projects have also used the syndicated loan
market to raise funds and the principle has gradually filtered down to smaller transactions.
The decision to syndicate should be based on a trade off between agency and co-ordination
costs and diversification of and relationship building within the banking group. Many syndi-
cated loans are still denominated in US dollars or Eurodollars, but other key currencies can
include sterling, Euros, Swiss francs and Japanese yen. Choice of the funding currency basis is
important, especially in syndication where all banks need to have good access to thosefunds.
168

Exhibit 15.4
Borrowing cost under an interest rate collar agreement
18
16
14 Risk assumed by
lender or seller
Cost of borrowing (%)
of collar
Upper collar rate
12
10
Lower collar rate

6 Risk assumed
by borrower
4
4 6 8 10 12 14 16 18
Market interest rates available to borrower (%)
Unhedged cost of borrowing

Cost of borrowing under collar agreement
Syndicated credits can be for national or international borrowers and provided by national
or international lenders. They may be structured as conventional revolvers, multi-option or
single currency loans. As such they may consist of revolving or term bank lines, commercial
paper liquidity (back-up) lines, standby letters of credit (for commercial paper, private place-
ments, industrial revenue development bonds, Eurobonds and so on), bankers acceptances,
receivables financings and the like. Pricing is generally based on Libor (or local equivalent),
prime, certificates of deposit, or bankers acceptances, in varying combinations, for funding
periods ranging from days to one, two, three, six, 12 months or even longer in specific
cases. Participants include all types of financial institutions, but are primarily money centre
banks, regional and major international banks. Syndicated credits or loans are arranged by
an agent or lead manager group that oversees the structure, pricing syndicate configura-
tion, construction of a timetable, selling, documentation and closing of the transactions,
as well as administering the facility until final maturity. The agent or lead manager could
169

Project Financing
be a commercial bank providing loan funds, or either a merchant bank or a commercial

bank which acts solely as the arranger of the loan and will usually negotiate the terms and
conditions of the transaction on behalf of the lending or funding group or syndicate and
monitor a borrowers financial condition during the term of the loan as well as monitoring
performance against the numerous covenants and default provisions and monitoring any
security or collateral.
Syndicated loans are usually structured as term loans and amortised according to a
fixed schedule. Repayment may begin after a term of years known as a grace period, or
immediately. The interest rate is often floating and the lender ordinarily funds this through
a matching deposit in the relevant inter-bank market in the same amount and term, which
is renewed each interest period. However, long term fixed rate funds may be generated
synthetically using currency or interest rate swaps, which can alter the borrowing currency
and rate but introduce another layer of risk as the swap contract obligation is independent
of the underlying loan repayments. More information on swaps is provided in Chapter 25.
One major advantage of syndicated loans for borrowers is the large size of financing
available, their flexibility, and the fact that they are relatively quick and cheap to arrange
because this is an established market. The downside is dealing with a number of slightly
different needs and wants from different lenders and frequent cast changes of bank personnel.
So agency costs can increase.
2 Private placements
A private placement is the direct sale or placement of a debt or an equity security by a
corporation to one or more sophisticated investors or qualified institutional investors or
equivalent terms in different jurisdictions. These are closely defined categories of investors.
Usually the term private placement contemplates such investors as life insurance companies,
pension funds and other financial institutions. However, a private placement may be arranged
with a bank in the same way as a term loan or even with certain individuals.
A private placement in the United States is exempt from registration with the Securities
and Exchange Commission provided it conforms to certain SEC guidelines. The term private
placement usually refers to placements of long-term debt instruments but has also been
used for equity or other securities such as mezzanine debt or convertibles. This discussion
of private placements will be concerned primarily with debt private placements in the United
States which largely consists of unsecured senior notes with fixed interest rates and final
maturities of roughly five to 15 years.
The private placement market in the United States is an important source of long-term
debt financing for many international and domestic corporations. It is particularly important
for project companies which do not have access to the public debt market because of their
size and lack of operating history. The private placement market may be the only source of
long-term debt financing for some project companies.
The following text describes the market and provides guidelines for choosing and
arranging private debt financing. It discusses private placement loan agreements and
interest rates from both the borrowers and lenders viewpoints. Private placements differ
from public offerings in that private placements do not require regulatory approval, do
170

not require public disclosure, and are arranged with a limited number of sophisticated
institutional investors.
The private placement market may be accessed through a commercial bank or
investment bank.
The private placement market that currently exists is US-based. Transaction sizes range
from $30 million to over $1 billion and maturities typically stretch from five years to
30 years. Most issuance is senior unsecured, though it would be very rare for private
investors to go unsecured if other senior lenders had security, says Rothenberg. Benefits
of the private placement market include flexibility (staggered drawdown dates, maturi-
ties, fixed and/or floating rate and multiple currencies, which are all possible in a single
transaction), callability, a lender base that does not expect ancillary business unlike
the bond market and simplicity (no debt ratings or SEC registration is required).1
The private placement market has several advantages.
1 Private placements do not require registration under securities law.

2 The borrower can retain absolute control of when it wishes to enter the market. That
entry does not have to be at the end of a registration period, as with a public offering.
Thus, the borrower can have its papers ready, and wait until market conditions are
to its liking.
3 The interest is usually at a fixed rate. Pricing (and hence the coupon interest rates) of
privately placed debt closely follows the market for publicly traded bonds. While public
bonds are priced continuously in the secondary market throughout each trading day, the
rates for new private placements are set within each institution by finance committees
which usually meet once a week. Thus, movements in private rates typically lag behind
public rates, although both are affected by general economic conditions. This lag can be
used to advantage.
A disadvantage of the private placements market is that interest rates may be higher than
the public US market or the Eurodollar market for similar rated debt. Part of the spread
reflects the lack of liquidity in a traditional private placement. However, with Rule 144A, in
the United States the liquidity premium that issuers have had to pay for a private placement
has decreased. Foreign borrowers in the United States will find the marketplace for private
placements somewhat limited. Only the larger institutional investors have the sophistication to
analyse foreign credit arrangements, and their total investment in foreign loans may be limited
to 5% or 10% of their assets. Funds are provided by specialist longer term investors including
insurance companies, pension plans and other similar investment management entities.
The 50 largest US life insurance companies are a principal source of private long-term
debt for corporations in the US and overseas and a substantial portion of all of their invest-
ments in debt securities may be in private placements. In other countries, private placements
have begun to pick up some of the funding gap arising from a reluctance to lend by banks
following macroeconomic uncertainties and increased regulatory expectations, especially
around capital provision against the lending portfolio.
171

Project Financing
Investment criteria of investors

Although the investment policies of life insurance companies vary, their investment criteria
may be broken into four areas.
1 Amount: most life insurance companies prefer investments of around US$5 million to
US$20 million, with bigger companies preferring larger amounts because of the resulting
economies, not least in terms of information acquisition and due diligence costs. In the case
of large issues, most of these lenders will act as lead lender when they are not interested
in providing the full amount of a proposed financing. The lead lender may offer to assist
the borrower in finding sources for the remaining portion of the financing and normally
acts as spokesman for the lending group.
2 Credit risk: while most private issues are not rated, the borrowers creditworthiness is
expressed in terms of a debt rating as in the public market. Typically, life insurance
companies lend to the equivalent of Baa credits. However, some will only consider loans
involving stronger credits (medium to strong Baa and A credits). On the other hand, other
investors desire to maximise yield by lending a portion of their available funds to strong
Ba and weak Baa credits. They will consider project financing but are generally risk-averse,
as their needs are certainty to meet future claims from policy holders.
3 Maturities: most life insurance companies prefer final maturities in the seven to 15 year
range. Many will consider maturities in the two to seven year range as well, and some
will consider maturities beyond 15 years, in some cases even up to 30 years.
4 Industry: generally, lenders are open-minded about the industry of the borrower. However,
for a variety of reasons, most have one or more industries they tend to avoid. On the
other hand, many have developed expertise in lending to certain industries.
The investment criteria of life insurance companies will vary with developments in the
economy and capital market. Weaker credits will be avoided when capital markets are tight
and interest rates high.
The major challenge for a borrower in a private placement is the need to appreciate
that investment decisions will take longer so that due diligence can be completed. Without
an external rating, information asymmetries are high and longer term investors in situations
without a secondary market are cautious. The length of time and detailed documentation
and negotiation can be a source of stress for anxious borrowers.
In addition to large insurance companies, there are several other sources of private
long-term debt.
1 Japanese leasing and life insurance companies have been active investors in privateissues.
2 Smaller insurance companies do not have specialised staff and often participate in place-
ments being led by large life insurance companies. They are primarily interested in making
small investments in higher quality issues.
3 While the investment objectives of bond funds differ, most are permitted to invest in private
issues to some extent. For a variety of reasons, most are not significant participants in the
private market, but there are some funds formed primarily to invest in private placements.
172

A majority of these are managed by large life insurance companies and their investment
interests are essentially the same as those of the sponsor.
4 In the US, roughly 90% of private pension funds are corporate, with non-profit organi-
sations and multi-employer plans accounting for the remainder. Public pension funds
consist of state and local employee retirement funds. Private and public pension funds
are managed by bank trust departments, investment advisory firms, or are self-managed.
Typically, they limit their participation to higher quality issues. State laws often prohibit
public pension funds from investing in less than A credits. In general, pension funds are
not a significant source of funds for private issuers or for project financing. However fast
growing economies such as India are encouraging pension provision by individuals and
thus developing a thriving private placement market that raises funds for both public and
private sector entities.2
5 Casualty insurance companies, foundations, savings banks, fraternal organisations and
university/college endowment funds are less important sources of private debt financing,
but may have special interest areas, such as renewables. However, even taken together,
they are not a significant source of capital for private placements. Like private and public
pension funds, they typically participate in higher quality issues.
The use of agents or advisers

The term agent in a private placement context refers to investment advisers and brokers who
assist borrowers, for a fee, in privately placing debt securities. Investment banks and capital
markets groups of large commercial banks act in this capacity. Accountants, consultants and
lawyers also sometimes act as agents.
The fees agents charge for their services vary, but historic indicative costs were in the
ranges shown in Exhibit 15.5 for a Baa credit.
Exhibit 15.5
Historic indicative fees for a Baa credit
Size of issue Fee as percentage

of principal
US$5,000,000 to US$25,000.000 7
8 to
US$25,000,000 to US$50,000,000 to 1
over US$50,000,000 3
8 to
Fees for a private placement in connection with a more difficult financing such as a project
financing might be considerably higher in view of the difficulty of the particular assignment.
Although these fees are generally contingent on completion of a successful financing, agents
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expect in many situations to receive retainer fees in any event to cover the time and out-of-
pocket expenses required to prepare the financing memorandum.
3 Description of a typical term loan or debt private placement

agreement
The more important elements of bank term loans and private placements are discussed in
detail in this section. The discussion is not intended to be exhaustive. Rather its purpose is
to familiarise and provide a general understanding of typical terms and covenants in bank
term loans and institutional private placement agreements.
Term loan agreements and private placement loan agreements differ as to substance
depending on the lender and borrower involved. Usually the provisions of a loan agreement
may be grouped into six categories.
1 Loan terms and closing the loan. These provisions describe the loan and the conditions
and requirements which must be satisfied in order to close.
2 Financial covenants. These covenants outline the payments and circumstances for optional
prepayment of the loan.
3 Affirmative covenants. These clauses outline the on-going responsibilities of the borrower
beyond the timely payment of principal and interest.
4 Protective covenants. These provisions place limitations on the actions and operations of
the borrower designed to protect the lender.
5 Default and remedies. These provisions describe when the agreement will be in default
and the remedies that are available to the lender.
6 Boilerplate. These are fairly routine provisions primarily designed to protect the lender
and establish procedures for administration of the loan.
The specific provisions within each of these categories are discussed in detail below.
Loan terms and closing the loan

These provisions concern three main areas: a description of the promissory notes, the terms
of the agreement to transact the loan, and the date and place of closing as well as the condi-
tions that must be met for a closing.
The notes(s)
The borrower authorises the note(s) and specifies the form, usually contained in an attached
exhibit. Further, the date, currency, principal amount, interest rate and the timing and amount
of required repayments are outlined.
Making the loan

The borrower and the lender agree to transact the loan, usually at 100% of the face
value. The date, time and place of closing are specified. The amount and payment of the
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commitment fee, if any, are stated. The method for payment of the loan proceeds to the
borrower is set forth.
Conditions of closing
In order to be assured that everything is in order at the closing, the lender makes a commit-
ment to lend contingent upon the fulfilment of a number of conditions.
1 Instruments and proceedings. The documents are to be executed to the satisfaction of

the lender.
2 Representations and warranties by the borrower. The borrower assures the lender that
no problems exist towards the closing of the loan. Typical representations and warranties
made by the borrower will include the following:
the borrowing corporation is in good standing in its own state and as a foreign
corporation in all states where it does business, and is legally authorised to conduct
its present business;
the borrower has correctly provided all recent historical consolidated financial statements;
the borrower has filed all required tax returns;
the borrower has good title or a valid lease to all its properties and is subject to no
mortgage, lien or other security interest except as permitted by the loan agreement;
there is currently no material litigation against the borrower, except as specified;
closing the loan will not cause an event of default to occur under any other agreement
to which the borrower is a party;

no material adverse change has occurred in the borrowers business or prospects since
the date of the most recent financial statement;

the borrower is not a party to any burdensome agreement that would have a material
adverse effect on the borrower; and

the approval of the loan is not required by any governmental body.
3 Representation and warranties of the lender. The lender represents that the note is being
purchased for investment and not with a view toward resale. (This provision is included
in order to ensure that the financing is exempt from the registration requirements of the
Securities Act of 1933.)
4 Opinion of special counsel. The lenders special counsel must render a favourable opinion
as to the good standing of the borrower, the validity of the transaction, the exemption
of the financing from various federal statutes that apply to public offerings, the validity
of the opinion of the house counsel for the borrower, and any other representations the
lender may reasonably require.
5 Opinion of company counsel. The borrowers house counsel may be required to render
an opinion on a number of matters, including the following:
the good standing of the borrower;
the validity of the transaction and the validity of the necessary corporate approvals;
the exemption of the transaction from federal securities laws;
the good standing of the borrower as a foreign corporation in any states in which it
is active;
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the good standing of each subsidiary and clear title by the borrower to stock of

subsidiaries;
that the loan agreement will not cause breach of any other agreement;
that government approval of the transaction is not necessary (as in the case of regulated
industries under some circumstances);

the clear title to all property involved in the transaction;
the borrowers notes will not be subordinate to other senior debt; and
the absence of material litigation, except as may be disclosed.
6 Application of proceeds. The lender may specify and the borrower may agree to the
specific use of proceeds as a condition of closing. This is common when the proceeds will
be used to repay existing debt.
7 Accountants opinion. An opinion regarding validity of the borrowers financial statements,
and a certificate confirming the reasonableness of its provision for income taxes.
Financial covenants
The financial covenants describe how the loan will be repaid under normal circumstances
or may be prepaid under special circumstances. The borrower argues for flexibility and the
lender seeks to protect its yield in any accommodation. These provisions generally fall into
five categories.
Required payments
These provisions outline the repayment schedule for the loan. The repayment of the loan may
be arranged in a variety of ways. Level amortisation of principal, or of interest and principal
is one approach. An agreement may not require repayments for the first few years (two to
three years) of the loan, sometimes called a blind spot or grace period. After a possible grace
period or blind spot, the agreement may require equal or gradually increasing payments over
the remaining life of the loan. There may be a balloon payment at final maturity, although
typically such a payment will not constitute a significant portion of the principal amount of
the loan (perhaps 10% to 15%). Accelerated prepayments may be required if the earnings
of the borrower exceed a certain level.
Lenders viewpoint: the attitude of most lenders towards the structure of required
prepayments can best be described as flexible. Within the bounds of their investment
policies, they are generally willing to consider any repayment schedule which appears
appropriate for, and can be justified by, the borrower. However, no lender wants to
take a significant risk on refinancing a balloon payment. Their main concern is to assure
that the borrowers projected cash flow will be sufficient to meet principal and interest
payments when due.
Borrowers viewpoint: a borrower should propose a payment schedule which is
consistent with its projected cash flows and be able to justify its position to the lender.
Accordingly, careful preparation and review of forecasts is essential to negotiating the
repayment schedule.
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Optional prepayments without penalty (doubling-up)

Most loan agreements allow the borrower to make additional prepayments without penalty
at principal due dates. Thus, the timing of optional prepayments is governed by the basic
repayment schedule. In general, optional prepayments are allowed in an amount up to
the next required payment hence doubling-up. The principal payment may be credited
against the last payment due. Further, most agreements establish a dollar limitation on these
optional prepayments.
Lenders viewpoint: during periods of high interest rates, lenders prefer to exclude or
minimise this option by requiring a prepayment fee. Their intent, of course, is to prevent
reductions in the average lives of high-yielding loans. On the other hand, provision may
be made for unlimited doubling-up when interest rates are relatively low.
Borrowers viewpoint: this option is important to the borrower during periods of high
interest rates because it gives the borrower the option to reduce the average life of a high
cost loan. Accordingly, the borrower should negotiate as liberal a provision as possible.
Restriction on refinancing
This clause, sometimes called the no financial refunding clause, prohibits the borrower from
retiring the loan during a specific period, typically five to 10 years, with funds borrowedelsewhere.
Lenders viewpoint: when interest rates are low, lenders may not be particularly concerned
with this provision. However, when interest rates are high, lenders attempt to lengthen
the period (ten years or more) during which financial refunding is prohibited in order to
lock in high-yielding loans. This is not unreasonable since the lender may, in turn, arrange
long-term funding to finance the loan.
Borrowers viewpoint: of course, when a company is borrowing during a period of high
interest rates, it would like to have the option of refinancing the loan with lower cost
funds at a future date. Accordingly, the borrower should attempt to minimise the length
of time financial refunding is prohibited or the penalty payments for refunding.
Optional prepayment under certain circumstances

This provision, sometimes called the divorce clause, allows the borrower to prepay the entire
principal amount without penalty (or, in some cases, with a penalty) if the lender is unwilling
to allow the borrower to take some action otherwise prohibited by the loan agreement. It is
not universal and, when used, normally pertains to the protective covenant restricting long-term
debt. Typically, the company is allowed to prepay the loan if the lender is unwilling to approve
additional long-term debt and a bona fide commitment has been received from anotherlender.
Lenders viewpoint: lenders usually will want to exclude this type of provision. They
argue that protective covenants are mutually binding and that there is no reason to allow
prepayment simply because the borrower cannot live within the terms of the agreement.
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Furthermore, they argue that modifications to loan agreements are common and can be
obtained if reasonable.
Borrowers viewpoint: while it is true that modifications to loan agreements are
commonplace and, if reasonable, usually approved, the fact still remains that the lender
can refuse. Accordingly, borrowers argue that loan agreements should contain a provision
allowing prepayment, preferably without penalty, if the lender is unwilling to allow
additional long-term debt. The borrower may wish to negotiate other unusual clauses
which will permit repayment, such as a merger of the company. The borrower argues,
if you are going to be reasonable in making modifications then you should be willing to
spell out certain circumstances in which modification is agreeable.
Optional prepayments with penalty

This clause allows the borrower to prepay the loan, in whole or part, with a penalty.
Usually, the initial penalty is the interest rate times the amount of principal being prepaid.
The penalty normally increases by an equal amount annually, reaching zero at the beginning
of the year the loan matures.
For example, a typical penalty schedule for an 11% 15-year loan might be as shown
in Exhibit 15.6.
Exhibit 15.6
Typical penalty schedule for an 11% 15-year loan
Year Percentage of principal

1 110.00
2 110.21
3 109.43
4 108.64
5 107.86
6 107.07
7 106.29
8 105.50
9 104.71
10 103.93
11 103.14
12 102.35
13 101.57
14 100.79
15 100.00
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When there is a grace period or blind spot, the option and penalty schedule may
begin in the year of the first required prepayment. Sometimes, prepayments are prohibited
for a certain initial period, say five years. This is called a no-call period. If there is a
no-call period, the penalty schedule may take effect and begin decreasing at the termi-
nation of this period. It is also important to note that the clause prohibiting financial
refunding usually governs the borrowers use of this provision. Therefore, during the
period financial refunding is prohibited, optional prepayments with penalty can only be
made with excess funds.
The definition of excess funds varies. Excess funds might be defined as being excess when
a borrower has no other debt obligations, has no plans to borrow in the foreseeable future
and will not be in violation of any protective covenant in the loan agreement upon making
the optional prepayment. This is a fairly standard provision and should not concern the
borrower unless the penalty scheduled unfavourably differs from the norms outlined above,
or the lender is proposing a more restrictive definition of excess funds.
Lenders feel borrowers place too much emphasis on the prepayment convenience in light
of the fact that infrequent use is made of the options they provide. However, borrowers
understandably have some difficulty in accepting that point of view. Borrowers seek flexibility
in all aspects of loan agreements.
Affirmative covenants
Affirmative covenants are promises by the borrower to perform certain actions. Examples
of affirmative covenants are summarised briefly below.
Financial statements and information

The borrower agrees to provide the lender with all releases to shareholders, quarterly and
annual consolidated and consolidating income statements and balance sheets, an annual
certification by an officer that the company is not in violation of the agreements protective
covenants and an annual certification by the auditors reviewing the officers certificate and
discussing any default which may have occurred during the period. Prompt reporting of an
event of default is also required.
Books of record and account

The borrower agrees to keep full and accurate accounting records and to make proper provi-
sions for depreciation of its properties.
Right to inspect properties and books

The borrower agrees to give the lender reasonable access to inspect its properties and to
examine its books and records.
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Payment of taxes
The borrower retains the right to contest any tax assessment in good faith as long as it
provides for adequate reserves in its financial records.
Maintenance of properties
The borrower agrees to maintain its operating assets in good and workable condition.
Compliance with laws

Compliance by the borrower with all laws and regulations with reasonable rights to contest
such laws or regulations.
Insurance
The borrower is required to carry adequate fire, casualty, business interruption and public
liability insurance, as well as legally required workmens compensation insurance. Either
annually or upon request, the borrower must report all insurance in force to the lender.
Permitted business (character of business)

The borrower agrees to remain in its present line(s) of business. Divestiture or diversifica-
tion into other lines of business is frequently limited to a small percentage of net sales, net
tangible assets, or some other variable.
Covenant to secure note equally with other lenders

Called the equal and rateable clause, this provides that the lender will be secured at least
equally with all other lenders, present and future, unless he specifically waives his claim.
Exception is made for prior and statutory liens.
Protective covenants
The protective or negative covenants are among the most important provisions in the loan
agreement. These clauses are designed to protect the lender and limit the actions and opera-
tions of the borrower. Broadly speaking, lenders view protective covenants as a means of
monitoring the financial health of borrowers. Lenders regard them as an early warning
system rather than a means of restricting the borrower. However, this is of small comfort
to borrowers. Protective covenants are restrictions, and the borrower must give consider-
able thought to their present and future implications. This requires careful review of the
borrowers plans and financial forecasts.
Many borrowers feel there is a relationship between interest rate and protective covenants.
In other words, it is felt that lenders will make concessions on rate if the borrower agrees
to more restrictive covenants and vice versa.
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As a general rule, this is not the case. Most lenders do not consider the two as being inter-
related. This stems from the lenders view of protective covenants as a means of monitoring
a loan. The interest rate compensates them for the risk they assume. Protective covenants
do not significantly diminish this risk. Rather, they help assure it will not increase.
Protective covenants must be tailored to a project companys particular needs. While
highly restrictive covenants are counterproductive for both parties, it is the borrowers respon-
sibility to ensure that the covenants are not unnecessarily restrictive. As mentioned earlier,
the borrower should outline the thinking regarding the need for or desirability of major
protective covenants as part of the financing memorandum when originally approaching the
lender. The borrower should propose a form of words if the issue is unavoidable. Although
the lender may disagree with the language proposed by the borrower for protective covenants,
it provides a basis for discussion. Of course, market conditions will influence lenders views
concerning protective covenants to a limited degree. Lenders tend to be more receptive to
less restrictive covenants when there is a surplus of funds in the market and show less flex-
ibility when the market is tight. In general, however, lenders are sympathetic to a borrowers
demonstrated needs for flexibility within reason.
Typical major protective covenants found in loan agreements are discussed in the
following sections.
Minimum working capital requirement

Loan agreements usually establish a minimum dollar amount of working capital. Depending
on the needs of the project company, the required dollar amount of working capital may
increase at specific points in the future. Sometimes, however, minimum working capital
may be some percentage of another variable such as long-term debt, net tangible assets or
revenues. The restriction pertaining to working capital may be coupled with a minimum
current ratio requirement.
Lenders viewpoint: lenders use this clause to assure that the borrower maintains an
adequate level of liquidity that is, that current liabilities do not increase disproportionately
to current assets, threatening the project companys ability to meet current obligations. The
different types of requirements are often combined to provide a greater degree ofprotection.
Borrowers viewpoint: it is important that this requirement allows sufficient room for
forecast error and potential adverse developments experienced by project companies from
time to time. The minimum dollar amount of working capital is the most favourable
type of requirement for a project company which is growing and, therefore, increasing
its working capital. However, the lender may seek periodic increases in the requirement.
Limitation on short-term debt

Short-term indebtedness may be limited in any of a number of ways. Typically, it is limited to
a stated dollar amount. Provision may be made for periodic increases in the specified amount.
Sometimes, allowable short-term debt is based on a formula relating it to the level of some
variable such as current assets or accounts receivable. Less frequently, there is nolimitation.
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Most agreements require that the borrower pay off completely (or down to a stated
amount) short-term debt for a specified period, typically 3060 days, each year. This is called
a clean-up. The company may be allowed to miss one or more clean-ups non-consecutively.
Agreements usually require that accounts payable be kept current during the clean-up period.
Under some agreements, short-term debt which is not cleaned up within a given year is
defined as long-term debt. This short-term debt does not have to be cleaned up as long as
the borrower is not in violation of the covenant restricting long-term debt. Such short-term
debt continues to be defined as long-term debt until it is cleaned up.
Lenders viewpoint: this clause is closely related to the working capital provision in
that both are intended to monitor liquidity. Lenders require this provision in order to
ensure the borrower does not borrow on a short-term basis in order to fund long-term
requirements. In other words, lenders want a company to use short-term debt for short-
term needs. Use of short-term debt to meet long-term financing requirements can lead
to liquidity problems.
Borrowers viewpoint: the borrower must be sure this limitation does not prevent it from
financing legitimate short-term needs. Like the provision for working capital, this clause
should provide sufficient room for forecast error and normal adverse developments which
would create an above-average need for short-term debt. Because most companies expect
to grow to some extent, allowable short-term debt should be permitted to increase as
the company grows.
Limitation on long-term debt

Lenders sometimes refer to long-term debt as funded debt. In addition to senior and subordi-
nated debt, funded debt normally is defined to include mortgage debt, bank revolving credits
and capitalised leases. Take-or-pay contracts, operating leases or contingent liabilities such as
guarantees may also be included. Typically, funded debt is limited either to a dollar amount or
the limitation takes the form of a running formula expressed as a percentage of consolidated
net worth, consolidated net tangible assets, or cash flow. In using such formulae, a wide
variety of possibilities exists, such as inclusion of different ratios for senior and subordinated
debt. In many agreements, these ratios are combined with a minimum pro forma interest or
fixed charge coverage test which must be satisfied in order to incur additional funded debt.
Sometimes, especially in the case of smaller companies where pro forma funded debt will
be relatively high, additional funded debt is simply prohibited.
Lenders viewpoint: broadly stated, the higher the percentage of funded debt in a companys
total long-term capitalisation (that is, long-term debt plus equity), the greater its financial
and overall risk. The limit lenders place on long-term indebtedness depends on their view
as to what constitutes an appropriate level of risk for the borrower. Since the appropriate
level of funded debt for a particular company depends on its industry, earnings performance,
size and several other factors, it is impossible to generalise. An interest or fixed charge
coverage test is often used because it is widely accepted as the principal determinant of
a companys ability to carry long-term debt.
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Borrowers viewpoint: any limitation on funded debt is a very significant restriction for
a project company. A borrower should attempt to negotiate the most liberal provision
possible, consistent with future financing requirements as demonstrated by its forecast in
order to provide for future financial flexibility. A formula which allows funded debt to
increase as a project company grows is the most favourable type of restriction. However,
lenders will prohibit additional funded debt entirely in some instances, particularly where
the lenders have a major stake in the success of the company.
Restriction on lease obligations

This covenant normally pertains to non-cancellable, long-term equipment or real estate
leases with a remaining term (to include renewal options) in excess of two to five years.
Such leases may be restricted in a number of ways. A most common type of limitation is
to limit annual rentals to a specified dollar amount. Alternatively, the capitalised amount of
such leases may be limited to some percentage of consolidated net worth or consolidated
net tangible assets or included under the restriction on funded debt. Many times leases are
included in the minimum fixed charge coverage test relating to funded debt. In some cases,
short-term operating leases with a term of less than two or three years and those involving
certain types of assets (data processing equipment, office equipment, automobiles, trucks,
office space and so on) are not restricted. Lenders give more attention to leases in cases
where leases play a significant financing role in a borrowers operation.
Lenders viewpoint: long-term, non-cancellable equipment and/or real estate leases are a
form of mortgage debt financing and regarded as such by lenders. Such leases obligate
a company to make fixed periodic payments pari passu with senior debt. Consequently,
lenders restrict such leases for the same reason they restrict funded debt: to limit total
financial risk (leverage or gearing) to an acceptable and prudent level.
Borrowers viewpoint: where a borrower such as most project companies cannot use
tax benefits currently, tax-oriented equipment leasing provides an attractive low cost
form of financing. A borrower should attempt to negotiate a provision which provides
flexibility, as in the case of funded debt, where a running formula is the most favourable
type of restriction for the borrower. However, the borrower should keep in mind the
close connection between this provision and the one pertaining to funded debt as viewed
by lenders.
Restricted dividend payments, other stock payments and the repurchase of

stock
Usually, restricted payments are limited to a stated percentage of aggregate consolidated net
earnings after a specified date, normally the most recent year-end. The percentage may range
from zero to 100%, depending on the particular circumstances of the project company.
In the case of private or closely held companies, a limitation is often placed on the total
compensation of stockholder/employees since increasing such compensation can be used as a
means of otherwise circumventing this protective covenant. Many times, this covenant has
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a clause which stipulates that the borrower must maintain some minimum net worth which
is stated as a dollar amount or as a percentage of another variable such as consolidated
net tangible assets or long-term capitalisation. Such a clause closely relates to the covenants
restricting funded debt and their provisions should be consistent.
Lenders viewpoint: the net worth of a company provides a cushion to the lender in the
event of unforeseen adverse developments. While a company may incur future operating
losses which will reduce its net worth and diminish its financial strength, the lender
explicitly considers this risk in making a loan. This covenant is designed principally to
prevent a borrower from undertaking financial transactions which would reduce its net
worth below a level acceptable to the lender. Of course, from the lenders standpoint, the
limitations on restricted payments, funded debt and working capital are closely related.
Borrowers viewpoint: as a practical matter, the limitation lenders placed on dividends is not
restrictive for a project company. The borrower should, nevertheless, attempt to negotiate
a covenant which provides ample flexibility. His main concern should be to assure that
the limitation is consistent with any planned financial transactions which would have a
negative impact on earnings or net worth (such as the repurchase of stock or a write-off).
Restrictions on supply and purchase contracts (take-or-pay agreements)

Take-or-pay agreements oblige a company to pay for product or services purchased from a
supplier at regular intervals over a period of time regardless of whether the goods or services
are in fact received. Of course, such agreements are contingent liabilities. These types of
agreements are not uncommon in project financing and in many instances are beneficial to
the borrower by providing an assured source of supply of needed raw material or service
at a predictable price.
Lenders viewpoint: the obligation is a contingent obligation if payment must be made

under a take-or-pay contract even though the product is not provided. If such contracts
are necessary, they should be disclosed at the time the loan agreement is made.
Borrowers viewpoint: opportunities may be presented to assure a source of supply or
service by entering into such contracts. Flexibility is required.
Limitation on guarantees and contingent liabilities

This provision usually limits guarantees and other contingent liabilities of the company
either absolutely or to a certain dollar amount. The allowable dollar amount may be stated
as a percentage of some variable such as net tangible assets. Exceptions are usually made
for guarantees and other contingent liabilities in existence at the time of the agreement and
those which arise in the normal course of business.
Lenders viewpoint: a guarantee places a contingent senior obligation on the company

which may result in a cash drain at an inopportune time. Consequently, guarantees need
to be limited for the same reason other senior indebtedness needs to be limited.
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Borrowers viewpoint: existing commitments should be preserved and enough room left
in the dollar limitation to cover planned transactions.
Limitation on sale and lease-back transactions

Sale and lease-back transitions are usually prohibited or only permitted to a modest ceiling. If
agreements do not specifically restrict sale and lease-back transactions they are usually limited
by the protective covenant pertaining to sale of assets, long-term debt or lease obligations.
Lenders viewpoint: the lender is losing potential collateral and the borrower is, in effect,
creating debt. It is reasonable for lenders to forbid major transitions of this type.
Borrowers viewpoint: the borrower may wish to preserve some flexibility to do small sale
and lease-backs. The borrower may argue for a dollar limitation subject to the restrictions
on lease obligations and the sale of assets.
Limitations on mortgages, liens and other encumbrances

Any impairment of free and clear title to the companys assets constitutes a lien. This provi-
sion is designed to prevent the borrower from incurring liens on its assets. Existing liens and
liens arising out of the ordinary course of business are excepted, as are tax liens and other
governmental liens, performance deposits and bonds, zoning restrictions, easements, mechan-
ics liens and so on. The pledging of receivables, inventory or other current assets as security
in exchange for credit accommodations is generally prohibited. Normally, purchase money
mortgages are a negotiated exception to the restriction on liens. The limitation on purchase
money mortgages is typically stated as a dollar amount or percentage of net tangible assets.
Lenders viewpoint: liens on a companys real or personal property can seriously impair
the lenders credit position since the value of any asset subject to a lien will be impaired
in the event the borrower has difficulty repaying the loan.
Borrowers viewpoint: this is a fairly standard covenant except with respect to
purchase money mortgages. Purchase money mortgages often can be a very favourable
financing alternative. The limitation should provide flexibility after consideration of
planned transactions.
Other protective covenants

Other protective covenants include clauses that are designed to protect the lender by placing
limitations on the actions and operations of the borrower with respect to:
investments;
issuance of shares or indebtedness by restricted subsidiaries;
companys consolidation, merger or disposition of property as an entirety;
subsidiaries consolidation, merger or disposition of property as an entirety;
acquisitions by the company and subsidiaries;
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sale, lease or other disposition by the company or any subsidiary of any substantial part
of its assets; and
transactions with shareholders, controlling persons and affiliates.
Default and remedies

This section describes conditions whereby the agreement goes into default and the remedies
available to the lender when default occurs. Five events of default are typically enumerated:
1 default on the payment of principal;

2 default on the payment of interest;
3 default in observing the protective covenants;
4 default in any other covenant, agreement or section of the agreement; and
5 a collection of other contingencies.
Some breaches constitute an immediate event of default and the total debt is immediately
due and payable.
Other breaches may require the lenders to serve written notice to the company demanding
that the breach be cured. If the problem is not resolved in a specified time period, for
example, 30 days, default occurs.
Acceleration of maturity means the entire principal amount outstanding, together with
accrued interest, is due and payable immediately. The optional prepayment penalty specified
elsewhere in the agreement may be required in addition to the principal and accrued interest,
provided applicable state law permits.
The first three events of default are clear as stated. The fourth default is a catch-all
that provides a method to enforce the affirmative covenants and miscellaneous provisions of
the agreement. The fifth and last event of default is a collection of different events that do
not necessarily breach any explicit provisions found elsewhere in the agreement, including
the following.
1 The borrower or any subsidiary admits in writing its inability to pay debts generally as
they become due.
2 The borrower or any subsidiary makes an assignment for the benefit of creditors, or
consents to the appointment of a receiver for itself or of the whole or substantial part
of its assets.
3 The borrower or any subsidiary consents to bankruptcy, has a petition in bankruptcy filed
against it or is adjudicated a bankrupt.
4 The borrower or any subsidiary files a petition or seeks reorganisation or arrangement
under the federal bankruptcy laws or any other applicable law.
5 The cross-default clause (see below) triggered when a default occurs under any other
credit agreement of the borrower or any of its subsidiaries. This provision establishes
the most stringent restrictions of any of the borrowers loan agreements as the governing
restrictions, and prevents one creditor from acting on a default before other creditors
can make their claims.
186

6 An adverse judgment (if the judgment or the cumulative sum of such judgments is greater
than some specified dollar sum) is not paid, stayed or appealed within a reasonable period
of time.
7 Any material representation or warranty made by the company in the loan agreement or
associated documents is false or incorrect in any material respect.
8 A court orders the dissolution of the company, or the split-up or divestiture of a substan-
tial part of the borrowers assets.
Cross default clauses are clauses inserted in an agreement so that a default in any of the
sponsors obligations can trigger an event of default in all of them. They are commonly
used to ensure no one bank group may be disadvantaged by queuing for access to any
collateral behind bank groups that have declared an event of default and the loan due and
payable immediately, that is, called the loan ahead of them. Lenders try and resist the
inclusion of cross default clauses, because of the potential risk that a small event may have
a disproportionately unreasonable impact on other activities. So in an extreme example,
technically, the non payment of a local grocery bill could cause a major project financing
to go into default.
Boilerplate
These provisions establish definitions and procedures for administering the loan and include
the following.
Modification of the agreement

The provision for amending or waiving portions of the agreement after the closing is reason-
ably standard and provides that the lender may waive any provision and the borrower
may rely on that waiver as long as it is in writing. All rights and provisions not explicitly
waived, however, remain in effect. Where more than one lender is involved, provisions may
be amended or waived with the consent of some predefined percentage of the notes, between
50% and 100%, and typically 6623%. Changes in some provisions may require approval
by every lender, namely:
the amount or due date of repayments of principal;

the amount and due date of interest payments; and
the proportion of note holders required to amend or waive any provision of the
loan agreement.
While the loan agreement or private placement agreement should be drafted with the future
in mind, nobody has perfect foresight. Unforeseen developments often precipitate the need
to modify the agreement. In general, lenders fully expect that the need for modifications
will arise and realise that the majority of modification requests are attributable to positive
developments. In short, they regard modifications as an important part of administering a
loan and most have procedures to assure expeditious decisions on requests.
187

Project Financing
A large majority of modification requests are approved. In most cases, modifications are
approved without a demand for a quid pro quo (for example, an increase in the interest
rate). While their viewpoints differ, in general, lenders only require a quid pro quo in cases
where the modification is necessitated by a deterioration in the borrowers financial condi-
tion or the lender will otherwise be exposed to increased risk.
Lenders are interested in maintaining good relations with borrowers. Reasonable and
expeditious handling of requested modifications strengthens the lenders relationship with the
borrower, but large institutions may also move slowly and decisions on private placements
made by insurance company investors may take longer than bankers decisions. The impor-
tant point for any borrower to understand is the true timing and process of decision-making
inside each provider of funds.
Definitions
This is a particularly important section of the agreement. It defines all the significant terms
used elsewhere in the agreement such as current assets, net tangible assets, funded debt, fixed
charges and net income. Most of these terms are used in establishing protective covenants. Of
course, in order to negotiate the protective covenants, the borrower must have a thorough
understanding of the definitions of these terms.
Expenses of the financing

Normally the agreement provides that the borrower will pay all reasonable expenses of the
transaction, including the fee for the lenders special counsel and any printing costs. As noted
earlier, without supervision, attorneys will sometimes drag out negotiations and run up fees
they know their clients will not have to pay. Emphasis that legal fees are to be reasonable
is important.
Finally, private placements can also be private placements of equity, with different docu-
mentation to the debt provisions described above.
1
Nevill, L, Going Private, 2011: 4 March 2011. Accessed at www.risk.net/credit/feature/2031363/borrowers-look-
private-placements-substitute-bank-lending#ixzz1biW1CWe3 on 24 October 2011.
2
www.adb.org/documents/books/rising_to_the_challenge/india/india-cap.pdf. See pp. 1267. Accessed 4 November
2011.
188

Chapter 16
Bond financing is an important source of funding for projects. It is expected that this form
of financing will increase because of the substantial funding needs required for major infra-
structure projects that cannot be provided by traditional syndicated bank loans. Providing
greater comfort to institutional investors has been the establishment by rating agencies of
groups dedicated to rating bonds backed by infrastructure projects, thereby expanding the
institutional base for bonds backed by such projects.
Certain bond structures used by municipalities in the United States have also been
used throughout the world to finance infrastructure projects. US municipalities that issue
bonds include states and local governments (cities and counties), political subdivisions of
municipalities such as special districts for water and sewer treatment, and public agencies
or instrumentalities that include authorities and commissions.
There are basically two different types of municipal bond structures: tax-backed bonds
and revenue bonds.1 Tax-backed debt obligations are instruments issued by municipalities
that are secured by some form of tax revenue.2 The municipal bond structure that has been
used for infrastructure financing in other countries is revenue bonds. With this structure,
repayment of the bonds is wholly dependent upon the revenues of the project.
Emulation of the revenue bond structure throughout the world has long been recognised
by experts. In a 1997 study completed under the auspices of the American Society for Public
administration, the following appeared:
The advantages of using municipal bonds to finance urban infrastructure are increasingly
evident to policy makers in emerging economies, some of whom are undertaking efforts
to accelerate the development of municipal bond markets in their countries. Many of
these efforts use the strengths of the US municipal market as a guide to suggest the
kinds of market characteristics necessary to attract issuers as well as investors to the
marketplace. Features of the US market are often difficult to recreate in these coun-
tries in the short run, but policy makers are using a variety of innovative techniques to
approximate essential market characteristics.3
Although we will describe revenue bonds, our primary focus in this chapter is on one type of
revenue bond used in the United States industrial development revenue (IDR) bonds. These
bonds can be used by corporations or project sponsors to finance certain types of capital
projects in the United States. They can be used to finance new facilities and equipment, as
well as the acquisition of existing assets. Industrial, commercial, manufacturing, warehousing,
distribution and certain pollution control facilities are among the types of capital investments
that may be financed through IDR bonds.4
189

Project Financing
Historically, the two types of tax-exempt bonds (that is, bonds whose interest is exempt
from federal income taxes) issued by US municipalities on behalf of private corporations were
referred to as pollution control revenue (PCR) bonds and IDR bonds. The primary issuers
of PCR bonds were by electric utilities and manufacturers in order to obtain financing to
construct and acquire pollution and control equipment. Although there is a distinction between
PCR bonds and IDR bonds, today they are simply referred to as IDR bonds5 and that is
the term we shall use in this chapter. However, it should be noted that another commonly
used term for IDR bonds is industrial revenue bonds (IRBs).
The economic motivation for the issuance of IDR bonds by a municipality on behalf of
a private company is an incentive to encourage a private company to locate and/or build
and operate facilities in that municipality.
Although there may be other advantages cited for issuing IDR bonds, the primary reason
is the potential reduction in funding costs that can be achieved via tax-exempt financing. That
cost saving, because the interest of an issue is not taxed at the federal level, varies based
on market conditions and prevailing maximum marginal tax rates,6 and must be weighted
against the potentially higher issuance costs compared with a taxable financing depending
on the complexity of the transaction, the additional time it may take to obtain financing in
order to obtain approval by the municipality (including public hearing), and just the mere
inconvenience or lack of flexibility that may result from dealing with some public officials
and board authorities.
Financing via IDR bonds can be attractive to foreign companies needing to establish or
acquire new operations in the United States.
Although our discussion in this chapter is on IDR bonds which are tax exempt, munici-
palities also issue bonds on behalf of private companies for projects that are subject to federal
income taxes but may or may not be subject to state and local taxes by the municipality that
issued them. One reason for the issuance of a taxable IDR bond is that the project does not
qualify for federal tax-exempt bonds treatment. We will describe the tax requirements for
tax-exempt treatment later in this chapter but for now it is important to note that certain
private activities may not qualify for tax-exempt status. For non-qualifying private activi-
ties, taxable revenue bonds can be issued by municipalities on behalf of private companies.
Another reason for the issuance of bonds that are taxable is that the municipality may have
exceeded its statutory limit on the amount of federal tax-exempt bonds it may issue. Of
course, because these bonds are taxable at the federal level, the funding cost is higher than
for tax-exempt bonds.7
1 Municipal revenue bonds

Before delving into IDR bonds, we will explain the fundamental characteristics of municipal
revenue bonds. Such bonds are issued for either project or enterprise financings where the
bond issuers pledge to the bondholders the revenues generated by the operating project that
is being financed.
Before revenue bonds are issued, a feasibility study is undertaken in order to determine
the economics of the project or enterprise. More specifically, the purpose of the feasibility
study is to determine whether the project or enterprise can be self-supporting based on the
190

forecasts of operating statistics for estimating cash flows. In addition to the feasibility study,
there must be a legal opinion wherein bond counsel opines/certifies that the issuer:8
is legally authorised to issue the bonds;

has properly prepared for the bond sale by enacting the various required ordinances,
resolutions and trust indentures and has done so without violating any other laws and
regulations; and
the security safeguards and remedies provided for the benefit of the bondholders and
pledged (either by the bond issuer or third parties) are supported by all government laws
and regulations.
As we explain later when we discuss federal requirements for obtaining tax-exempt status
to finance a private activity, the second bullet point above is critical in order to avoid an
issue being reclassified by the US federal tax authority the Internal Revenue Service as
a taxable bond issue.
The complete description as to how revenue received by the project or enterprise will
be distributed to the bondholders is provided in the trust indenture. Typically, the flow of
funds for a revenue bond is as follows. When revenue is received, it is placed in a revenue
fund and then distributed to other funds:
operation and maintenance fund;

sinking fund;
debt service reserve fund;
renewal and replacement fund;
reserve maintenance fund; and
surplus fund.
The priority of the disbursements to these funds is as follows (see Chapter 20).
1 The cash needed to operate the project or enterprise has the highest priority and those
funds are disbursed from the revenue fund to the operation and maintenance fund.
2 After these operation expenses are met, there is a disbursement to the sinking fund (as
specified by the trust indenture) which is used for the servicing of the bonds debt.
3 Any excess proceeds are then used to accumulate a reserve to cover any shortfalls in
future proceeds for servicing the debt with the specific amount that must be distrib-
uted being specified by the trust indenture. The debt service reserve fund is used for
this purpose.
4 The renewal and replacement fund and the reserve maintenance fund are used to accu-
mulate funds for the specific purpose for which those two funds were established.
5 After all of these disbursements from the revenue fund have been made, any remaining
proceeds are distributed to the surplus fund.
The trust indenture for a revenue bond will include covenants to protect the bondholders
regarding:
191

Project Financing
how the charges will be established for the products or services sold (that is, rate or user
charge covenant);
whether more bonds with the same lien may be issued (additional bonds covenant);
restrictions on the sale of the facility or enterprise; and
the maintenance of the facility.
Usually municipal revenue bonds are issued with 10-year call protection9 and have a manda-
tory sinking fund requirement. In addition, for almost all the municipal revenue bonds that
are IDR bonds there is an extraordinary (or calamity) call feature granting the issuer the
right to redeem the issue at par on any date should the project financed be confiscated by
eminent domain (compulsory purchase), be destroyed, or incur a loss of economic viability.
2 Qualification for the issuance of a tax-exempt bond

The tax regulations for qualifying as a tax-exempt bond are not simple. As one tax expert
specialising in this area notes:10
In a typical convoluted fashion, the Code first provides that interest on obligations (bonds,
notes, or other things treated as debt obligations for federal tax purposes, such as certain
financing leases) issued by a state or local government will be excluded from gross
income, but then goes on to say that such interest will not be exempt if the bonds are
private activity bonds, arbitrage bonds, or otherwise fail to meet other requirements. Then
the Code says that even private activity bonds may be tax exempt if they are qualified
private activity bonds, but the interest on such bonds will generally (but not always)
be treated as a special preference item for purposes of the alternative minimum tax.11
Here are the details that explain the above quote. Section 141 of the tax code covers private
activity bonds and qualified tax-exempt bonds. In non-technical terms, a private activity bond
is a bond issue that principally benefits or is utilised by a private entity/private business.
The tax code then goes on to specify two private business tests for determining whether a
bond issue is a private entity: the private use test and the private security or payment test.
If both of these tests are passed, then a bond issue is classified as a private activity bond
and is not tax-exempt.
Then the tax code states even though a bond issue is classified as a private activity, it can
still qualify for tax exemption if it is the type of private activity that the tax code defines as
qualifying for tax exemption. That is, if bond issue is a private activity bond based on the two
tests, it is not tax exempt unless it is a qualified private activity. Such bonds are then referred to as
qualified tax-exempt bonds or more appropriately, tax-exempt qualified private activitybonds.
The US Congress limits the use of tax-exempt bonds for private activities because of its
concern about the overuse of such bonds issued on behalf of private entities. Congress has
done so by imposing:12
restrictions on the types of private activities that are permitted tax-exempt status; and
annual volume cap limitations for private activity bonds that may be issued by a state.
192

Qualifying private activities

Congressional actions to curb what was viewed as an abuse of the tax-exempt privilege
began in 1968 with the passage of the Revenue and Expenditure Control Act of 1968. This
legislation did two things as it pertains to private activity bonds:
1 it established the basis for what is a private activity bond (that is, provided the two private
business tests mentioned above); and
2 it specified the private activities that would qualify for tax exemption and exceptions for
small issuers.
Exhibit 16.1 shows the activities that qualify for tax exemption as they pertain to exempt-
facility bonds.13 The first column of the exhibit identifies the relevant section of the tax code
and the second column the specific type of private activity. As explained below, subsequent
legislative changes to the tax code were enacted regarding the types of activities. The last
column of the exhibit shows the year that the type of private activity became qualified.
The Tax Reform Act of 1986 Act did the following:
1 re-established most of the private activities in the 1968 Act;

2 provided for an addition qualifying private activity: hazardous waste facilities; and
3 limited the exemption for several private activities that had been previously a qualified
private activity such as construction of sports facilities and privately owned airports, docks,
wharves and mass-commuting facilities.
Annual cap limitation on issuance

The annual (based on the calendar year) cap limitation on the issuance of tax-exempt quali-
fied private activity bonds for states was part of the Deficit Reduction Act of 1984 and the
amount has been amended by subsequent legislation. Section 146 of the tax code, which
covers the state volume limitation, specified the amount as the greater of: (i) a statutory
dollar amount multiplied by the population of the state; or (ii) a specified dollar million.
The limits are adjusted annually for inflation.
For example, for calendar year 2011, the following appeared in Revenue Procedure
201040 published by the Internal Revenue Service.
Private Activity Bonds Volume Cap. For calendar year 2011, the amounts used under
146(d)(1) to calculate the State ceiling for the volume cap for private activity bonds
is the greater of (1) $95 multiplied by the State population, or (2) $277,820,000.
So, for example, for the state of California, the US Census Bureau reported a population of
37,253,956 and therefore the annual ceiling for the state for 2011 was US$3,539,125,820
(= $95 37,253,956).14
There are certain private activities to which the private activity volume cap does not
apply. The third column in Exhibit 16.1 indicates the activities that are exempt from the
cap or have some other special treatment.
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Project Financing
Exhibit 16.1
Qualified private activities: exempt facility bonds
Internal Revenue Type of private activity Subject to Year

code section volume cap established
Sec. 142(c) Airport* No 1968
Sec. 142(c) Docks and wharves* No 1968
Sec. 142(c) Mass commuting facilities* Yes 1981
Sec. 142(e) Water furnishing facilities Yes 1968
Sec. 142(a)(5) Sewage facilities Yes 1968
Sec. 142(a)(6) Solid waste disposal facilities Yes/Noa 1968
Sec. 142(d) Qualified residential rental projects Yes 1968
Sec. 142(f) Local electric energy or gas furnishing facility Yes 1968
Sec. 142(g) Local district heating and cooling facilities Yes 1982
Sec. 142(h) Qualified hazardous waste facilities Yes 1986
Sec. 142(I) High-speed intercity rail facilities Yes b
1988
Sec. 142(j) Environmental enhancements of hydroelectric No 1992
generating facilities*
Sec. 142(k) Qualified public educational facilities Nob 2001
Sec. 142(l) Qualified green building and sustainable design projects Nob 2005
Sec. 142(m) Qualified highway and surface freight transfer facilities No b
2005
* Indicates private activities must be owned by the issuing government toqualify.

a
Exempt from the cap if governmentally owned. Subject to the cap if privatelyowned.
b
There are special rules regarding thecap.
Source: Adapted from Table 2 in Maguire S, Private activity bonds: an introduction, CRS Report for
Congress, updated 9 June 2006, p. 10
Other general rules

In addition to the rules described above for an issue to qualify for tax-exempt status, there
are other technical rules which will not be discussed here but which are important. These
include rules dealing with arbitrage and bond refundings. The use of derivative instruments
financial products used for risk control that we describe in Chapters 24, 25 and 26 must
be considered in light of these other rules.15
One particular aspect of the other rules for qualifying for tax exemption is the reissu-
ance of bonds. Under the tax code, generally a reissuance occurs when there are significant
modifications to the terms of a bond so that the bond ceases to be the same bond for tax
purposes.16 Reissuance is important because it generally results in the retesting of all the
rules that made the original issue qualified for tax-exempt status.
194

The specific types of modifications that are significant enough such that they may be
treated as a reissuance are:
Change in annual yield. Generally, a change in the annual yield of a tax-exempt bond
by more than the greater of of one percent or 5% of the annual yield of the
unmodified instrument will trigger a reissuance.
Change in timing of payments. Depending on the circumstances, a reissuance may

occur if there is a change in the timing of the payments due under the tax-exempt-bond
such as an extension of the final maturity or a deferral of payments prior to maturity.
Substitution of a new obligor or the addition or deletion of a co-obligor. If there is

a change in payment expectations, the addition or deletion of a co-obligor on a tax-
exempt bond may cause a reissuance. The substitution of a new obligor on tax-exempt
bonds is not a significant modification if the new obligor is related to the issuer and
the collateral for the bonds includes the original collateral.
Change in security or credit enhancement. If there is a change in payment expectations,

the substitution of new collateral for existing collateral of a tax-exempt bond may cause a
reissuance. Generally, however, the substitution of a similar commercially available credit
enhancement contract on a nonrecourse tax-exempt bond will not cause a reissuance.
Change in priority of an obligation. If there is a change in payment expectations, the

subordination of a tax-exempt bond to another obligation may cause a reissuance.
Change in the nature of a debt instrument. For example, changing a tax-exempt

bond from a recourse obligation to a nonrecourse obligation or vice versa may cause
a reissuance. Generally, a legal defeasance of a debt instrument in which the issuer
is released from all liability to make payments on the debt instrument is a significant
modification. However, there is an exception for tax-exempt bond defeasances under
the circumstances described in Regulation section 1.1001-3(e)(5)(ii)(B).
Change in payment expectations. Depending on the circumstances, a change in payment

expectations may cause a reissuance. A change in payment expectations may occur if
there is a substantial enhancement or substantial impairment of an issuers capacity to
meet its payment obligations. An issuers payment capacity for a bond issue includes
all of its sources of payment on the bonds, including collateral, guarantees, or other
credit enhancement.17
3 Structure for IDR financing

The principal participants in an IDR financing transaction are:
1 the municipality (political subdivision) that will issue the bond;

2 the private entity (private business);
195

Project Financing
3 the commercial bank or investment bank which arranges the financing;

4 the lenders (such as institutional investors or individual investors); and
5 bond counsel.
IDR bonds are issued by the political subdivision within whose jurisdiction the facility will be
located. The bond proceeds are used to purchase or construct equipment and facilities which
are subsequently leased or sold to the private entity. The political subdivision acts merely
as a conduit of funds between the lenders and the private entity in order to take advantage
of its ability to issue tax-exempt bonds. The issuer is not liable for principal and interest
payments on the bonds, or for any other costs incurred in connection with the financing. All
such costs and payments are made solely by the private entity through a financing agreement
between it and the issuer.
The specific structure of an IDR bond financing varies by location, and is governed by
the applicable state and local laws. These structures include financing by means of:
1 a loan agreement;
2 a lease agreement;
3 a lease/lease-back agreement; and
4 an instalment sale agreement.
Loan agreement
In a loan agreement type of transaction, the issuer loans the bond proceeds to the private entity
to enable it to construct or acquire the facility. The private entity then agrees, by a loan agree-
ment or a promissory note issued pursuant to the loan agreement, to make loan repayments
to the issuer sufficient to permit it to pay principal and interest on the bonds. Although a
loan transaction is the simplest financing structure, it is not always permitted under statelaw.
Lease
In a lease type of transaction, the issuer uses the bond proceeds to construct the facility, and
then leases the facility to the private entity for rental payments sufficient to pay the principal
and interest on the bonds. In most cases, however, the private entity actually constructs the
facility on behalf of the issuer. The private entity is given an option to purchase the facility
for a nominal, predetermined sum at the end of the lease term.
Lease/lease-back
In a lease/lease-back type of financing, the company leases the facility to the issuing body
for a front-end rental payment equal to the lesser of the cost of the construction of the
facility or the bond proceeds. The issuer simultaneously sub-leases the facility to the private
entity for sub-rental payments sufficient to pay the principal and interest on the bonds. This
structure is generally used when a private entity cannot convey title to the issuer, such as
when the property being financed is subject to the lien of a first mortgage bond indenture.
196

Exhibit 16.2
Project facility financed with IDR bonds supported by a contract or lease from sponsor
and a guarantee
Sponsor
company
1 Contract or
lease to 5 Payments
use a facility
2 Security
Municipality agreement and Indenture
4 Guarantee or political assignment trustee
subdivision of payments
3 Revenue 5 Debt service

bonds
Lenders
Continued

Project Financing

Summary
1 A private entity enters into a contract or lease with a political subdivision for the use of a facility. The
contract or lease contains a purchase option at a nominal purchase price after debt has beenrepaid.
2 The political subdivision enters into a security agreement with an indenture trustee and pledges
payments or rents due under the lease or contract to the indenturetrustee.
3 The political subdivision issues IDR bonds to the lenders on a basis whereby the lenders look solely to
the proceeds from the contract or lease with the private entity forpayment.
4 Simultaneously, the private entity directly guarantees payment of the bonds. (In the alternative, the
guarantee might run to the indenture trustee.)
5 The proceeds of the bonds are used to purchase the facilities; the contract or lease commences;
payments are made by the private entity directly to the indenture trustee and the indenture trustee
pays the debt service. The private entity claims income tax benefits of depreciation (straight line) and
interestexpense.
Instalment sale
In an instalment sale type of transaction, the issuer uses the bond proceeds to construct the
facility which it then sells to the private entity for a purchase price sufficient to pay the
principal and interest on the bonds. The private entitys obligation to make payments may
be either in the instalment sale agreement itself, or in a promissory note issued pursuant
to the instalment sale agreement. Title to the facility may pass to the private entity either
upon completion of construction of the facility, or upon payment in full of the principal
and interest on the bonds.
4 The process for issuing IDR bonds

The following is the typical process for the issuance of tax-exempt IDR bonds.
The first step in the process, after a private entity has determined that a project should
be undertaken, is an analysis by the chief financial officer or financial consultant to assess if
market conditions are such that the savings in interest costs will justify this type of financing,
taking non-financing fees and potential delays in obtaining approval into account.
If the financing benefits are sufficient to warrant utilisation of this type of financing, the
private entity should engage legal counsel to make a determination if the private activity will
be treated as a qualified tax-exempt private activity bond. The approval process is complex,
requiring considerable documents regarding the bonds to be offered and the issuer and
compliance with both federal and state requirements. Bond counsel should be an individual
or law firm specialising in municipal revenue bonds. Depending on the municipality, the
private entity can designate its own bond counsel or use bond counsel designated by the
municipality, although the former is more common.
If there are benefits that have been identified for this type of financing, a representative
of the private entity will have preliminary discussions with the appropriate officials of the
county/city or the state. For larger counties and cities there is a typically an agency with
198

the title Industrial Development Agency (IDA).18 Although the IDA can make a recom-
mendation for the issuance of tax-exempt financing, it is only a state agency that provides
final approval. This is because it is the state agency that must allocate the statewide volume
cap discussed earlier. The authorising state agencies have various titles. In some states it is
the states Department of Commerce or titles such as Development Finance Authority or
Economic Development Authority.
While the discussion can begin with an IDA, it can also start directly with the state
agency. Some states have regional officials for that purpose. For example, in the State of
Wisconsin, the designated official is the states Area Development Manager. Below we will
assume that the private entity starts the discussion with an IDA.
The IDA will require a detailed review of the feasibility of the project and the financial
capability of the private entity. For example, in addition to certified financial statements
of the financial issuer, pro-forma financial statements should accompany proposals for the
project which includes assumptions underlying the analysis, timetable for the completion of
the project, capital expenditure schedule and sources of financing. Other information requested
concerns whether the private entity or affiliates of the private entity have ever been involved
in bankruptcy or creditor rights proceedings, or been the subject of criminal proceedings
involving financial matters. If the private entity is involved in any litigation matters that
could impact its ability to meet the financial obligations, that information must be disclosed.
Since typically a private entity will have other debt obligations outstanding which may have
covenants that either limit further indebtedness or that may adversely impact the creditwor-
thiness of the bonds to be issued, all credit agreements must be disclosed.
Other statements about the project might have to be provided. For example, in North
Carolina, a private entity seeking funds for a manufacturing facility must provide the following:
Abandonment statement: This is a statement within the application certified by a corporate

officer that the development of the project will not cause or result in the abandonment
of another facility in North Carolina, owned or operated by the Operator or any affiliate
of the Operator. If the closing of any such facility is planned or anticipated, but that
abandonment has no cause and effect relationship with the proposed financing, the
statement will report the planned closing and explain why the facility is being closed.
If, in fact, a North Carolina facility is to be closed or abandoned as a result or cause
of the proposed financing, the statement will provide facts which demonstrate that the
concerned facility is being abandoned because of obsolescence, lack of available labour
or site limitations. Other North Carolina facilities and interests must be identified. The
discussion of those facilities will identify any relationships with the proposed project, and
in particular whether employees at the facility being closed will be offered employment
opportunities at the new facility.19
Once this is done and there appears to be consensus amongst the major parties, substantive
negotiation takes place and based on the initial agreements, an inducement resolution is
typically prepared by bond counsel in consultation with the private entity. The inducement
resolution specifies that the private entitys intent to issue a specified amount of the bonds
for a specific use.
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Project Financing
The project is then approved by the IDA and the negotiations continue until a final
resolution is approved. A public hearing may be necessary before an approval/recommenda-
tion is provided by the IDA.
Because of the annual cap on a states issuance, the IDA must contact the appropriate state
agency and request an allocation. Typically, the appropriate agencys staff will then review
the project in order to make a recommendation on whether there should be an allocation
of the states volume cap for the project. Beyond the ability of the private entity to repay
(since the obligation is that of the private entity not the municipality) and the amount that
will be invested, the evaluation of the project for purposes of recommendation will consider:
how the project will create new job opportunities and/or the retention of current workers;
the economic conditions of the location where the project will be located; and
the taxes (real estate or intangible taxes) that the project will provide to the municipality.
With respect to jobs, there might be a formula that links the amount of financing and the
number of jobs created. For example, for the State of North Carolina there is a jobs test
that requires that the project:
Must create or retain number of jobs with the size of financing (currently one job for
every $250,000 in financing).
Approval of the volume cap allocation for the private entitys project results in a letter sent
to the private entity from the states agency that sets forth the amount of the volume cap and
any other conditions that the private entity must satisfy. Because the states agency will be
concerned that the bonds will not be sold, a condition set forth in the letter is usually that
there must be a contract with a financial institution indicating a commitment to purchase
or privately place the bond issue.
At the bond closing, the private entity must notify the states agency and furnish pertinent
information about the terms of the sale, including identifying the issues underwriter or buyer
(in the case of a private placement) and the issues interest rate and maturity.
1
There are structures that have characteristics of both of these types of structures, asset-backed securities issued
by municipalities being one example.
2
There are three different types of tax-backed debt: general obligation debt, appropriation-backed obligations, and
debt obligations supported by public credit enhancement programs.
3
The study was first published by the Research Triangle Institute in 1997 and then subsequently published in a
journal. See Leigland, J, Accelerating municipal bond market development in emerging economies: an assessment
of strategies and progress, Public Budgeting & Finance 17(2), June 1997, pp. 5779. Also see Fabozzi, FJ, The
use of municipal bonds for financing subnational infrastructure projects, report prepared for the United Nations
Office for Project Services, 1997.
4
The general obligation structure, a form of tax-backed debt, has also been used in emerging market countries.
In 1996, the City of Rio de Janeiro was able to issue several bond issues in the Eurobond markets that were
general obligations bonds backed by tax revenue.
5
Krellenstein, GM, Pollution control revenue, industrial development revenue, and conduit financing bonds, in
Feldstein and Fabozzi (eds), The Handbook of Municipal Bonds, 2008, John Wiley & Sons, ch. 64, p. 1041.
200

6
Although the interest payments are exempt from federal income taxes, there may be other tax consequences.
More specifically, they may be subject to the alternative minimum tax (AMT). The treatment of interest income
at the state and local level varies.
7
The American Recovery and Investment Act of 2009 authorised the issuance of a new type of taxable municipal
bond, Build America Bonds (dubbed BABs), wherein the issuer is subsidised for the higher cost of issuing a
taxable bond rather than a tax-exempt bond in the form of a payment from the US Department of the Treasury
(35% of the interest payments). Issuance of such bonds ceased at the end of 2010 but the US Congress has been
considering several proposals to reactivate the program.
8
Feldstein, SG, Fabozzi, FJ, Grant, A, and Ratner, D, Municipal bonds, in Fabozzi (ed), The Handbook of Fixed
Income Securities, 8th edition, 2012, McGraw-Hill, ch. 11.
9
Call protection means that the issuer cannot pay off the principal prior to the maturity date to take advantage
of a decline in interest rates. This is an advantage to the bondholder who is concerned that the issuer might call
the bonds when interest rates decline and then be forced to reinvest the proceeds received at a lower interest
rate. Call protection is a disadvantage to the issuer.
10
Another layer of complexity is then added. Even if the interest is exempt from federal income taxes, it may still
be subject to special treatment under provisions of the Code depending on the tax status of the investor.
11
Israel, PE, Summary of federal tax requirements for tax-exempt bonds, in The Handbook of Municipal
Bonds, ch. 7, p. 91.
12
The legislative history is provided in Maguire S, Private activity bonds: an introduction, CRS Report for
Congress, updated 9 June 2006.
13
Other types of private activities not covered in the exhibit are mortgage revenue bonds (Section 143), qualified
small issue bond (Section 144(a)), qualified student loan bond Section (144(b)), qualified redevelopment bond
(Section 144(c)), and qualified 501(c)(3) bond (Section 145).
14
The California Debt Limit Allocation Committee, Determination and adoption of the 2011 state ceiling on
qualified private activity bonds, Agenda Item No. 10, 26 January 2011.
15
See Lough, SB, Financial products used in the tax-exempt bond industry, www.irs.gov/pub/irs-tege/teb1a03.pdf.
16
IRS, Reissuance of tax exempt obligations: some basic concepts, last reviewed or updated on 19 May 2011:
www.irs.gov/taxexemptbond/professionals/article/0,,id=239480,00.html.
17
See endnote 16.
18
It should be noted that outside the United States, IDAs may be entities that promote inward investment but may
not always be authorised to issue IDR bonds.
19
Available at www.thrivenc.com/incentives/financial/other-cost-saving-programs/industrial-revenue-bond/explanation-
of-required-application-exhibits.
201

Chapter 17
Commercial paper and back-up credit

facilities
Commercial paper (CP) is a short-term promissory note. The traditional form of CP is that
of an unsecured promissory note. Consequently, the CP market was limited to entities with
strong credit ratings. However, today lower credit-rated entities can issue secured CP by
obtaining credit enhancement (usually via a bank-issued letter of credit) or collateral such
as pools of assets. Although the primary issuers are corporations, the market is used by
sovereigns, municipalities (who can issue tax-exempt CP) and other non-corporate entities
such as project companies.
The CP market began in the United States in the 19th century with the major issuers
being non-financial businesses. By the early 1980s, the CP market only developed in two
countries outside the United States: Canada and Australia. Subsequently, the CP market
developed in other countries with the Euro-CP (ECP) market founded in 1985. ECP is issued
and placed outside the jurisdiction of the currency of denomination.
The CP market is of critical importance to financial markets. This is clear from the actions
taken by governments when this sector of the financial markets experienced a crisis. In the
case of an individual major issuer of CP, when a crisis has occurred in the United States
such as Penn Central in the 1970s the Federal Reserve Bank has provided support in such
instances to banks that were providing back-up lines of credit for lower-rated issuer in order
to bolster confidence in the market. More recently, of course, is the US crisis in the market
in the fall of 2008 attributable to the US sub-prime mortgage crisis and the credit crisis
that ensued. The crisis raised concerns that the US recession would worsen unless support
was provided to the CP market. To restore investor confidence, the Federal Reserve and
the Department of the Treasury enacted programs targeted at providing credit andliquidity.
In this chapter, we discuss CP as a funding source. Because of its pioneering of CP and
experiences with the CP market, the US market has been the model used by other coun-
tries. However, there are many significant differences in the US and non-US CP markets
with respect to the characteristics of CP paper, the issuers of CP, and the regulation and
organisation of the market.
1 Advantages of commercial paper financing

There are three advantages commonly cited as to why entities can benefit from issuing CP
for financing needs.
The principal advantage cited for using the CP market to obtain funding is that it repre-
sents an attractively priced source of funds which is usually cheaper than other funding sources
of similar maturities, such as bank loans based on prime or Libor.1 However, whether the
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Commercial paper and back-up credit facilities
CP market offers a project company seeking a lower funding cost than long-term financing
requires more detailed analysis than a casual observation of the cost of short-term bank
borrowing versus CP rates.
A second advantage is that the borrowing entity can diversify its funding sources outside
traditional commercial bank lenders by using this broadly based market. Investors include
individuals, money market funds and corporate treasurers investing in short-termmaturities.
Finally, the CP market provides an issuer with flexibility since tenors and issuing dates
can be tailored to the issuers specific needs. Notes can be issued and funds disbursed on
a same day basis without the need for prior notification as is normal in revolving credit
arrangements. (These benefits link back to discussions raised in Chapters 9 and 10.)
2 Concerns with using CP funding

CP is a short-term funding source. As such there are risks associated with this funding vehicle
when a project company is seeking long-term funding.
First, a project company seeking long-term borrowing costs faces floating funding costs.
Consequently, when short-term rates rise, funding costs for the period rise. One way to
mitigate this risk is by locking in an interest rate using an interest rate swap. However,
this derivative instrument described in Chapter 25 has its own risk associated with it:
counterparty risk.
A second risk for a project company is the inability to issue new CP to replace maturing
CP at maturity. As explained later, although there are arrangements for issuers of CP to
reduce this risk by using back-up facilities, there remains the risk that either the projects
perceived or actual creditworthiness may change so as to make CP issuance difficult or
changes in the CP marketplace may do the same. This second risk, referred to as rollover
risk, was highlighted in the 20082009 credit crisis where a combination of the weakening
of operating performance by some CP issuers and tightening in the credit market led to
bankruptcy or major restructurings.
3 Maturity characteristics of CP
CP issued in the United States typically has a maturity that is less than 270 days. The reason
why CP maturity does not exceed 270 days is due to the US Securities Act of 1933. This act
mandates that unless otherwise exempt, securities must be registered with the Securities and
Exchange Commission (SEC) and the issuer must therefore incur the costs associated with
SEC registration filings. However, there is a provision in the act exempting the registration of
CP if the securitys maturity does not exceed 270 days. Hence, to avoid the costs associated
with SEC registration, CP issuers rarely issue paper with maturities exceeding 270 days. In
the ECP market, maturities can be considerably longer than 270 days.
In practice, CP issued in the United States is usually less than 90 days. The reason is that
there is another factor that an issuer must take into consideration in making the maturity
decision: whether or not the CP it issues would be eligible collateral for a bank borrowing
from the Federal Reserve Banks discount window. In order to be eligible, a CPs maturity
may not exceed 90 days. Since eligible CP can be issued at a lower cost than CP that is
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Project Financing
not eligible, CP with a maturity of less than 90 days is preferred by issuers. In the United
States, the average maturity for CP is about 30 days.
4 Selecting a CP agent
In the United States, CP can be issued in one of two ways. The first is by the borrower
directly placing paper with investors with the assistance of an agent. This method for issuing
CP is commonly used by issuers such as financial companies that require continuous funds
to provide loans to customers. In this case, the issuer would typically have its own sales
forces for selling CP.
This is not the likely procedure that will be used by project companies and issuers in
the Euro CP market. Instead, they will issue CP using the services of an agent typically
a securities firm that is affiliated with a bank holding company. CP issued in this way is
referred to as dealer-placed CP. In doing so, the agent does not take on underwriting risk
(that is, buy the issue and risk not placing all of it with investors) but rather does so on a
best efforts basis.
Once appointed, the CP agent will advise and assist its client in setting up an issuing
vehicle (if necessary), structuring support facilities, obtaining credit ratings and generally
providing guidance on proper market entry. Criteria used in the selection of a CP agent are:
the agents track record and experience in selling and trading short-dated instruments;
the agents image in the market as a highly professional and respected financial institution;
the ability to ensure broad distribution of an issuers paper (both onshore and offshore);
the ability to generate timely and informative activity reports; and
the experience of the agent and knowledge of the issuer and its industry.
There are model CP dealer agreements. The Securities Industry and Financial Markets
Association (SIFMA) previously the Bond Market Association (BMA) publishes a Model
Global Commercial Paper Dealer Agreement that can be used by issuers and dealers for both
issuance in the United States and the European markets.
5 Governmental approvals by non-US issuers

In the case of non-US issuers and/or guarantors, local counsels opinion will be required,
to ensure that issuance of the commercial paper of guarantee will not violate any laws or
regulations of the country in which the issuer and/or guarantor is resident. In some instances,
evidence of specific authorisation by governmental authorities may be required. Non-US issuers
and/or guarantors may also need to provide evidence of their central banks approval for
foreign exchange to be available to meet commercial paper obligations.
6 Jurisdiction for non-US issuers

Non-US issuers must agree to submit to the non-exclusive jurisdiction of US federal and state
courts. In the case of a non-US guaranteed program, local (foreign) counsels opinion will
204

be required on: (i) enforceability in the guarantors home courts of any judgment obtained
in the United States on the guarantee; and (ii) the right of holders of the commercial paper
to bring suit on the guarantee in those same courts. Non-US issuers must appoint an agent
for service of process in the United States. Such an agent can be either a representative of
the issuer resident in New York, the issuing/paying agent, or some other party appointed
by the issuer.
7 Commercial paper ratings

An issuer should obtain a commercial paper rating from at least two major rating agen-
cies to enable the paper to enjoy the broadest possible distribution and marketability. This
rating must be the highest available in order to assure rollover and continued access to the
commercial paper market.
There are three major companies that evaluate the risk of default of issuers and summarise
their evaluation in the form of a rating: Moodys Investors Service, Standard & Poors
Corporation and Fitch Investors Service. The rating agencies have separate ratings for secu-
rities longer than one year and securities less than one year; the meanings of these ratings
differ. The ratings are provided in Exhibit 17.1.
Exhibit 17.1
Short-term rating systems by Fitch, Moodys and S&P
Fitch Moodys S&P Ability to pay

short-term debt
F1+ or F1 P1 A1+ or A1 Superior
F2 P2 A2 Satisfactory
F3 P3 A3 Adequate
F4 NP B or C Speculative
F5 NP D Defaulted
In assigning its long-term credit ratings, the primary concern of the rating agency is the
expected credit loss. In contrast, for short-term credit ratings (such as that assigned to CP)
the agencys rating is based on the probability of default. Given that the rating is an assess-
ment of the issuers likelihood to default, one can think of the ratings as a measure of the
distance in terms of time from what a rating agency would classify as a Non Prime rating.
The ratings are used by money market mutual funds in determining the amount of CP
that they are permitted to hold. The SEC requirements establish two categories of eligible
CP: first-tier paper and second-tier paper. In general, to be categorised as first-tier paper the
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Project Financing
SEC requires that two of the rating companies rate the issue as 1. To be categorised as
two-tier paper, requires that one rating company rate the issue as 1 and at least one other
rate it as 2 or two companies rate it at 2. It is the second-tier paper that is considered
medium-grade and for which there are restrictions on the amount that can be held by money
market mutual funds.
The issuers CP agent can greatly assist this process due to its knowledge of the issuer
and familiarity with the individuals and procedures of the rating agencies. Both the agent
and the rating agencies will require information concerning the amount, terms and condi-
tions of available credit facilities. The adequacy of bank credit facilities should be analysed
in co-operation with the agent before applying for a commercial paper rating.
8 Credit support facilities

It is normally required that CP issuers maintain bank credit facilities covering 100% of the
CP outstanding (see Exhibit 17.2). On a selected basis, where the size of the program and the
borrowers credit standing warrant, less than 100% coverage may be required. In the case of
an issue irrevocably backed by a prime bank, no additional credit facilities may berequired.
The credit facility provides liquidity for the program should investors decline for any
reasons to purchase an issuers paper. The level of support provided by such facilities is one
factor considered in the assignment of a credit rating.
A CP issuer may have committed and uncommitted credit facilities. The former is a credit
facility wherein the terms and conditions are clearly set forth in the documentation between
the borrower and the bank. In contrast, in an uncommitted credit facility, a bank is not
under any contractual obligation to lend a specific amount to the borrower. Consequently,
in evaluating the credit facilities available to a CP issuer, the major focus is on committed
credit facilities because uncommitted credit facilities could be withdrawn unilaterally by the
bank without any recourse available to the CP issuer.
In the evaluation of committed credit facilities, the degree of flexibility granted to the CP
issuer as set forth in the documentation is closedly examined. For this purpose, for example,
A.M. Best Company a firm that provides credit ratings for the insurance industry in its
evaluation of committed credit facilities in assigning CP ratings looks at:
covenants;
material adverse change (MAC) clauses;
events of default;
cross-default and cross acceleration provisions;
maturity date;
conditions of funding;
changes in control or management; and
renewal procedures for multi-year or 364-day revolving credits.2
206

Exhibit 17.2
Standby letter of credit used to back commercial paper
Borrower 2 Guarantee
1 Loan 3 Funds 4 Payment

Bank
agreement loaned of loan
Special 2
purpose Standby letter
corporation of credit
3
Commercial 3 Funds 4 Payment
paper loaned of paper
Purchaser of
commercial
paper
Continued

Project Financing

Summary
1 A special purpose corporation is established by the borrower to issue commercial paper, and loan the
proceeds to theborrower.
2 The borrower arranges for a bank to provide a standby letter of credit for the special purpose corporation.
The borrower provides a guarantee to thebank.
3 The commercial paper is issued, and funds are loaned to the special purpose corporation, which in turn
loans the funds to theborrower.
4 The borrower repays the loan to the special purpose corporation, which repays the commercial
paperinvestor.
9 Credit enhancement facilities

Irrevocable back-up facilities are typically in the form of a letter of credit (LOC). A bank-
issued LOC is agreement between the bank (referred to as the LOC issuer) and its customer
(the CP issuer for the purpose of our discussion here) whereby the bank at the request of
the CP issuer will pay a specified amount to the LOCs beneficiary (in the case of CP, the
lender to the CP issuer is the beneficiary) if the lender presents the bank with documents in
accordance with the conditions as set forth in the LOC. The CP issuer typically agrees to
reimburse the bank for any payments made to the beneficiary.
The LOC shifts the credit risk from the CP issuer to the bank.
A LOC will specify the following.
The stated amount, which is the specific or maximum amount that can be drawn upon.
Whether the stated amount can be drawn down partially and, if so, whether a partial
drawdown of the stated amount can be reinstated.
The expiry date, which is the date by which the drawdown must occur.
The documents that must be presented by the beneficiary to the bank.
LOCs in the United States are governed by Article 5 of the Uniform Commercial Code
(UCC). Every state has adopted the UCC.
There are three types of LOCs used for credit enhancement:
commercial LOC;
standby LOC; and
direct pay standby LOC.
A commercial LOC is used in commercial trade transactions for goods and services and the
intent is that the bank issuing the LOC will be called upon by the beneficiary to draw on the
LOC. It is the last two types of LOCs that are used for CP credit enhancement. A standby
LOC is intended as a credit enhancement for a payment obligation. The expectation is that
funds will not be drawn down under the LOC by the beneficiary except in a default. (See
208

Exhibit 17.2.) The direct pay standby LOC is a hybrid of the two other LOCs in that it is
expected by the LOC issuer that it may be drawn upon and it is issued for the purpose of
credit enhancement. (See Exhibit 17.3.)
Exhibit 17.3
Direct pay letter of credit backing commercial paper
Borrower 1 Guarantee
2
Commercial 2 Funds 3 Payments Bank
paper
Purchaser of 1 Direct
commercial pay letter of
paper credit
Summary
1 A borrower seeking an A-1 rating on its commercial paper arranges for a bank with an A-1 rating to
provide a direct pay letter of credit to purchasers of the borrowers commercial paper. The borrower
guarantees its paper to thebank.
2 Investors purchase borrowers commercial paper on the basis that they can look directly to the A-1 rated
bank for repayment if the borrower fails topay.
3 Payments are made by theborrower.
Under existing federal bankruptcy laws in the United States and the Internal Revenue
Code use of a stand-by letter of credit necessitates creation of a nominally capitalised,
special purpose corporation, whose sole function is to issue commercial paper with proceeds
on-lent to an end-user. The purpose of this structure is to isolate the actual issuer from the
end-borrower, thereby insulating the former from certain effects of the Federal Bankruptcy
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Project Financing
Law, which tend to be prejudicial to investor interests. Depending on the structure, it may
also be necessary to restrict sales of paper to 45 days or less in order to secure a clean legal
opinion from counsel on the bankruptcy issue.
The direct pay standby LOC structure eliminates the need to establish a nominally
capitalised issuing vehicle and/or restrict the maturity of paper sold. Whereas the IRC and
stand-by letter of credit represent a liability of the bank to provide a secondary source of
funds to issuers with which to pay off maturing notes, the direct pay commercial letter
of credit represents a direct liability of the bank to pay off each note as it matures. The
investor, in this case, looks primarily to the bank as a source of payment. Since the issuer
essentially never gets between the bank and the investor, the fact of his possible bankruptcy
is irrelevant to the investor.
In addition to saving legal costs, the direct pay letter of credit also facilitates the rating
process since the rating agencies will look solely to the credit standing of the bank(s) issuing
the letter of credit to arrive at their rating (subject to the availability of a clean legal opinion
on the bankruptcy issue). This can be particularly advantageous to issuers whose credit
standing, earnings history, financial disclosure policies and foreign earnings base make it
awkward for them to comply with rating agency requirements, or make disclosures regarding
their financial statements or operations.
10 Asset-backed commercial paper

To provide customers with low-cost funding for various types of receivables, banks developed
asset-backed commercial paper (ABCP) in the early 1980s. In non-technical terms, ABCP
is a form of securitisation (see Chapter 13) and therefore is backed by specific assets such
as receivables and issued by conduits structured to be a limited-purpose bankruptcy remote
entity (a special purpose vehicle). The conduits either purchase the assets or originate the
assets that serve as the collateral for the securitisation.
ABCP was heavily utilised by originators of mortgage loans. The difficulties in the US
sub-prime mortgage market beginning in the summer of 2007 made investors wary about the
underlying assets. From August to December 2007, there was a run on the market causing
what some have described as a panic similar to occurred in the Great Depression.3
A discussion of the challenges facing the traditional ABCP market is beyond the scope
of this chapter.4
1
The US Federal Reserve web site (www.federalreserve.gov/releases/cp/) provides the prior days average rates for
CP for different types of issuers (financial, non-financial, asset-backed), different ratings and different maturities.
2
AM Best Methodology, Draft: analyzing commercial paper programs, 2 December 2011. The AM Best short-
term ratings are AMB-1+, AMB-1, AMB-2, AMB-3, and AMB-4.
3
Covitz, D, Liang, N, and Suarez, G, The evolution of a financial crisis: panic in the asset backed commercial
paper market, Federal Reserve Board Finance and Economics Discussion Series: 2009-36, 18 August 2009.
4
For a discussion of these challenges, see Croke, JJ, Manbeck, PC, Mohan, TP, and Samy, SA, A challenge for the
future: issuing ABCP in the new regulatory environment, Journal of Structured Finance, Spring 2011, pp. 924.
210

Chapter 18
General principles of leasing and types of

leases
Evidence of leasing has been found in one of the early, first known legal texts containing
contract law the Codex Hammurabi that operated in Ancient Babylonia (17921750 BC)
where reference is made to the leasing of agricultural land to third parties. Leasing today
contains elements that Hammurabi and his administrators would recognise, but has also
become a very sophisticated form of finance heavily reliant on understanding different tax
rules. This is also a rich area for the application of techniques now widely used in forms
of Islamic finance. Successful leasing requires up-to-the-minute expert understanding of the
tax and accounting rules of all jurisdictions involved.
This chapter and the one that follows it can only offer guidance on general principles
and observed historic practice.1 In this chapter we provide the general principles of leasing
as well as the various types of leases. In the next chapter, we turn our attention to cross-
boundary or cross-border leasing.
We must note at the outset that the future of leasing is uncertain for major companies
switching to the new International Accounting Standard (IAS) system until there is further
clarification of the new rules. Since the benefits typically associated with leasing are tax
benefits which depend on tax rates, the uncertainty regarding leasing arising from the IAS
changes is compounded by anticipated changes in tax regimes as Western countries that have
experienced structural problems attempt to promote growth. Consequently, in this chapter
we emphasise examples that would still be useful despite anticipated changes, and that might
provide ideas for creative development in future structures.
As will be clear when the chapters unfold, leasing is a complex area and the endnotes
offer further sources of information. Although the total volume of documentation involved
in any lease is formidable, the individual documents are straightforward and not particularly
complex. Consequently, leasing is a practical financing alternative for sponsors that are willing
to take the time to understand and negotiate such a transaction.
In the right situations, the rewards for such an exercise are extremely attractive financing
costs, especially if the lease is a leveraged lease as we describe in this chapter. Leveraged
leases can also be attractive tax-oriented investments for corporations but such leases are not
passive investments. Professional expertise and technical skill are needed in pricing, negoti-
ating, closing and administering leveraged lease transactions. For the lessor, the leverage in
a leveraged lease is like a double-edged sword: both the benefits and the risks are magnified
by leverage.
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Project Financing
1 What is a lease?
The term lease has a number of different meanings and the definitions of different forms
of leases are sometimes generalised or used interchangeably.
Statement of Standard Accounting Practice 21 (SSAP 21) defines a lease as:
A contract between a lessor and a lessee for the hire of a specific asset. The lessor
retains ownership of the asset but conveys the right to the use of the asset to the lessee
for an agreed period of time for the payment of specified rentals. The term lease as
used in this statement also applies to other arrangements in which one party retains
ownership of an asset but conveys the right to the use of the asset to another party
for an agreed period of time in return for specified payments.
Paragraph 14 of SSAP 21
International Accounting Standard 17 (IAS 17) defines a lease as:
An agreement whereby the lessor conveys to the lessee in return for a payment or
series of payments the right to use an asset for an agreed period of time.
Paragraph 4 of IAS 17
The common theme for both definitions is the separation of ownership and use of
an asset.
Historically, leasing came about because a piece of equipment was too expensive to
purchase up front, and rather than use a loan structure where title passed to the new
owner but was reassigned to the provider of funds as collateral, the ownership of the
asset and its title remained with the provider of the equipment and not the end user. The
tax benefits that accrue to the lessor (which has the absorptive capacity in its cash flows
to benefit from the amounts and timing of the allowances) are passed on to the lessee in
the form of a reduction in the costs of purchasing the right to use the asset (the lease).
When governments wished to support industry by offering large capital allowances for
new equipment purchases, the leasing business expanded, initially to support equipment
purchases such as capital items for consumers, or to support the construction and use
of specialist capital items (for example, by the US government). This broadened to offer
support for certain industries (for example, through the use of the US MARAD Title XI
loan guarantee scheme to finance US constructed and flagged ships) moving into areas
where firms used their tax positions to absorb capital allowances for specific equipment
and enhanced cash flow by owning this equipment and leasing it to other firms. The next
step in the logical progression was cross-border leasing, exploiting allowances in different
tax jurisdictions, which we discuss further in the next chapter.
In a project finance context, leasing can be used to finance most of the equipment and
facilities of a project and thus used with numerous project financing structures. Consequently,
a knowledge of leasing in context is essential to understanding the potential of its use in
many forms of project financing. So, for example, even though rules to optimise leasing of
buildings and real estate may be different from those used for equipment leasing, the project
finance structures and principles used to finance real estate portions of projects can often be
212

General principles of leasing and types of leases
used in designing project finance packages to finance capital equipment and these may or
may not include a leasing element, dependent on the context.
2 Different forms of leases

There are a number of general types of leases and each jurisdictions rules need to be carefully
checked to see if all of these forms are recognised and valid and how they are treated for
accounting and tax purposes. There are several ways of looking at the rich variety ofleases.
Looking at leases when considering tax treatment, the following classifications are
commonly used.
1 Non-tax-oriented leases, may be called leases, and will include conditional sale leases
and hire-purchase leases. These are the leases commonly offered with car purchases and
personal computers, for example. They may include an option to buy the equipment for
a notional sum at the end of the lease.
2 Tax-oriented true leases, which in turn fall into two subcategories:
single-investor leases (also called direct leases) in which the lessor is at risk for the
entire amount of the funds used to purchase the leased equipment. This is illustrated
in Exhibit 18.1; and
leveraged leases (discussed further below), in which at the outset of the transaction the
lessor provides a portion of the funds needed to purchase the leased equipment, and
borrows the balance of the funds on a non-recourse basis.
3 A terminal rental adjustment clause (TRAC) lease fixes the residual price and thence the
purchase price when the lease is set up. In this form, the lease works as if it is a true
lease, so tax benefits can be used. At the end of the lease four options exist:
purchase;
extending the lease to cover the residual amount;
returning the equipment and receiving any excess over the residual amount on sale of
the equipment; or
replacing the equipment and using any excess in value over the residual to offset against
the next lease.

TRAC leases are used for motor vehicles and trailers and have specific constraints aboutusage.
A major characteristic differentiating these three types of leases is the form of purchase
options available to the lessee.
In a true lease the lease term is for less than the economic life of the leased equipment
and the lessee has only a fair market value purchase option at the end of the lease term.
Hence the lessor is considered to be the true owner of the leased equipment.
In a conditional sale lease, the lessee either has a nominal fixed-price purchase option or
the lease automatically passes title to the lessee at the end of the lease.
TRAC leases are a special category of leases for over the road vehicles that retain the
characteristics of a true lease even though they contain the equivalent of fixed-price
purchase options for the lessee and a put option for the lessor.
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Exhibit 18.1
Non-leveraged lease (direct lease)
Lessee
3 Rent
1 Lease
payment
Lessor 2 Title Manufacturer
2 Purchase
price
Summary
1 A lessor enters into a lease agreement with alessee.
2 The lessor pays the purchase price for the leased equipment and takes title to theequipment.
3 The lease begins and the lessee commences rental payments to thelessor.
3 Different types of lessors

There are three main categories of lessors involved in project financing:
third-party leasing companies offering true leases and conditional sale leases to projects;
vendors interested in selling equipment to the project which provide lease financing as an
inducement to completion of a sale; and
sponsors or parties interested in the completion of a project, and providing leases as a
means of moving capital into the project.
4 The conditional sale lease or non-tax oriented lease

Instalment financing for equipment is sometimes accomplished through an instrument called
a conditional sale lease.
214

A conditional sale lease (or non-tax oriented lease) usually either gives the lessee a
bargain purchase option or renewal option not based on fair market value at the time of
exercise or requires the lessee to purchase the equipment for a fixed price at the conclusion
of the lease, as discussed above under Different forms of leases. This type of transaction is
regarded by tax authorities as a conditional sale or a secured loan, not a true lease. Such a
transaction, therefore, transfers all the tax effects of ownership to the lessee and does not
generate the lowered lease payments associated with true leases in which the lessor claims
the tax benefits.
Generally, the lessee in a non-tax oriented lease is considered to have legal title as
well as being considered the owner for tax purposes. However, this is not always the case
since the test for a true lease for legal purposes has been held by some courts to be more
liberal than the test for a true lease for tax purposes. For example, in the United States,
conditional sale leases for tax purposes include leases for a term that is more than 80% of
the original useful life of the leased property, or leases in which the estimated fair market
value of the leased property at the end of the lease term is less than 20% of the original
cost. In some instances the lessor under such circumstances might be considered to be the
owner for legal purposes.
The lessee under a conditional sale lease treats the property as owned, depreciates the
property for tax purposes, and deducts the interest portion of rental payments for tax
purposes. The lessor under a conditional sale lease treats the transaction as a loan and
cannot offer the low lease rates associated with a true lease since the lessor does not retain
the ownership tax benefits of depreciation.
Equipment financing offered by vendors is often in the form of a conditional sale lease.
Most leasing outside the United States is structured in a manner which is similar to a
conditional sale lease, although the tax implications may not be the same.
5 The true lease or lease as part of the financing of a sales package

The purchase, ownership and use of capital equipment involve the following cash flows:
1 the operating cash flows consisting of the cash flows the equipment will generate;
2 the cash flows associated with tax ownership consisting of tax deductions for depreciation
(in some instances, one or more tax credits may also be available); and
3 the financing cash flows of interest and principal payments and tax deductions for
interest expense.
Tax-oriented leases, called true leases, repackage those cash flows and redistribute them to
parties able to most efficiently use them so as to create value for the lessee and the lessor.
Substantial cost savings in project financing of facilities and equipment located in the
United States may be achieved through the use of a tax-oriented true lease in which the
lessor claims and retains the tax benefits of ownership. The lessor passes most of the modi-
fied accelerated cost recovery system (MACRS) tax depreciation deductions, in the form of
reduced rentals, through to the lessee. This type of lease is called a true lease for tax purposes.
The lessor claims depreciation deductions and the lessee deducts the full lease payment as an
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expense. The lessor in a true lease owns the leased equipment at the end of the lease term,
subject to granting a fair market value purchase option to the lessee.
The intent of the parties (as evidenced by the facts) is the key test for determining whether
a transaction constitutes a true lease or a conditional sale or loan. As indicated previously,
a purchase option based on fair market value (rather than a nominal purchase option) is a
strong indication of intent to create a lease as opposed to a conditional sale or lease. The
test is whether the interest of the lessor in the leased property is a proprietary interest with
attributes of ownership, rather than a mere creditors security interest in the leasedproperty.
A lease generally qualifies as a true lease if all the following criteria are met.
1 At the start of the lease, the fair market value of the leased property projected for the
end of the lease term equals or exceeds 20% of the original cost of the leased property
(excluding front-end fees, inflation and any cost to the lessor for removal).
2 At the start of the lease, the leased property is projected to retain at the end of the initial
term a useful life that: (i) exceeds 20% of the original estimated useful life of the equip-
ment; and (ii) is at least one year.
3 The lessee does not have a right to purchase or release the leased property at a price that
is less than its then fair market value.
4 The lessor does not have a right to cause the lessee to purchase the leased property at
a fixed price.
5 At all times during the lease term, the lessor has a minimum unconditional at risk invest-
ment equal to at least 20% of the cost of the leased property.
6 The lessor can show that the transaction was entered into for profit, apart from tax
benefits resulting from the transaction.
7 The lessee does not furnish any part of the purchase price of the leased property and has
not loaned or guaranteed any indebtedness created in connection with the acquisition of
the leased property by the lessor.
It is critical to stay up to date on new rulings that may affect tax deductibility, so expert
knowledge combined with research is needed before planning a transaction.2
How true leasing works

The lessee first makes a decision about the equipment it needs and decides on the manufac-
turer or contractor that will supply it. Any special features or design specifications desired,
the terms of warranties, guarantees, delivery, installation and services are further specified
by the lessee at the outset in a pro-forma sales contract. The lessee also negotiates theprice.
After the equipment and terms are specified, the lessee enters into a lease agreement
with the lessor.
The lessee negotiates the term of the lease, the rental, any capitalised costs, whether sales
tax, delivery and installation charges should be included in the lease, and other optional
considerations with the lessor.
After the lease is signed, the lessee assigns its purchase rights under the sales contract to
the lessor, who then buys the equipment exactly as specified by the lessee. When the property
216

is delivered, tested and formally accepted by the lessee, the lessor pays for the equipment,
and the lease comes into effect. Rental payments are net to the lessors, so taxes, service,
insurance and maintenance are the responsibility of the lessee.
Principal advantage is low cost

The principal advantage of using a true lease to finance an equipment acquisition for a
project is the economic benefit which comes from the indirect realisation of tax benefits
which would be otherwise lost. If the project is unable to generate a sufficient tax liability
to use fully the accelerated depreciation deductions, the cost of owning new equipment will
effectively be higher. Under these conditions leasing is a less costly alternative, as the lessor
uses the tax benefits from the acquisition, and passes on most of these benefits to the lessee
project through lower lease rental payments.
Rationalisation of the loss of residual value

The lower cost of leasing realised by a project lessee throughout the lease term in a true
lease must be weighed against the loss of the leased assets residual value at the end of the
lease term. Using a discounted cash flow method of analysis to evaluate the tax and timing
effects, the present value of the residual value loss is diminished relative to the accrued cash
flow benefits, as its realisation is postponed until some future period. In an absolute sense,
the surrender of the future value of the residual value is of small significance as long as the
lease term constitutes a substantial portion of the economic life of the asset, and renewal
options permit continuity of control of the asset by the lessee.
6 Leveraged lease
The leveraged form of a true lease is the ultimate form of lease financing. The most attrac-
tive feature of a leveraged lease from the standpoint of a lessee is its low cost as compared
with that of alternative methods of financing. Leveraged leasing also satisfies a need for
lease financing of especially large capital equipment projects with economic lives of up to
25 or more years, although leveraged leases are also used where the life of the equipment is
considerably shorter. The leveraged lease can be a most advantageous financing device when
used for the right kinds of projects and structured correctly.
Single-investor non-leveraged leases are simple two-party transactions involving a lessee
and a lessor. In single-investor leases (sometimes called non-leveraged leases or direct leases),
the lessor provides all of the funds necessary to purchase the leased asset from its own
resources. While the lessor may borrow some or all of these funds, it does so on a full-
recourse basis to its lenders and it is at risk for all of the capital employed.
A leveraged lease is conceptually similar to a single-investor lease. The lessee selects
the equipment and negotiates the lease in a similar manner. Also similar are the terms for
rentals, options and responsibility for taxes, insurance and maintenance. However, a lever-
aged lease is appreciably more complex in size, documentation, legal involvement and, most
importantly, the number of parties involved and the unique advantages that each partygains.
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Project Financing
True leveraged leases are generally offered only by corporations acting as lessors. This
is because in a leveraged lease the tax benefits available to individual lessors are much more
limited than those available to a corporation.
The lessor in a leveraged lease becomes the owner of the leased equipment by providing
only a percentage (typically about 20%) of the capital necessary to purchase the equipment.
The remainder of the capital (typically about 80%) is borrowed from institutional investors
on a non-recourse basis to the lessor. This loan is secured by a first lien on the equipment,
an assignment of the lease, and an assignment of the lease rental payments.
The cost of the non-recourse borrowing is a function of the credit standing of thelessee.
The lease rate varies with the debt rate and with the risk of the transaction including
any residual value the lessor hopes to achieve.
The lessor in a leveraged lease can claim the entire tax benefits incidental to ownership
of the leased asset and the residual value even through the lessor provides only 20% of the
capital needed to purchase the equipment. This ability to claim the tax benefits attributable
to the entire cost of the leased equipment and the residual value while providing and being
at risk for only a portion of the cost of the leased equipment is the leverage in a leveraged
lease. This leverage enables the lessor in a leveraged lease to offer the lessee much lower
lease rates than the lessor could provide under a direct lease.
The legal expenses and closing costs associated with leveraged leases are larger than
those for single-investor non-leveraged leases and usually confine the use of leveraged leases
to financing relatively large capital equipment acquisitions. However, leveraged leases are
also used for smaller lease transactions that are repetitive in nature and use standardised
documentation so as to hold down legal and closing costs.
Several parties may be involved in a leveraged lease. Small direct or single-investor non-
leveraged leases are basically two-party transactions with a lessee and a lessor. However,
leveraged leases by their nature involve a minimum of three parties: a lessee, a lessor and
a non-recourse lender.
Several owners and lenders may be involved in a leveraged lease. An owner trustee is
named to hold title to the equipment and represent the owners or equity participants, and
an indenture trustee may be named to hold the security interest or mortgage on the property
for the benefit of the lenders or loan participants. Sometimes a single trustee is appointed
to perform both of these functions.
In order to understand true leveraged leasing, it is necessary to review the rights, obliga-
tions, functions and characteristics of the various parties that may be involved; the structure
of a leveraged lease; the cash flows; and the debt arrangements possible. Since these differ
from jurisdiction to jurisdiction, much of what follows uses the US context as an example.
Parties to a leveraged lease

The lessee
The lessee selects the equipment to be leased, negotiates the price and warranties, and hires
the use of the equipment by entering into a lease agreement. The lessee accepts, uses, oper-
ates and receives all revenue from the equipment. The lessee makes rental payments. The
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credit standing of the lessee supports the rent obligation, the credit exposure of the lenders
of leveraged debt and the credit exposure of the equity participants.
Equity participants
The equity participants provide the equity contributions (typically about 20% of the purchase
price) needed to purchase the leased equipment. They receive the rental payments remaining
after the payment of debt service and any trustee fees. They claim the tax benefits incidental
to the ownership of the leased equipment, consisting of the tax depreciation deductions and
deductions for interest used to fund their investment. The equity participants are sometimes
referred to as the lessors. Actually, in most cases, they are the beneficial owners by way of
an owner trust structure that is the lessor. Equity participants in a leveraged lease are also
sometimes referred to as equity investors, owner participants, or trustors.
Loan participants or lenders

The loan participants or lenders are typically banks, insurance companies, trusts, pension
funds and foundations. The funds provided by the loan participants, together with the equity
contributions, make up the full purchase price of the asset to be leased. The loan participants
provide the balance of the purchase price not covered by the equity investment, the balance of
80% of the purchase price in our example. This loan is on a non-recourse basis to the equity
participants. As noted earlier, this loan is secured by a first lien or charge on the leased equip-
ment, an assignment of the lease, and an assignment of rents under the lease. Principal and
interest payments that are due to the loan participants (or lenders) from the indenture trustee
are paid by the lessee to the indenture trustee, which then pays the loan participants. The
loan participations may have different maturities to satisfy the appetites of differentlenders.
Owner trustee
The owner trustee represents the equity participants, acts as the lessor, and executes the lease
and all of the basic documents that the lessor would normally sign in a lease. The owner
trustee records and holds title to the leased asset for the benefit of the equity participants,
subject to a mortgage to the indenture trustee.
The owner trustee:
may issue trust certificates to the equity holders evidencing their beneficial interest as
owners of the assets of the trust;
issues bonds or notes to loan participants evidencing the leveraged debt;
grants the security interests that secure repayment of the bonds (that is, in the lease, the
lease rentals and a first mortgage on the leased asset) to the indenture trustee;
receives distributions from the indenture trustee;
distributes earnings to the equity participants; and
receives and distributes any information or notices regarding the transaction that are
required to be provided to the parties.
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Project Financing
The owner trustee has little discretionary power beyond that specifically granted in the trust
agreement and has no affirmative duties.
The owner participants indemnify the owner trustee against costs and liabilities arising out
of the transaction, except for wilful misconduct or negligence. From the standpoint of the equity
participants, additional practical reasons often cited for having an owner trustee are asfollows.
1 An owner trust is a simple and convenient way to hold title to the equipment where there
are two or more equity participants.
2 The lessee and loan participants have the practical convenience of dealing with one entity
where there is an owner trustee.
3 The existence of the owner trustee helps justify keeping the non-recourse leveraged debt
off the balance sheet of the equity investor.
4 Equity participants may avoid the need to qualify to do business in the state in which
the equipment is located.
5 Loan participants (lenders) want an owner trustee in order to prevent a trustee in bank-
ruptcy for an equity participant from disavowing the lease or delaying payments due
under the lease.
6 The owner trustee may provide the equity participant with a shield against tort liability.
7 Under the Internal Revenue Code, the owner participants share in the tax benefits. The tax
advantages of a partnership are gained without the need for a formal partnershipagreement.
8 Some types of equipment such as aircraft must be owned by US owned corporations.
Consequently, a foreign-owned corporation must use a US trustee to act as a lessor.
These reasons have various degrees of merit. It can be argued in some instances listed above
that an owner trustee is unnecessary. Where a leveraged lease has a single equity investor,
the parties may conclude that an owner trustee is not needed and that the equity investor
may act as the lessor. However, the modest cost of an owner trustee as compared with the
apparent and possible benefits usually justifies the use of an owner trustee in a leveraged
lease unless the transaction is extremely simple and straightforward.
Indenture trustee
The indenture trustee (sometimes called the security trustee) is appointed by and represents
the lenders or loan participants. The owner trustee and the indenture trustee enter into a
trust indenture whereby the owner trustee assigns to the indenture trustee, for the benefit
of the loan participants and as security for the leveraged debt and any other obligations, all
of the owner trustees interest as lessor in:
1 the equipment to be leased;

2 the lease agreement;
3 the lessors rights to receive rents (including all payments) owed by the lessee (subject to
such exceptions as the lessor and lessee agree to);
4 the lessors rights to receive any payments under any guarantee agreements (subject to the
same exceptions as the payments due the lessor); and
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5 the lessors rights under any ancillary facility support agreements such as easements, service
contracts, supply contracts and sales contracts.
The indenture agreement sets forth the form of the notes or loan agreements, the events of
defaults, and the instructions and priorities for distributions of funds to the loan participants
and other parties.
The indenture trustee receives funds from the loan participants (lenders) and the equity
participants when the transaction is about to close, pays the manufacturer or contractor
the purchase price of the equipment to be leased, and records and holds the senior security
interest in the leased equipment, the lease, and the rents for the benefit of the loan partici-
pants. The indenture trustee collects rents and other sums due under the lease from the lessee.
Upon the receipt of rental payments, the indenture trustee pays debt payments of principal
and interest due on the leveraged debt to the loan participants and distributes revenues not
needed for debt service to the owner trustee. In the event of default, the indenture trustee
can foreclose on the leased equipment and take other appropriate actions to protect the
security interests of the loan participants.
Single trustee acting as both an indenture trustee and an owner trustee

A single trustee may assume the duties of both an owner trustee and an indenture trustee
in a leveraged lease. Where a single trustee is used, the trustee is referred to as the owner
trustee. Those who favour using a single trustee in a leveraged lease transaction argue that
such an arrangement is simpler and reduces the costs of the transaction.
Although the use of a single trustee in a leveraged lease has become an increasingly
common arrangement, serious conflicts of interest may arise between the equity participants
and the loan participants in the event of a default by the lessee. Such potential conflicts make
the use of a single trustee unattractive if there is any question regarding the lessees credit. In
the event the lessee defaults, the trustee is faced with conflicting choices. For example, if the
trustee repossesses and sells the equipment quickly for cash at a price that is only sufficient
to return the loan participants debt balance, the equity participants are left with nothing. On
the other hand, if a higher price can be obtained by selling the leased equipment using an
instalment sale, the equity participants might recover part or all of their investment. In the
instalment sale alternative, however, the loan participants are subject to additional risk, so
that the use of an instalment sale to achieve the objectives of the equity participants might
result in a breach of the fiduciary duties of the trustee to the loan participants. A possible
solution is to permit the trustee to resign one or both of the trusteeships in the event of
a default. However, this can generate further problems since a successor trusteeship under
such circumstances would be difficult to arrange and the loan participants or the equity
participants, or both, would be left in a difficult position to pursue their respective claims.
Manufacturer or contractor
The manufacturer or contractor manufactures or constructs the equipment to be leased. The
manufacturer or contractor (or supplier) receives the purchase price upon acceptance of the
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Project Financing
equipment by the lessee and delivers the equipment to the lessee at the beginning of the lease.
The warranties of the manufacturer, contractor, or supplier as to the quality, capabilities
and efficiency of the leased equipment, are important to the lessee, the equity participants
and the loan participants.
Packager or broker
The packager or broker is the leasing company arranging the transaction. In many instances,
the packager is purely a broker and not an investor. From the standpoint of the lessee, it
may be desirable that the packager also be an equity participant, and the packager may, in
fact, be the sole equity participant.
Guarantor
A guarantor may be present in some leveraged lease transactions. Although a member of the
lessee group may not guarantee the leveraged debt under Internal Revenue rules, a member
of the lessee group may guarantee the lessees obligation to pay rent.
A party unrelated to the lessee may guarantee either rents or debt. Such a guarantor
might be a third party such as a bank under a letter of credit agreement, an insurer of
residual value, or a government guarantor. Where rents are guaranteed by a third party, a
controversy may arise under the US rules, as mentioned earlier in this chapter under 4 The
conditional sale lease or non-tax-oriented lease. This relates to whether the lessor is really
at risk for an amount equal to 20% of the cost of the equipment. It can be argued that
such a guarantee is merely the equivalent of a second credit exposure and does not alter
the fact that the lessor is at risk.
Structure of a leveraged lease

A leveraged lease transaction is usually structured as follows where a broker or a third-party
leasing company arranges the transaction.
The leasing company arranging the lease enters into a commitment letter with the
prospective lessee (that is, obtains a mandate) outlining the terms for the lease of the equip-
ment (including the timing and amount of rental payments). Since the exact rental payment
cannot be determined until the debt has been sold and the equipment delivered, rents are
agreed upon based on certain variables, including assumed debt rates and the delivery dates
of the equipment to be leased.
After the commitment letter has been signed, the packager prepares a summary of terms
for the proposed lease and contacts potential equity participants to arrange for firm commit-
ments to invest equity in the proposed lease, to the extent that the packager does not intend
to provide the total amount of the required equity funds from its own resources. Contacts
with potential equity sources may be fairly informal or may be accomplished through a
bidding process. Typical equity participants include banks, independent finance companies,
captive finance companies and corporate investors that have tax liability to shelter and
funds to invest and understand the economics of tax-oriented leasing. The packager may
222

also arrange the debt either directly or in conjunction with the capital markets group of a
bank or an investment banker selected by the lessee or the lessor. If the equipment is not
to be delivered and the lease is not to commence for a considerable period of time, the debt
arrangements may be deferred until close to the date of delivery.
The packager may agree at the outset to bid firm or to underwrite the transaction on the
mandated terms and may then syndicate its bid to potential equity participants. However,
the lessee may prefer to use a bidding procedure without an underwritten price in the belief
that more favourable terms can be arranged using this approach.
In some instances, the lessee may prefer to prepare its own bid request and solicit bids
directly from potential lessors without using a packager or broker to underwrite or arrange
the transaction. This might be the case, for example, where the lessee has considerable expe-
rience in leveraged leasing and the transaction is a repetition or clone of previous leases of
similar equipment that the lessee has leased, such as computers or computer systems.
If an owner trustee is to be used, a bank or trust company mutually agreeable to the
equity participants and the lessee is selected to act as owner trustee. If an indenture trustee
is to be used, another bank or trust company acceptable to the loan participants is selected
to act as indenture trustee. As discussed previously, a single trustee may act as both owner
trustee and indenture trustee.
Exhibit 18.2 illustrates the parties, cash flows and agreements among the parties in a
simple leveraged lease.
If the leveraged lease is arranged by sponsors of a project who want to be the equity
participants, the structure and procedures are essentially the same as those for a leveraged
lease by a third-party equity participant. In such circumstances, the sponsors are the equity
investors. If some of the sponsors can use tax benefits and some cannot, the equity partici-
pants may include a combination of sponsors and one or more third-party leasing companies.
This arrangement is more complex, but the structure and procedures are essentially the same
as those for a leveraged lease by a third-party equity participant.
Closing a leveraged lease transaction

Participation agreement
The key document in a leveraged lease transaction is the participation agreement (sometimes
called the financing agreement). This document is, in effect, a script for closing thetransaction.
When the parties to a leveraged lease transaction are identified, all of them except the
indenture trustee enter into a participation agreement that spells out the various undertakings,
obligations, mechanics, timing, conditions precedent and responsibilities of the parties with
respect to providing funds and purchasing, leasing and securing or mortgaging the equip-
ment to be leased in considerable detail. More specifically, the equity participants agree to
provide their investment or equity contribution; the loan participants agree to make their
loans; the owner trustee agrees to purchase and lease the equipment; and the lessee agrees
to lease the equipment. The substance of the required opinions of counsel is described in the
participation agreement, and the representations of the parties are detailed. Tax indemnities
and other general indemnities are often set forth in the participation agreement rather than
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Exhibit 18.2
Typical leveraged lease
5 Rents
3 Equity Indenture 3 Term

funds trustee debt funds
4 Purchase 6 Debt
price service
2 Mortgage, 7 Revenue not

Manufacturer assignments of needed for Lenders
lease and rents debt service
4 Title 3 Bonds
1 Owner trust Owner

agreement trustee
1 Trust
1 Lease
certificate
7 Revenue not
Equity
needed for Lessee
participants debt service
Tax benefits
Internal
Revenue
Service
Continued

Summary
1 An owner trust is established by the equity participants; trust certificates are issued, and a lease
agreement is signed by the owner trustee as lessor and thelessee.
2 A security agreement is signed by the owner trustee and the indenture trustee; a mortgage is granted on
the leased asset, and the lease and rentals are assigned as security to the indenturetrustee.
3 Notes or bonds are issued by the owner trustee to the lenders; term debt funds are paid by the lenders
to the indenture trustee; equity funds are paid by the equity participants to the indenturetrustee.
4 The purchase price is paid and title is assigned to the owner trustee, subject to themortgage.
5 The lease commences; rents are paid by the lessee to the indenturetrustee.
6 Debt service is paid by the indenture trustee to thelenders.
7 Revenue not required for debt service or trustees fees is paid to the owner trustee and, in turn, to the
equityparticipants.
the lease agreement. The form of agreements to be signed, the opinions to be given, and the
representations to be made are usually attached as exhibits to the participation agreement.
Key documents
The key documents in a leveraged lease transaction that are in addition to the participation
agreement are the lease agreement, the owner trust agreement, and the indenture trustagreement.
The lease agreement is between the lessee and owner trustee. The lease is for a term of
years and may contain renewal options and fair market value purchase options. Rents and
all payments due under the lease are net to the lessor, and the lessee waives defences and
offsets to rents under a hell or high water clause.
The owner trust agreement creates the owner trust and sets forth the relationships between
the owner trustee and the equity participants that it represents. The owner trust agreement
spells out the duties of the trustee, the documents the trustee is to execute, the distribution
to be made of funds it receives from equity participants, lenders and the lessee. The owner
trustee has little or no authority to take discretionary or independent action.
The owner trust grants a lien or security interest on the leased equipment and assigns
the lease agreement, any ancillary facility support agreements and right to receive rents under
the lease to the indenture trustee (which may also be the owner trustee). It spells out the
obligations of the indenture trustee to the lenders.
Indemnities
Lessee indemnities fall into three general categories.
1 A general indemnity protects all of the other parties to the transaction from any claims
of third parties arising from the lease or the use of the leased equipment.
2 A general tax indemnity protects all of the other parties to the transaction from all
federal, state, or local taxes arising out of or in connection with the transaction except
from certain income tax or income-related taxes.
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Project Financing
3 Special tax indemnities by the lessee protect the owner participants from the loss of
expected income tax benefits as a result of the acts and omissions of the lessee and certain
other events.
The coverage of the special tax indemnities beyond the acts and omissions of the lessee is
a matter of significant negotiation between the lessee and lessor.
Closing the lease

When the transaction is about to close, the equity participants pay the amount of their
equity investments to the indenture trustee. As noted earlier, this investment must be at
least 20% of the cost of the equipment to qualify as a true lease for federal tax purposes.
Usually the equity participants investment will be in the range of 20 to 25% of the
acquisition cost of the leased equipment, including the expenses incurred in connection
with the acquisition of the equipment and the closing of the lease transaction, such as
legal costs, printing expenses and brokers fees. The loan participants pay the balance of
the acquisition cost of the leased equipment to the indenture trustee. The owner trustee
simultaneously issues equity participation certificates to the equity participants and prom-
issory notes, bonds, or debt certificates to the loan participants. The debt evidenced by
the notes, bonds, or debt certificates is without recourse to either the owner trustee or
the equity participants.
In the meantime, a lease agreement for the equipment has been signed by the owner
trustee (as lessor) and the lessee. The indenture trustee has recorded a security interest or
mortgage on the equipment to be leased. The owner trustee assigns the lease agreement and
the right to receive rents under the lease to the indenture trustee as security for the benefit of
the loan participants under a security agreement between the owner trustee and the indenture
trustee. The loan participants agree to look exclusively to lease rentals for repayment or, in
the event of default by the lessee, to their security interest in the lease, the rentals and their
mortgage or security interest in the leased equipment.
In most lease transactions, the lessee has already contracted to purchase the equipment
at the time that the lessee seeks to arrange the lease financing. Where these circum-
stances exist, the lessee assigns the purchase contract or the construction agreement to the
owner trustee (as lessor). This assignment conveys to the owner trustee all of the lessees
rights, title and interest to receive delivery, to be transferred title, and to be protected by
warranties. The lessee also obtains the consent of the manufacturer or contractor to the
foregoing assignment.
At the closing of the purchase of the equipment, the lessee signifies its acceptance of
the equipment by signing an acceptance certificate. The indenture trustee pays the purchase
price for the equipment to the manufacturer, contractor, or any construction lenders and
also pays any expenses (legal fees, printing fees, brokerage fees and so on) being financed as
part of the transaction. The indenture trustee uses funds collected from the loan participants
and the equity participants for that purpose. Title is then conveyed to the owner trustee,
subject to the previously recorded security agreement and mortgage. The equipment is then
delivered to the lessee, and the lease commences.
226

Cash flows during the lease

The equity participants receive cash flow from three sources: rents after the payment of
debt service and trustee fees, tax benefits and proceeds from the sale of the equipment at
the conclusion of the lease.
The lessee pays periodic rents to the indenture trustee, which uses such funds to pay
currently due principal and interest payments to the loan participants and to pay trustee fees
for its services. The balance of the rental payments is paid to the owner trustee. After the
payment of any trustee fees due the owner trustee and any administrative or other expenses,
the owner trustee pays the remainder of the rental payments to the equity participants.
The equity participants also realise cash flow from tax benefits as quickly as they can
claim such benefits on their quarterly tax estimates and tax returns.
The leveraged debt is usually amortised over a period of time identical to the lease term,
with payments of principal and interest due on or shortly after the due date of the rental
payments. These payments may be monthly, quarterly, semi-annual, or annual. Where opti-
mised debt structures are used for competitive reasons, the rental payments approximately
equal the debt service payments plus deferred income tax. This has the effect of reducing
the leveraged debt payments in the later years of the lease. Rental payments are usually level
but (subject to tax authority limitations) may vary upward or downward (sawtooth rents)
to achieve a maximum yield for the lessor. Also, debt payments may be concluded entirely
before the lease term ends in order to generate additional cash for the lessor.
When the lease terminates, the equipment is returned to the owner trustee, who sells or
releases the property at the direction of the owner participants.
The lease agreement usually requires the lessee to furnish the owner trustee and the
indenture trustee with financial statements, evidence of insurance and other similar informa-
tion. The trustees distribute this information to all parties to the transaction.
Debt for leveraged leases

Debt for leveraged leases is available from a variety of sources. The lead equity source or
packager may arrange the debt. Sometimes the lessee may prefer to have the debt arranged
by its commercial bank, the capital markets group of its commercial bank, or its investment
bank. Most leveraged lease debt is raised in the private placement market at little or no
premium over what the lessee would expect to pay directly for such debt in the public debt
market. Debt may be arranged in tranches with different maturities to attract investors with
preferences for certain maturities. The sources include:
insurance companies;
pension plans;
profit-sharing plans;
commercial banks;
finance companies;
savings banks;
domestic leasing companies;
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Project Financing
foreign banks;
foreign leasing companies;
foreign investors;
institutional investors; and
investment funds.
Other less frequently used instruments and sources of debt which may be useful in special
circumstances include the following.
Commercial paper investors

Commercial paper (see Chapter 17) has sometimes been used for leveraged debt for short
(five to seven years) leveraged leases. The major risks in using commercial paper are the
floating interest rates and the inability to roll over the commercial paper. Such debt may
require a back-up line of credit. Interest rate risk can be hedged to some extent by using
interest rate futures or interest rate swaps.
Public debt markets

It is possible, but not very practical, to use the public debt markets for leveraged debt. Public
debt is expensive since it must be registered under the Securities Act unless it is guaranteed
by an agency of the United States. Also, the lessee will have a difficult time in amending
the lease where public debt is used.
Government financing
If government financing is available, such financing can sometimes be used as leverageddebt.
Industrial revenue bonds

Industrial revenue bonds, including bonds in which interest is tax free, can often be used as
leveraged debt. (See Chapter 16.)
Supplier financing
Supplier financing can be an excellent source of leveraged debt (shipyard financing for a
ship, for example). Export-Import Bank financing offers such opportunities. One difficulty
in using this source is matching the debt maturities to the lease maturities. Where the lease
is for a longer term than that of the supplier financing, wraparound debt is difficult to
arrange, particularly since the security interest of such debt must usually be subordinate to
the supplier financing. (See Chapter 14 on construction financing.)
228

Multicurrency financing
Where the lessee generates more than one currency from the sale of its product or service, it
may prefer the leveraged debt to be in one or more matching currencies. Debt and rents can
be arranged to satisfy this need. Currency swaps can be used to hedge the foreign exchange
risk of foreign currency debt. (See Chapter 25.)
International currency and bond markets

The attractive interest rates available in the Eurodollar and Eurobond markets will prob-
ably bring these markets into use in the future. Floating rate notes (FRNs) with interest rate
hedges or futures may also be used. (See Chapters 25 and 26.)
Bridge financing
If interest rates on fixed long-term debt are, in the opinion of the lessee, unusually high,
the lessee may arrange bridge financing on a floating interest rate basis with a view to
refinancing term debt at a more favourable fixed interest rate at a later time. The floating
debt might, for example, have a term of 15 years identical to the lease term, float at one
over Libor for five years, three over in the sixth year, four over in the seventh year, and so
on. Such an arrangement enables the lessee to arrange financing with a commercial bank,
which feels assured under these circumstances that it will be taken out (have its loan paid
off) at the end of five years.
Facility leases
Leveraged leases have been used increasingly in recent years to finance the use of equipment
that is impractical to move, such as electric generating plants, mining equipment, refineries and
chemical facilities. The equipments lack of portability does not make it limited-use property
for tax purposes so long as the facility is reasonably expected to have a fair market value
equal to a required percentage of its original cost at the conclusion of the lease. In the US,
the 20% useful life tests mentioned earlier in this chapter are met if, at the conclusion of
the lease, the facility can continue to be used at its original location for a period of time
equal to 20% or more of the base lease term plus any fixed rate renewal terms.
Facility support agreements

A series of facility support agreements are needed in order to provide the lessor with rights
to the leased equipment upon the conclusion of the original lease.
The lessor will want either to own the land on which the facility is located or to have
a leasehold interest in the land that is at least 20% longer than the base lease term and
any fixed rate renewal lease terms available to the lessee. The lessor will also want ease-
ment and access rights to the property on which the facility is located. If supply contracts
for raw material, fuel, or energy are necessary for successful operation of the facility, these
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Project Financing
must be assigned by the lessee to the lessor at the conclusion of the initial lease. Rights of
way for power lines, rail lines, pipelines and roads may be necessary, as may access rights
to adjoining port, rail, or pipeline facilities. The leased equipment facility may be part of a
large complex of similar facilities in some cases, and in such a case the lessor should have
rights to service, fuel, energy and so forth, shared in common with the other facilities owned
by the lessee or other parties.
Exhibit 18.4 (shown in Example of a leveraged lease of an electric generating facility by
a utility) is a diagram of a leveraged lease of an electric coal-fired generating facility that
illustrates the parties, the cash flows and the agreements involved in a facility lease transac-
tion in which the owner trustee takes title during construction. This transaction contemplates
the assignment of the facility support agreements.
In this example, the purpose of the facility support agreements between the lessee
and the owner trustee is to provide the owner trustee with access to all properties and
things necessary or desirable to allow the owner trustee (acting on behalf of the equity
participants) to operate the electric generating facility as an independent commercial electric
generating unit and to sell electricity generated by the facility into a grid. The agreements
stipulate that maintenance services, fuel supply, power transmission and/or distribution
and other things are to be provided by the lessee (for which the lessee will be reim-
bursed), while a third party is operating the facility on behalf of the lessor or on lease
from the lessor. Without facility support agreements, the assets of the project have little
value as collateral. The facility support agreements are assigned to the indenture trustee
as support for the leveraged debt. They remain in effect throughout the interim lease
term, the base lease term, and any renewal lease terms, and for at least long enough
thereafter to meet the useful life tests of the Internal Revenue Service. Another purpose of
the facility support agreements is to ensure that the facility will have value to someone
other than the lessee at the end of the lease so as to satisfy the true lease requirements
of the Internal Revenue Service.
For example, the mere ownership of the facility by the owner trustee, without the under-
lying supply contracts for coal to be used as fuel for the facility, might seriously undermine
the value of the facility for collateral security purposes and residual value purposes. To
protect the interests of the equity participants and the loan participants, it is necessary for
the lessee to assign to the owner trustee any coal supply contracts that might be advanta-
geous or valuable to it. The owner trustee, in turn, assigns its interest in such contracts to
the indenture trustee for the benefit of the loan participants.
The supplier to the facility must consent to the assignment, and the form of consent is
usually included as part of the coal supply agreement.

While it is possible to arrange a facility lease in a fairly short time, the financial planning
for a large facility is complex and may involve a typical lead time extending over several
months. Exhibit 18.3 is a flowchart for a facility leveraged lease transaction showing the
decisions that will be made and the events that will take place from the inception to the
completion of such a transaction.
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Exhibit 18.3
Critical path chart of leveraged lease financing for an electric generating unit
Apply for state

agency approvals
Select equity
on rights allowed
counsel
under facilities
agreement
Obtain
Offering
engineers
Lease Equity Select lessee Select debt memorandum Syndicate Filings and
survey insurance
provisions commitments counsel counsel for equity equity recordings
reports and
syndication
so on
Offering
1 mo. Select 1 mo. 2 wks. 1 mo. Review first 2 wks. 3 mos. Re-draft 1 wk. 1 wk. 39 mos. 2 wks.
Analyse memorandum Commence Complete Apply for IRS Receive IRS Lease
proposal/equity Place debt draft of documents/
proposals for debt negotiations documentation ruling ruling commences
participant documents negotiate
placement
Apply for
File Rule 7(d)
Select debt Obtain state public
Cash flow Exemption Opinions of
placement engineers utility
analysis Certificate counsel
adviser certificates commission
w/SEC
approval
Apply for Execute

Lessee/
Prepare related state owners certificate,
equity Initiate first
application agency approvals equipment specs
meetings to draft of
for IRS on rights allowed and operating
finalise documents
ruling under Facilities rights certificates
structure
Agreement and so on
Apply for FERC

approval, If
applicable
Cumulative
time period 1 2 2.5 3.5 4 7 7.25 7.5 16.5 17
(month)

18/06/2012 07:50
Project Financing
Credit exposure of equity participants

As noted earlier, equity participants realise their yields from the following sources.
1 The interest rate spread between their yield on investment and their cost of funds.
2 Tax benefits from any tax credit and tax depreciation deductions.
3 The residual value of the equipment at the conclusion of the lease.
Although equity participants sometimes like to view their credit exposure as being limited
to their original equity investment, most of which may be recovered in the first few years
of the lease term of a leveraged lease, this is not the case if a forgiveness of the leveraged
debt occurs in the later years of the lease. In such a situation, the lessor may be deemed to
realise taxable income from the forgiveness. Forgiveness might occur, for example, where the
lessee defaults and the indenture trustee (on behalf of the loan participants) repossesses and
sells the equipment for less than the outstanding principal of the leveraged debt.
For these reasons, leveraged leases are available only to lessees that present no apparent
credit risk. Lenders and equity sources must be confident regarding the lessees ability to
meet all of its obligations under the lease, both for rental payments and for maintenance
of the leased equipment.
Whilst some legal and tax systems (for example, the US) have clear rules about the
implications of any advantages arising from debt forgiveness, this is not universally true.
Points of contention between lenders and equity participants

Since the indenture trustee has an assignment of the rental payments, an assignment of the
lease, and a first lien on the equipment, and since the lien position of the equity participants
is junior to that of the loan participants unless otherwise provided, points of contention
can arise between the equity participants and the lenders as each group seeks to protect its
respective interest in the transaction. An inter-creditor agreement (also discussed in Chapter
10) can be useful to discuss and agree these potential future pitfalls.
Indenture defaults which are not lease defaults

The equity participants must be sure that any event of indenture default that does not consti-
tute a lease default is controlled by the equity participants or by the owner trustee acting on
their behalf. In the absence of such protection, the equity participants could find themselves
in default under the indenture and lose their interest in the equipment even though the lessee
might continue to possess and use the equipment.
Control of sale of leased property in the event of default

The equity participants in a leveraged lease should have some protection against the sale
of the leased property to satisfy lenders in the event of a default by the lessee. Since the
loan participants have a first lien on the leased property, they are interested in selling
232

the property at a price that approximates their exposure, whereas the equity participants
want to follow a strategy for realising the maximum amount obtainable from a continu-
ation of the lease, a release of the leased equipment, or a sale of the leased equipment.
Also, if tax benefits have not vested, the equity participants will suffer a further loss if
the leased equipment is sold to a third party.
Cure default rights of equity participants

The equity participants will want to negotiate the right to cure defaults of the lessee so as
to prevent the indenture trustee (on behalf of the loan participants) from foreclosing and
selling the leased property at a fire-sale price. The lenders, on the other hand, may resist
this approach because it limits their ability to seize the equipment at an opportune time for
resale, and because the value of the equipment may deteriorate in the hands of a lessee that
is in financial difficulties and unable to properly maintain the equipment. This conflict can
usually be resolved by permitting the equity participants to take action to prevent or cure
a default on a basis whereby the equity participants have the right to purchase the notes
evidencing the leveraged debt as they come due or the right to make up a certain number
of consecutive rental payments to cover some or all future debt payments.
Fish or cut bait provisions

Another point of contention may arise where a technical default occurs that may be impractical
or impossible to remedy and the indenture trustee begins to withhold payments otherwise
due to the equity participants in order to build an unofficial security deposit for the lenders.
In order to provide equity participants with protection against such an occurrence, fish or
cut bait provisions are negotiated that require the indenture trustee either to accelerate the
entire loan within some time limit or to pay the equity participants under suchcircumstances.
Tax indemnity payments

Tax indemnity payments that may be due to the equity participants are another possible
area of disagreement. Since tax payments and indemnifications by the lessee against their
loss are the lifeblood of the equity participants yields and return on their investments, the
equity participants argue that they should receive any tax indemnity payment to which they
are entitled ahead of the lenders. Loan participants, of course, argue that their claim against
the lessee and the leased equipment arising out of the leveraged debt is ahead of any claim
of the equity participants. The trend has been for the claim of equity participants to prevail
on this issue. The equity participants rights to tax indemnity payments are carved out of
the lessees obligations assigned to the loan participants.
Payments by the lessee under general indemnities and liability insurance proceeds are
also frequently carved out for the benefit of the equity participants.
In arranging a leveraged lease the equity participants and the lessee should have a clear
understanding with the loan participants on these points at the time of arranging, pricing
and obtaining a commitment for the leveraged debt so as to avoid misunderstandings at a
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later date, particularly where interest rates may have moved upward between the time of
commitment and the time of closing.
Indemnification for future changes in tax law

Where a company requiring equipment intends to use a true lease to finance its equipment
acquisitions, the lessee and lessor must agree as to which of them will bear the burden of
future tax changes. In the past this issue was not much of a problem because historically
corporate tax rate changes were very rare and, when they occurred, had been around 2%.
However, significant accounting changes are anticipated to the treatment of leases as a
result of the convergence between the International Accounting Standards (IAS) project and
the Financial Accounting Standards Board (FASB) project. IAS and FASB had, as of November
2011, asked for further stakeholder comments on a revision based on a previous round of
discussions and changes. Tax changes also cannot be ruled out as different countries struggle
with the effects of the 2012 financial problems in Europe.
The tax benefits available to a lessor usually consist of accelerated depreciation deductions.
During the early years of a lease, tax deductions attributable to accelerated depreciation equal
all or part of taxable rental income. This results in deferral of taxable income attributable
to the lease rentals until the later years of the lease when depreciation deductions decline
or are exhausted. If in the early years of a lease the tax rate rises above that assumed by
the lessor for pricing, the lessors cash flows and yield will rise during the years in which
the lessor claims depreciation deductions. On the other hand, if the tax rate is higher than
assumed by the lessor for pricing during the years in which the rental income exceeds the
depreciation deductions, the lessors cash flow and yield will decline or even disappear.
Lessors generally take the position that they should be held harmless by the lessee in the
event of any tax law changes or tax rate changes adversely affecting their contemplated yield
or cash flow. Lessors argue that the lessee is no worse off under such an indemnification
than the lessee would have been had the lessee purchased the leased equipment and directly
claimed tax benefits associated with equipment ownership. Lessees, on the other hand, gener-
ally take the position that after delivery of the leased equipment, lessors should assume the
risk of loss of tax benefits for any reason except as a result of acts or omissions of thelessee.
The problem facing both lessees and lessors is how to engage in equipment leasing and
protect themselves in view of the future tax rate uncertainties. A significant tax rate change
can have disastrous consequences for a lessor, and the possibility of such a change is veryreal.
Initial questions facing lessors and lessees include the following.
1 What is the definition of the tax covered by the indemnity?

2 What is the risk of tax rate change that is to be covered?
3 What event or events will trigger a tax indemnity?
4 For what period of time will tax indemnities apply? For the entire lease, or for a limited
number of months or years?
5 How will the loss (or gain) resulting from indemnified tax rate risks be computed?
6 How will the indemnified party be compensated?
7 Under what circumstances can the lessee or lessor terminate the lease?
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Definition of the tax to be covered by the tax rate change indemnity

Although the discussion here is directed at tax indemnities that relate to changes in the regular
US federal corporate income tax rate, there are other corporate income and excise taxes
that may affect the lessors yield and cash flow, and lessors may seek indemnity protection
against changes in those tax rates. These other corporate income tax and excise taxes may
include the following:
1 state or city income tax;

2 the federal alternative minimum tax; and
3 federal income or excise surtax based on the regular federal income tax or the alternative
minimum tax such as the so-called superfund tax.
The definition of the tax which is to be covered by a tax rate change indemnity should,
consequently, be precise.
Lessees inclined to provide some degree of protection to lessors with regard to the regular
federal corporate tax rate are generally going to be reluctant to provide further protection
for various other potential corporate taxes based upon income.
A lessor that may be subject to the alternative minimum tax is going to be hard-
pressed to convince a lessee to provide indemnity protection against such an occurrence.
Competition from lessors with no risk of being subject to alternative minimum tax will
force most lessors to assume that risk. In any event, a corporations liability for alternative
minimum tax may take several years to determine, which makes such an indemnity very
impractical to administer.
The risk of tax rate change to be covered by an indemnity

An early question to be addressed is to define what risk of tax rate change is to be covered
by the tax indemnity. These, of course, range from none to the entire risk of change.
However, there are methods of limiting or sharing the risk that the parties may wish to
consider. These may be expressed in terms of the number of months or years in which the
indemnity is to be in effect. The limits may also be expressed in terms of dollar caps or
limits on the compensation to the indemnified party. A lessee providing an indemnity will
also want a two-way-street clause which will provide the lessee with the benefits of tax rate
changes that improve the lessors cash flow or yield.
Dimensions of the problem: the triggers

The trigger for activation of a tax indemnity covering a change in the corporate tax rate
will usually be related to one or more of the following events.
1 A defined amount of percentage change such as, for example, from 34% to 36% orhigher.
2 The cumulative effect of the tax rate change measured by some stated amount of yield
or cash flow.
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Project Financing
3 The cumulative effect of the tax rate change and any other tax law changes measured by
some stated amount of yield or cash flow.
It is often impractical, uneconomical and not in either partys best interests to trigger indem-
nity clauses for small changes in the tax rate or tax law that have a relatively minor effect
on yield or cash flow, particularly in the case of smaller leases (materiality issues).
Time limits on tax indemnity

Some of the various possibilities for defining the time limits, during which tax indemnities
or lease rate adjustments will apply, include any changes in tax rates that become effective
and/or are actually enacted into law, on or before:
1 the date the lease commences (this traditionally has been the lessees risk with right of
cancellation of the lease);
2 some date in the future between the lease commencement date and the date the base
lease term terminates;
3 the date the base lease term terminates; and
4 some date in the future after the termination of the base lease term.
One possibility for compromise in an otherwise satisfactory lease arrangement is presented

by the lessee assuming the risk of tax rate change for a period of time that is somewhat
less than the entire lease term and also gaining the benefits of a tax rate change during the
same time period that would otherwise improve the lessors yield or cash flow.
Basic remedies for an indemnified party

In the event a tax indemnity is triggered, the parties have two basic remedies:
1 they may continue the lease with a lump sum payment and/or certain adjustments to
rents or term; or
2 they may terminate the lease on some agreed basis which will usually involve a payment
or payments by the lessee to the lessor (burdensome buyout price).
Usually the lessee will want the right to terminate the lease if certain events occur, such as the
rent adjustments and so on, being above a certain level if the lease is continued. The lessor
will usually wish to have a right to avoid the buyout by waiving some (or all) of the tax
indemnity rental adjustments. (All parties need to check these rights do not jeopardise any tax
allowances or contravene any tax rules about the classification of the lease for tax purposes.)
Computation of the loss or benefit

Lessees will seek the benefit of any windfall gain to the lessor resulting from a tax rate
change. This benefit may take the form of future decreased rents.
236

Lessors will seek to gear any adjustment to which they are entitled as a result of a tax
rate change so as to preserve both their cash flow and yield (a double-barrelled indemnity).
Lessees will usually prefer indemnities to the lessor limited to maintaining the lessors
yield. The computation of any loss or benefit to a lessors yield as a result of tax legisla-
tion may be somewhat sensitive for lessors since they may not care to disclose how they
arrived at their yield. However, since lease yield timeshare plans are available to everyone,
a defined formula of input to serve as a basis for yield maintenance offers one avenue
for agreement.
Typically, the lessor might compute the adjustment, submit it to the lessee for approval,
and the two parties either agree or then sort out any differences. Another approach is to use
an independent third party such as an accounting firm to compute the appropriate adjust-
ment where the parties are unable to agree.
A further question the parties must face is whether the lessor after-tax yield is to be
preserved under the old law or the new law. Another question is what will constitute the
target yield under the new tax law or under a matrix of new tax rates.
Lessors may be more concerned with maintaining a certain cash flow than maintaining
a certain yield.
The so-called double-barrelled indemnity mentioned earlier whereby the lessor maintains
both a certain yield and cash flow has not been unusual in the past.
There is also the question of recovery of lessee and lessor costs in originally entering
into the transaction. Usually each party will bear its own costs.
Specific remedies of the indemnified party

The remedies available to the indemnified party or to the party subject to liability for an
indemnity payment include the following.
1 Cancellation of the lease with each party bearing its expense.

2 Cancellation of the lease with some stated amount of dollar compensation by one party
to the other party to the lease.
3 Adjustment of the lease rentals over the term of the lease.
4 Adjustment of the lease rentals over some shorter period than the entire term of the lease
(resulting in high/low rentals, for example).
5 Extension of the term of the lease with the same rents or higher rents.
6 Payment of a lump sum.
The parties might predetermine a rental adjustment or a term adjustment by a matrix formula
in the lease documentation. So-called unwind provisions to terminate the lease if certain
events occur run counter to IRS true-lease guidelines. Tax lawyers will have to rationalise
their way around such guidelines in the light of the special circumstances involved. So-called
burdensome buyouts may be unacceptable to lessees if unduly burdensome.
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Leveraged debt provisions should contemplate possible tax indemnity

Lessors and lessees should be careful in arranging debt for leveraged leases to obtain the
agreement of debt participants in the event of a tax indemnity event to either early prepay
the debt or terminate the lease while leaving the debt in place. Failure to obtain such consent
will undermine the tax indemnity remedies and options of the lessee. Obviously, this type
of consent should be obtained at the outset of lease negotiations and included in the debt
participants commitment letter. Such a provision cannot be left until late in the lease nego-
tiations as a routine request.
Risk of future rate change is significant

The risk of a change in the future corporate tax rate that will adversely affect the yields
and cash flows of lessors is significant.
Lessors and lessees must consequently be concerned with the new dimensions of this
risk in future lease documentation. Lessors must be satisfied that a proposed lease transac-
tion makes economic sense on a worst case basis. In the final analysis, adjustments in the
original lease rate pricing may be the key to resolving negotiation disputes regarding who
will bear the risk of future corporate tax rate changes.
Leveraged leases with individual investors

Leveraged leases of equipment can be structured with individual investors acting as equity
participants. Usually these are structured as partnerships. The income tax requirements and
consequences for individual equity participants in a leveraged lease are very different from
those for corporations. At-risk rules prevent effective leveraging. Interest deductions and
depreciation deductions are severely limited by income tax preference limitations. In any
event, a discussion of leveraged leases by individuals acting as lessors is beyond the scope
of this chapter. However, a number of renewable energy projects are exploring the use of
adapting structures of this type to provide project finance in this growing sector.
Example of a leveraged lease of an electric generating facility by a utility

This example contemplates the sale and true lease-back by a utility of a coal-fired electric
generating facility which is under construction, with long-term financing under a leveraged
lease. Exhibit 18.4 illustrates the major agreements and cash flows involved in thistransaction.
There are a number of key agreements:
participation agreement;
partnership and agency agreement;
support facilities agreement;
trust indenture and mortgage;
lease agreement;
238

construction supervision agreement;

coal supply agreement; and
construction contract assignment.
We describe each document below.
Participation agreement
The participation agreement is the key driving agreement in this leveraged lease. It is between
the lessee, the owner participants (sometimes called equity participants), the indenture trustee
and the owner trustee.
This agreement outlines the proposed transaction and the undertakings and obligations
of the various parties to the agreement.
Partnership and agency agreement

This agreement is between the owner participants and the owner agent. It spells out the
duties and responsibilities of the owner agent and the obligations of the owner participants.
(The owner participants are sometimes called equity participants and the owner agent is
sometimes called owner trustee.)
Support facilities agreement

The purpose of the support facilities agreement between the lessee and the owner agent lessor
is to provide the lessor (owner agent) with access to all properties and things necessary or
desirable to allow the lessor to operate the electric generating facility as an independent
commercial electric generating unit. The facilities agreement provides for maintenance services,
fuel supply, power transmission and/or distribution and other things to be provided by
the lessee (for which the lessee would be reimbursed), for such period as the lessor may
choose, while a third party is operating the facility on behalf of the lessor or on lease
from the lessor. Without a support facilities agreement, the assets of the project have little
value as collateral.
The facilities agreement is assigned to the bondholders as support for the debt. It remains
in effect throughout the interim term, the basic term, and any renewal terms, and for at
least 10 years thereafter.
Since this transaction is to be structured as a true lease, another purpose of the facili-
ties agreement is to ensure that the facility will have value to someone other than the
lessee at the end of the lease so as to satisfy the true lease requirements of the Internal
Revenue Service.
A common facilities agreement provides for the joint use of certain facilities by the lessee
and the lessor (owner agent) during such a period when both parties would be using such
facilities as a result of the support facilities agreement.
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Project Financing
Trust indenture and mortgage

The trust indenture and mortgage is between the owner agent (on behalf of the partnership)
and the indenture trustee. It spells out the duties and responsibilities of the indenture trustee
and the rights, obligations and duties and remedies of the owner agent.
Among other things, the trust indenture and mortgage sets forth the form of bonds to
be issued to evidence the leveraged debt, and assigns to the indenture trustee for the benefit
of bondholders and as security for payment of the bonds, a first lien on the leased assets,
easements, support agreements, rents and any payments received under the lease.
Lease agreement
The lease agreement is between the utility as lessee and the owner agent on behalf of the
partnership, as lessor. The lease is a net true lease in which the lessee is responsible for
maintenance and repair of the facility in a manner consistent with the original performance
specifications and sound engineering practices. All expenses of operations, fees, taxes (other
than the lessors income tax) are for the account of the lessee. The lessee assumes liability
for, and indemnifies all parties to, the transaction from and against any and all liens, encum-
brances, obligations, losses, damages and penalties in respect of the leased facility and the
acquisition, financing, use and operation thereof.
Construction supervision agreement

The construction supervision agreement is between the utility lessee and the partnership.
The participation agreement contemplates that the title to the property to be leased will be
transferred to the owner agent (lessor) while the plant is still in early stages of construc-
tion. Although the facility is being constructed by a third-party contractor, the utility has
been and wishes to continue to supervise the performance of a construction contract with
the third-party contractor.
Therefore, the purpose of this agreement is for the partnership to use the services of the
utility in its capacity as construction supervisor to oversee the construction testing, delivery
and acceptance of the facility.
Coal supply agreement

The mere ownership of the facility by the lessor, without the underlying supply contracts
for coal to be used as fuel in the facility, might seriously undermine the value of the
facility for security purposes and residual value purposes. To protect the interests of the
partnership (as lessor) and bondholders, it is necessary for the lessee to assign any coal
supply contracts which might be advantageous or valuable to the partnership as lessor. The
partnership, in turn, assigns its interest in such contracts to the indenture trustee for the
benefit of the bondholders.
The supplier must consent to this arrangement, and a form of consent is usually included
as part of the coal supply agreement.
240

Exhibit 18.4
Leveraged lease of an electric generating facility
7 Equity
contributions Indenture
Trustee
10 Rents
8 Progress
payments and
purchase price
5 Trust indenture
mortgage, assignments
of rents, support 11 Debt
agreements and service
contracts
Construction 7 Loan
9 Title 12 Cash not proceeds
company
needed for
debt service
Owner Owner agent Loan

2 Partnership and
partnership 6 Bonds
participants agency agreement participants
(lessor)
12 Cash not
needed for
debt service
13 Income 1 Participation
3 Lease
tax return agreement
4 Assignments of
Internal construction contract,
13 Tax
Revenue support facilities agreement, Lessee utility
benefits coal supply contract
Service
easements and so on
Continued

Project Financing

Summary
1 A participation agreement is entered into between the owner agent, the lessee, the loan participants
and the indenture trustee. This agreement constitutes the master agreement for the leveraged lease and
spells out the general rights and obligations of theparties.
2 A partnership and agency agreement is entered into between the owner participants and a bank or trust
company acting as the owner agent andlessor.
3 A lease agreement is entered into between the partnership and thelessee.
4 The lessee assigns to the partnership its interest in the construction contract, support facilities
agreements, coal supply contracts, easements, and soon.
5 The owner agent, on behalf of the partnership, enters into a trust indenture and mortgage with the
indenture trustee and assigns to the indenture trustee all rents and other payments to be received under
the lease, the construction contract for the facility to be leased, the support facilities agreements, coal
supply contracts, easements, and so on, all as security for bonds (leveraged debt) which are to be sold
by the owneragent.
6 Bonds are issued to thebondholders.
7 Loan proceeds and equity contributions are paid to the indenturetrustee.
8 Purchase price is paid to the constructioncompany.
9 Title to the leased facility is conveyed by the construction company to thepartnership.
10 The lease commences and rental payments commence to be paid by the lessee to the indenturetrustee.
11 The indenture trustee services the debt to the loanparticipants.
12 Cash not needed for debt services is distributed to the ownerparticipants.
13 In the meantime, the owner participants file income tax returns and receive tax benefits associated with
equipmentownership.

The participation agreement and the lease agreement contemplate that the partnership (lessor)
will take possession of the facility during the early stages of construction. The construction
contract must be assigned by the utility lessee to the partnership.
Non-tax oriented leveraged leases

It is possible to have a leveraged lease which is not a true lease. In such a lease a variety of
security instruments are used to build the total financing necessary to purchase the asset or
equipment to be financed. For example, debt, secured by a senior first secured interest may
be used to finance 60% or 70% of the cost of the equipment.
Subordinated debt (to senior debt used in the financing) may then be used to finance
the remainder of the cost of the equipment.
Taking the transaction a step further, where residual value risk is assumed by lenders,
there may be three tiers of lenders in the transaction with a third tier of lenders depending
wholly or in part upon the realisation of residual value for repayment.
The lenders in a three tier transaction might be as follows.
242

1 Senior secured lenders, with a first security interest in the asset and perhaps the general
credit of the lessee.
2 Lenders with a security interest in the financed asset, which is subordinated to secured
lenders (in effect, a second mortgage). This second mortgage may be supported by the
general credit of the lessee or it may depend upon the cash flows of the transaction.
3 Lenders which look solely to the residual value of the equipment at the end of the lease
as the source of funds available to repay their principal and accrued interest. Except for
the residual value at the end of the lease, such lenders are junior to the subordinated
lenders and senior lenders.
In large transactions, each tier of loans may be syndicated or securitised. A trustee may be
used to hold title, act as a collection agent, and act as a disbursement agent.
The interest rate for each tier of financing varies with the perceived risk of the loan
and security. There may, of course, be further tiers of lenders or securities supporting the
transaction if that is desirable.
Non-tax oriented leveraged leases may be structured to be on or off-balance sheet for
the lessee, subject to the specific tax rules that pertain.
These types of leases can be used for very large transactions such as sale and leasebacks
of aircraft pools, equipment inventories, as well as single discrete assets.
These leases may also be used in developing countries when a lease is superior to a first
mortgage to protect the property rights of the lender or lessor. A trustee will act as the
lessor in such transactions.
7 TRAC leases
These leases were mentioned at the start of this chapter. The name TRAC lease is derived
from the fact that such a lease contains a terminal rental adjustment clause. Properly struc-
tured, a TRAC lease can be used to provide a lessee with true tax-oriented lease rates even
though the lease contains a TRAC. TRAC leases occur in the US.
Equipment eligible for TRAC leases

TRAC leases are used to finance motor vehicles used in a trade or business. While the statute
is not entirely clear on the subject, the term motor vehicles most likely includes only motor
vehicles licensed for highway use. Under this definition, such motor vehicles as trucks, truck
tractor and trailer gigs, automobiles and buses are eligible for TRAC leases. On the other
hand, such vehicles as farm tractors, construction equipment and forklifts probably are not
eligible for TRAC leases.
Terminal rental adjustment clause defined

A terminal rental adjustment clause permits or requires an upward or downward adjustment
of rent to make up any difference between the projected value and the actual value of a
leased motor vehicle upon the sale or disposition of the vehicle.
243

Project Financing
How a TRAC lease works

At the time a typical TRAC lease is signed, the lessee and lessor agree on a monthly rental
and a table of projected residual values for the leased motor vehicles at various agreed dates
on which the lease may be terminated. When the lessee terminates the lease, the value of the
terminated motor vehicles is determined either by an arms-length resale to a third party, by
agreement between the lessee and the lessor, or by an independent appraisal. If the value at
termination is less than the agreed projected value, the lessee pays the lessor the difference.
If the value of the equipment at termination is more than the agreed projected value, the
lessee may keep all or part of the difference, depending on the terms of the leaseagreement.
TRAC leases are sometimes called open-end leases because the liability of the lessee at
the end of the lease is open-ended. However, as noted above, the lessee has upside potential
if the leased equipment is worth more than the projected residual value.
Except for TRAC clause, a TRAC lease must qualify as a true lease
A TRAC lease must meet the usual Internal Revenue Service requirements for a true lease.
The projected termination value depends on the length of time of the leasing agreement,
so a four year agreement might have a 20% residual and a five year a 10% residual, as
indicative numbers.
Advantages of TRAC leases

TRAC leases provide lessees of vehicles with the benefits of true lease rental rates while at
the same time protecting lessees against the loss of potential upside residual value.
TRAC leases also encourage lessors to take substantial residual values into consideration
in pricing rents since lessors are protected against downside risk by the terminal rental
adjustment clause.
TRAC leases consequently provide lessees with a very attractive cost for the use of leased
over-the-road vehicles.
TRAC leases may be on or off-balance sheet.
A modified TRAC scheme, known as a split TRAC, allows the lessor to assume some
of the residual value and the lease may be classified as an operating lease.
8 Synthetic leases
One of the attractions of a true lease of equipment for lessees is the off-balance sheet treat-
ment of the lease obligation. One of the drawbacks of a true lease of equipment for many
lessees (and particularly those able to utilise tax benefits associated with equipment owner-
ship) is the possible loss to be experienced when the true lease terminates and the equipment
may have to be acquired from the lessor.
The synthetic lease was developed to meet this need by providing the lessee with off-
balance sheet treatment of the lease obligation while at the same time protecting the lessees
cost of acquiring the residual value of the leased equipment at the termination of the lease. Tax
244

benefits of equipment ownership are claimed by the lessee in a synthetic lease. The rental in a
synthetic lease is approximately equivalent to the lessees debt rate for comparablematurities.
Synthetic leases are off-balance sheet leases in which the lessee retains tax benefits associ-
ated with ownership. Such synthetic leases are structured using a lease agreement between the
user or owner of equipment or real estate as the lessee and an investor as the lessor in a
manner which satisfies the requirements for an operating lease defined in Financial Accounting
Standards Board No. 13 and related accounting rules. Such synthetic leases are attractive
to businesses which are substantial users of capital equipment. Synthetic leases may also be
attractive to companies requiring real estate to provide services such as supermarkets, food
service businesses and other chains which are seeking medium-term financing to expand their
businesses either by acquiring new sites or locations or are interested in acquiring existing
leased locations. However, stricter accounting rules apply for synthetic leases of real estate
as compared with synthetic leases of equipment and they have diminished in importance in
the US.
1
More information can be found in World Leasing Yearbook, 31st edition, 2011, Euromoney.
2
Rules are constantly changing here are some recent examples of additional criteria and guidelines for leases
in the US:
[2010] 26CFR1.178-1 Sec. 1.178-1 Depreciation or amortisation of improvements on leased property and
cost of acquiring a lease.
[2010] 26CFR1.168(j)-1T Sec. 1.168(j)-1T Questions and answers concerning tax-exempt entity leasing.
[2010] 26CFR5c.168(f)(8)-2 Sec. 5c.168(f)(8)-2 Election to characterise transaction as a section 168(f)(8)lease.
[2010] 26CFR1.280F-5T Sec. 1.280F-5T Leased property (temporary).
[2010] 26CFR5f.168(f)(8)-1 Sec. 5f.168(f)(8)-1 Questions and answers concerning transitional rules and
related matters regarding certain safe harbour leases.
[2010] 26CFR1.467-1 Sec. 1.467-1 Treatment of lessors and lessees generally.
[2010] 26CFR1.467-3 Sec. 1.467-3 Disqualified leasebacks and long-term agreements.
[2010] 26CFR5c.168(f)(8)-5 Sec. 5c.168(f)(8)-5 Term of lease.
[2010] 26CFR5c.168(f)(8)-3 Sec. 5c.168(f)(8)-3 Requirements for lessor.
245

Chapter 19
International leasing
Leasing is widely used as a method of equipment financing throughout the world. Leasing
or chartering of ships has long been used as a method of finance or project financing.
Modern equipment leasing was introduced in most countries as vendor financing for computer
mainframes and peripherals, and quickly expanded to general equipment leasing. In this
chapter, we shall discuss cross-boundary or cross-border leasing and look at recent devel-
opments in some of the jurisdictions that have been well known for leasing in the past.
The changes in accounting standards together with the upheavals in many financial markets
and the increase in economic growth in rapidly expanding economies such as China, as
one example, and new techniques such as those developing in Islamic finance are changing
the use of leasing in project financing, the mix of leasing business written and the range
of providers of funds.1
1 Cross-boundary leasing or cross-border leasing

Cross-boundary leasing refers to a lessor in one country leasing property that is physically
located in another country, so that the rentals are paid from the country where the property
is located to the lessor in its home country.
Cross-boundary leases have historically been used for ships, aircraft, railroad rolling stock,
barges, trucks, containers and similar mobile assets that by nature move between countries.
Such leases have also been used for assets such as offshore rigs and barge facilities. However,
the volume of other types of cross-boundary leases has not been large due to the following
factors that discourage cross-boundary leases.
Withholding tax on the rentals that is sometimes based upon the gross amount of the
rentals (Canada, for example).
The lessor based in country A may become subject to local property, income or franchise
tax in country B. Further, the presence of the leased property may subject other lending
activities of the lessor based in country A to tax in the lessees country, B.
Import restrictions waived for the lessee as a locally resident company may not be available
to the lessor.
Tax shelters associated with equipment ownership are usually substantially reduced or
not available.
The general overhead expense involved in administering and documenting cross-boundary
leases is higher than for leases in the lessors home country. Credits are more difficult
to analyse. Enforceability is less certain. Title documentation is less clear. (See also the
political risks discussed in Chapter 5.)
246

The lessor generally demands rents to be paid in the same currency as its funding, which
may not match the lessees needs or desires.
Currency exchange restrictions discourage cross-border leasing.
Double dip leasing

Related to cross-boundary leasing is the concept of a double dip tax-oriented lease that uses
the enhanced benefits resulting from the tax benefits associated with equipment ownership
in more than one country. The term double dip refers to the double use of tax shelter on
the same equipment acquisition.
A double dip lease takes advantage of inconsistent tax laws for determining tax owner-
ship in the two countries involved. A lease transaction that qualifies as a true lease because
the lessor can claim the tax benefits associated with equipment ownership in one country
(A) may be considered to be a conditional sale in another country (B). The lessee under a
true lease that qualifies as a conditional sale in the second country (B) can then claim tax
benefits associated with equipment ownership in the second country (B) either as the owner/
user or even as a lessor to a lessee-user in a follow-on lease.
The differences in characterising a lease as either a true lease or a conditional sale (or
hire-purchase agreement) can usually be explained in terms of the substance of the transac-
tion rather than its form (see also Chapter 18).
So, for example, the United States determines whether a transaction qualifies as a true
lease in which the lessor can claim tax benefits associated with equipment ownership on the
basis of the substance of the transaction taking into consideration a number of characteris-
tics. In the United States, the lessor is considered to be the true owner where the lessor has
property rights that in substance indicate the lessor is the true owner.
In contrast to the US tax law, a number of other countries determine true lease status
or conditional sale (or hire-purchase agreement) status on the strict basis of legal ownership
or compliance with a strictly defined formula inside which a transaction can be structured to
fall. The United Kingdom and certain countries with a tradition based on English law tend
to view legal ownership and tax ownership as identical, and so a fixed price purchase option
(with reasonable expectation of exercise) is treated as a conditional sale or hire-purchase
agreement. However, it must be noted that the rules for qualifying a lease transaction as
either a true lease or a conditional sale are constantly under review. Therefore, tax counsel
should be consulted to determine the current criteria for determining true lease or conditional
sale status. Double dip leasing is becoming less easy to find as harmonisation of tax regimes
continues. A historic example is provided for reference purposes in Exhibit 19.1.
247

Exhibit 19.1
Double dip lease
4 Loan
agreement (68%
of ship cost)
UK owner/
8 Loan
lessor (12% of UK lenders
proceeds
ship cost)
6 15-year
bareboat charter, 12 Debt
level payments service
5 15-year bare-
7 Assignment Indenture
boat charter, CSA.,
of true lease trustee
for single payment
12 Funds not
needed for
debt service
8 Funds for 20 US owner/ 9 Flag US Coast

US investors
per cent of cost lessor requirements Guard
3 Assignment 8 Progress
2 True lease 10 Delivery:
of construction payments and
(15 years) title passes
contract purchase price
Oil company 1 Construction UK shipyard

contract
11 Rents

Summary
1 Oil Co enters into a construction contract with a shipyard in the UK. Oil Co will pay 100% of construction
progress payments, and has the right under this contract to transfer the right of delivery to a thirdparty.
2 US true lease: Oil Co engages a US corporation (US owner/lessor) to serve as owner of the vessel for
US tax purposes and US vessel documentation purposes. US owner/lessor secures financing from US
investors for 20% of the cost of the vessel. The US investors are, in effect, the investors in a leveraged
lease and entitled to US tax benefits. US owner/lessor bareboat charters the vessel to Oil Co for 15
years, for a total amount equal to 100% of the cost of the vessel. Payments are level over 15years.
3 Funding agreement: US owner/lessor enters into a funding agreement with Oil Co. The construction
contract is assigned to the US owner/lessor that agrees to fund 100% of the construction progress
payments and the delivery payment under the construction contract in return for the right to take
delivery and title from theshipyard.
4 A UK corporation (UK owner/lessor) is engaged to serve as owner of the vessel for UK tax purposes. UK
owners secure financing from UK lenders for 85% of 80% of the cost of the vessel. UK owner itself is
prepared to fund 15% of 80% of the vesselcost.
5 Conditional sales agreement: US owner/lessor enters into a conditional sales agreement (CSA) with UK
owner/lessor, under which US owner/lessor bareboat charters the vessel to UK owner/lessor.
The cost of the CSA to UK owner equals 80% of the cost of the vessel. This amount is 100% prepaid
by UK owner/lessor upon delivery of the vessel to US owner/lessor. UK owner/lessor tenders funds to
US owner/lessor as needed to make construction payments under the fundingagreement.
The CSA provides for passage of title from US owner/lessor to UK owner/lessor after 25 years, or upon
early termination of a financial lease from UK owner/lessor to US owner/lessor, describedbelow.
6 UK financiallease.
The cost of the financial lease to US owner/lessor equals 80% of the cost of the vessel, and is paid
over a period of 15years.
At the end of the 15-year period the financial lease may be renewed for 10 years at nominalcost.
Upon termination, UK owner/lessor will appoint US owner/lessor as its agent to sell the vessel to a
third party. UK owner/lessor will provide US owner/lessor with 97.5% of net sale proceeds as a rebate
of rentals or sales commission, after deduction of amounts owed under the financiallease.
7 Security.
US owner/lessor assigns the true lease, including rentals due, to UK owner/lessor as security for
performance of the UK financial lease. The lease and rentals due are, in turn, assigned to the UK
lenders as security for the UK owners loan (described in 4).
UK participants have a security interest in thevessel.
8 Funds are provided by the UK lenders, the UK owner/lessor, and the US owner/lessor for the progress
payments and final payment of the purchase price of theship.
9 Flag of vessel: US owner/lessor documents the vessel with the US Coast Guard as a vessel of the United
States. The vessel must be deflagged at the end of the 15-year CSA, at which time title will pass to UK
owner/lessor.
10 Delivery: title passes from the shipyard to the US owner/lessor.
11 The lease between the US owner/lessor and the Oil Co commences and rents are paid by the Oil Co to
an indenturetrustee.
12 The indenture trustee services the UK debt and distributes rent not needed for debt service to the US
owner/lessor.
13 The US investors and the UK owner/lessor file tax returns and claim tax benefits associated with
equipmentownership.
249

Project Financing
2 Examples of leasing in different national contexts

For leasing to be an effective financing alternative, a number of important concepts need to
be clarified in the national legal systems involved in the transaction.
First of all, it is important that an organisation can earn profits through the use of
assets as compared with the ownership of assets and the separation of legal ownership and
economic ownership needs to be clear. There also need to be clear mechanisms to allocate
risks to the parties best able to manage, control or absorb them. This would normally take
place through a well-developed insurance market2 (see also Chapters 12 and 22).
In considering the different requirements from local legal and tax rules designed to
support the development of domestic or cross-boundary leasing activity, the following areas
need to be considered, clarified and preferably enshrined in the commercial codes that would
apply to this transaction:
regulation of leasing activity;

initial costs of the transaction;
ownership of the asset;
tax issues; and
end-of-lease issues.
Regulation of leasing activity

The first question is whether leasing activity counts as a financial services business and is
subject to the regulatory framework that pertains to financial services. This could stifle new
leasing companies, or leasing activity in developing economies because the agency costs
associated with compliance with the legislation for financial services could be high compared
with the revenues from leasing.
Initial costs of the transaction

If the equipment is being leased in from an overseas supplier, and there are exchange control
procedures in place, then appropriate permissions for the remittance of the down payment
and any leasing payments needs to be negotiated. The time to get these permissions docu-
mented and agreed may cause some delays. There may also be other arrangement fees and
the reimbursement of legal fees and so on, all of which may need to be pre-agreed, with
the difficulty that the final amount may not be known and professionals may be less likely
to agree to a cap to fees where there is uncertainty about the details of the transaction. In
the event that there is a prepayment account in place to buffer the lease payments, as may
exist with other project loans, this also requires approval especially if these funds are being
held in an overseas currency or outside countries A and B, to return to our example.
Ownership of the asset

If the lessor is a foreign entity, then the law needs to be clear that assets within a national
boundary can be owned by non-nationals who may also be able to enforce their rights of
ownership should things go wrong.
250

Can the appropriate mortgage, lien or charge be registered?

Can a lessor or lenders repossess?
What happens in the case of bankruptcy if the bankruptcy is of the lessor, can the lease
migrate to another party without going through a foreclosure?
If the lessee goes bankrupt, can the lessor repossess the asset?
Are concepts around loan covenants and responsibilities around maintaining assets well
enshrined in the countrys commercial laws?
These issues apply to all project financing, but are especially important here where the lessor
owns the asset. (See also Chapters 2, 5 and 8.)
Tax issues
Clarification will be needed of import duties, delivery charges, customs processing charges and
so on, as well as added value taxes relating to the initial purchase and any leasingpayments.
Will the lease payments attract any tax deductibility?

Is accelerated depreciation permitted?
Is there any withholding associated with external remittances?
End-of-lease issues
Commercial laws and tax laws need to recognise the following situations that may occur at
the end of the lease term:
the existence of the right to purchase leased assets at a bargain or nominal price;
the existence of the right to purchase leased asset at a fair market price;
the existence of the right to renew a lease for nominal rental payments (the so-called
bargain renewal option);
the existence of the right to renew a lease at fair market rentals; and
the existence of the right to return the equipment to the lessor.
Another consideration, linked to the last three points above, is the fate of the equipment
when the lease ends.
Does the ownership of the equipment automatically transfer to the lessee?

What are the implications of this for the types of leases that exist in different jurisdictions?
Considering the fair market value, this list addresses the existence of a right to purchase,
but the difference between right and obligation also need to be viewed in terms of option
theory and whether the inclusion of a right to purchase equipment at a predetermined sum
may give rise to an overvalued option if the second-hand market for this type of equipment
is not restricted.
251

Project Financing
3 Some examples of different leasing approaches

The following areas illustrate different approaches to leasing.3
France
A crdit-bail is a leasing transaction whereby the lessee has a purchase option at a residual
value. This is determined in advance and takes the rental payments made into account. These
transactions relate to equipment or property acquired for business use. Crdit-bail companies
are governed by following strict regulations:
specific authorisation to be delivered by the Comit des Etablissements de Crdit (Committee

of Credit Institutions);
status of Socit Financire (finance company) from the Bank of France; and
certain other obligations including minimum capital, prudent ratios, and the supervision
of the Commission Bancaire.
Banks and finance companies can carry on crdit-bail operations as well as other types
of leasing operations for various types of equipment. The use of French leveraged leasing
activity with former colonies has been challenged as a form of subsidy and thus queried
by the EU.
Article 39 C of the French tax code has been used for shipping and other large ticket
items. It addresses new assets only (other than ships for which there is a 24 month post
delivery window). French tax lease benefits are not available for individuals, a difference
from the partnership structures that exist in other countries.
The single investor tax lease allows the special purpose vehicle lessor to offset losses
resulting from accelerated depreciation against group profits and pass these benefits through
to the lessee in the lease payment structure. These leases also include an option topurchase.
A pool of banks, constituted for a single transaction, can create a groupement dintrt
economique (GIE) a single purpose company for leasing. For example, a GIE buys a new
aircraft and leases it simultaneously to an airline, thereby qualifying for accelerated tax
depreciation deductions. The members of the GIE need to have tax liabilities for about half
the life of the lease transaction in order to make use of the accelerated depreciation deduc-
tions. GIE structures are also common in Francophone Africa, where they may also be used
for micro leasing as a mechanism to support economic development.
There is another leasing structure in the form of a tax-transparent partnership or socit
en nom collectif. The leased assets need to be in France or the EU and if movable, need
to be operated in or registered in France. The term operated in requires an asset to be
used in the specified location for more than two-thirds of the tax year. In this partnership
structure there is the possibility of tax deductibility of losses at member level but, as in all
these cases, attention needs to be paid to the rules.
French operating leases have also been structured by banks to take advantage of favour-
able double taxation agreements with countries such as China and Turkey, and pass the
benefit to lessees, especially airlines.
252

Ireland
Prior to the recent economic problems in Ireland, a growing cross-boundary leasing opera-
tion, especially around aircraft leasing had developed. An attractive corporation tax regime
coupled with a large number of double taxation treaties and an absence of withholding tax
payments on lease payments made out of Ireland combined to make this a very attractive
leasing location. Specifically double taxation agreement signed with Singapore in 2011 offers
a gateway for Far Eastern companies into Europe, especially airlines.
The centre of expertise created in the Republic is now facing a number of challenges:
the domestic market downturn and increased local taxes may cause expert workers to move
to other centres; the larger downturn in world economies may result in fewer air journeys
with the result in more repossessions of aircraft. Whilst in the past the US had supported
leasing companies setting up in Ireland especially through the American Jobs Creation act
of 2004 those jobs may well repatriate back to the US. Thus far, a number of leasing
companies that were subsidiaries of larger financial groups caught up in the financial turmoil
of 20102011 are being sold in an orderly manner without a major bankruptcy. The chal-
lenge Ireland faces is the relatively easy mobility of the cross boundary leasing market and
the retention of a profitable financial service in a recovering economy.
Japan
In the past, Japan had a very active leasing market, especially for large ticket items such
as aircraft. Since the mid 1990s, this has been largely confined to the Japanese operating
lease (JOL), with historic leveraged lease structures, such as Shogun leases disappearing. In
the early 2000s the tax rules changed and the operating lease has declined in importance
since then.
A JOL can be described as an operating lease with asset risk taken by the lessor, a
Japanese investor or provider of equity who then leverages the rest of the transaction but is
able to use the tax benefits associated with the depreciation of the aircraft. The overall lease
payments cannot exceed 90% of the acquisition costs of the asset by the lessor. A variant
form, the JOL with a call option has a fixed price purchase option.
The JOL arose from changes in Japanese tax rules relating to Japanese leveraged lease
investors and the ability to claim depreciation on cross-border deals, making these structures
less attractive. Airlines, the major users of Japanese leasing schemes, supported the JOL
structure because, as an operating lease, aircraft assets were off-balance sheet. Lessors could
still use and pass through tax benefits, so the pricing of the transaction was attractive. The
main changes in legislation that took place in 2005 required investors to both take an active
part in the transaction and take some exposure in the residual value of the aircraft in order
to optimise the tax benefits. This was a significant change to the more passive stance of
previous years and led to a number of investors leaving the market. It also effectively ruled
out bargain purchase agreements and full payout leases.
JOLs are 10- to 12-year transactions and relatively inflexible. Changes to the lease
provisions need to be ratified by groups of Japanese investors who need to be informed
and consulted about any alterations and given sufficient time to meet the requirements of
253

Project Financing
the investors and those of the airline. Investors earn fixed income during the lease with a
potential capital gain when the aircraft is disposed of at the end of the lease.
Under the 2007 tax reforms, some leases can be viewed as sales, if for example, one of
the following conditions would be met:
the ownership of the asset transfers to the lessee at the end of the lease for a nominal
amount;
the lessee has an option to buy at the end of the lease, for a bargain purchase price; or
the leased asset is configured specifically for the lessees business requirements.
Shoyuken iten gai or finance leases were also defined in the 2007 tax reform changes. These
are leases that are non-cancellable and where the lessee is liable for costs during the opera-
tion of the lease. In these circumstances, the lessee is treated as the buyer of the assets and
as such can claim depreciation. The end-of-lease purchase is often notional.
In general, Japanese leasing transactions have concentrated on well-known names, espe-
cially in the aircraft industry.
China
Financial leasing was first introduced in China in the mid 1980s and has recently expanded
to include big-ticket items (such as plant equipment including ships and airplanes) and the
leasing of cars for domestic use. Whilst the emphasis is on domestic leasing, cross-border
leasing has been expanding slowly. Transactions are subject to central government policies
on credit restrictions and the regulation of domestic banking activities overseas. Domestic
leasing laws have been incrementally enacted leading to some inconsistencies that the 2005
Measures and 2007 Measures, mentioned below, attempted to address.
There are two systems in use.
1 The China Banking Regulatory Commission system (CBRC): leasing companies adopt
a formal structure called a finance leasing company (FLC). The 2007 Measures allow
FLCs to engage in a wider range of activities than before but this means that they now
fall under the regulatory framework that covers financial institutions and are required to
hold a minimum capital of RMB 100 million.
2 The Ministry of Commerce system (MOFCOM): the MOFCOM introduced the 2005
Measures to allow foreign investors to invest in FLCs with a maximum 100% interest, but
in contrast with the CBRC system, organisations are not treated as financial institutions
and are only required to capitalise with $10 million. A second MOFCOM regime known
as the Trial Reform was implemented in 2004 to allow domestic non-financial institu-
tions to enter the leasing business with a minimum registered capital of RMB170million.
Many domestic PRC lessors use trusted relationships to structure awards for offshore
companies. Since domestic FLCs are not permitted to establish wholly-owned offshore leasing
companies without various government approvals, setting such an operation up can be straight-
forward only once the approvals including permission to inject capital into an offshore
254

operation and in the case of shareholder loans, the granting of a State Administration of
Foreign Exchange (SAFE) quota to cover the loans have been obtained.
Foreign assets may also be the subject of import licences and import tax on duties may
also apply. Foreign borrowing by domestic entities in order to leverage a lease will also
be subject to various government approvals. Withholding tax treatment of different leasing
payments has been the subject of some recent changes and requires up-to-date specialistadvice.
Financial and operating leases are now registered in an online system through the Credit
Reference Centre of the Peoples Bank of China and access to this information requires
registration as a member of the system.
Leasing is expected to be a growth area in China as the economy continues to expand.
Australia
Australia has developed a very sophisticated leasing activity that has used direct leases,
leveraged leases and cross-border leases. The Australian government has relaxed its defini-
tion of royalty payments to exclude equipment lease payments but the challenge to remain
competitive as other jurisdictions amend tax treaties and the continued use of withholding
tax is limiting cross-border leasing from Australia.
Africa
In Africa, domestic leasing is developing in many nations. South Africa has a well-developed
leasing industry including tax-oriented leasing.
Americas
In the Americas, Canada and Mexico have substantial leasing activities, including tax-oriented
leasing. Both Canada and Mexico have withholding tax on rents paid under US cross-border
leases. Money-over-money leasing is carried on throughout South America, particularly in
Brazil, Chile and Colombia.
Middle East
Islamic leasing in the Middle East has developed in recent years for leases in foreign countries
as well as in the Middle East. Islamic law forbids the receipt of interest for loans. This has
barred wealthy institutions and individuals in the Middle East from investment opportunities
such as lending syndicates. Certain leases are permitted under Islamic law (see also Chapter
11) so there is potentially a large pool of funds that may consider leasing transactions.
Islamic leasing is described in more detail below.
5 Islamic leases
One of the most interesting potential sources of capital is the Islamic lease. Briefly stated,
interest is prohibited under a strict interpretation of Islamic law. However, finance leases
are not prohibited.
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Project Financing
Under Islamic law, the Shariah is a codification of the rules set forth in the Quran, the
Holy Book as revealed to the Prophet Mohammed. The Shariah laws cover property rights,
contracts and work ethics as well as human rights and the role of the state. The concept of
private property, free enterprise and profits are accepted and permitted.
Islamic financial law prohibits Riba or interest. Fixed monetary return on capital not
associated with risk, labour or service is not permissible. Some Muslim scholars, also debate
whether Riba refers to interest or usury. Judaism and Christianity (both Old and New
Testaments) also prohibit Riba but the term was interpreted by enterprising religious scholars
as referring to usury and not interest. The practice of hiring or renting was prevalent in
Arabia before the advent of Islam, and was brought within the principles of Shariah from
the Prophets time. Rental contracts, or Ijara, as the rental contract is known, were used
for the hire of assets, labour and services. In recent years the Ijara transaction structure was
developed into a finance lease or Ijara wa Iktina.
The general requirements for an Islamic finance lease are as follows.
1 The lease must cover specific equipment.

2 The lessor owns the equipment during the lease term.
3 The lease is for a fixed term; the lessee has a right to uninterrupted use during the leaseterm.
4 In theory, the lessee does not have a purchase option. Residual risk can be passed to the
lessee by a separate contract. Also, the lessee can prepay to acquire the asset.
5 Generally insurance is provided by the lessor, but the lessee is responsible formaintenance.
6 The lease rate in theory must be fixed, but can contain rental rate adjustments that may
make the lease rate look like a floating rate.
The volume of Islamic leases domestically or on a cross-border basis is not large by US or

UK standards. However, some cross-border Islamic leases for large assets such as ships have
been quietly entered into by private investors. Because of the restrictions on earning interest
that prohibits Islamic investors from participating in loan syndications, Islamic leases have
the potential to become a significant source of funds.
Islamic finance is also covered in Chapter 11.
1
See, Nevitt, PK, and Fabozzi, FJ, Equipment Leasing , 4th edition, 2002, John Wiley & Sons.
2
See, for example: Naim, A, Leasing in developing countries: IFC experience and lessons learned, Access Finance
(23), the World Bank Group, June 2008; and Fletcher, M, Freeman, R, Sultanov, M, and Umarov, U, Leasing
in development: lessons from emerging economies, International Finance Corporation, Washington DC, 2005.
3
Euromoney publishes its World Leasing Yearbook which contains useful articles and descriptions of equipment
leasing laws and status in a great many countries.
256

Chapter 20
Financial models*
Most loan, franchise and concession agreements will require that project sponsors provide the
information generated from a financial model so that the investment properties of a project
can be understood. It is needed to ensure that the future cash flows are sufficient to repay
the debt obligations under the anticipated conditions, as well as other possible scenarios
including pessimistic ones. A well constructed model will provide the user with the ability
to undertake a wide variety of what-if analyses. The information generated from a model
is not only needed at the inception of a project but throughout the projects life. It must
continue to demonstrate the viability of the project to its stakeholders.
Models are usually developed by suitably qualified specialists using a spreadsheet. In
the early phases of a project, a model is normally developed by the sponsor as part of the
project proposal taken to providers of finance. During loan negotiations, the bank may take
over responsibility for the model or create its own model. This responsibility will typically
remain with the bank but will sometimes revert to the sponsor after the financial close-out.
This chapter provides an overview of the key elements of a spreadsheet model. It is impor-
tant for the modeller to understand the theory behind the model. An experienced modeller
will know when certain factors can be safely ignored. For instance, a model for a project with
only one currency may safely ignore any currency adjustments. However, if a second currency
is introduced and the exchange rate of the two currencies is expected to change over the
projects life, the modeller must understand how to add the necessary currencyadjustments.
1 Project finance versus public-private partnership financing models

Public-private partnerships (PPP) are a subset of project financing and discussed further in
Chapter 30. As such, from a modelling perspective, there are very few differences between
financial models for a project financing and a PPP financing. The main difference is that PPPs
usually have a revenue stream based on the projects availability whereas conventional project
financings usually have a revenue stream dependent on the product (or service) price and demand.
In addition, a project financing will often produce a product whereas a PPP often provides a
service. However, these are not hard and fast rules and there are project financings with capacity
and operating and maintenance payments and PPPs in which the investor takes a marketrisk.
2 Characteristics of a project finance/PPP model

A project finance/PPP financial model will typically have:
a functional currency;
usually two bank accounts (operating and escrow);
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Project Financing
a waterfall of accounts;
cash traps (restrictions on dividend policy);
cash sweeps (sinking funds and loan prepayments); and
loans.
3 Models in different phases of a project

Models are used in different phases of a project: planning, negotiating, and constructing
and operating phases.
In the early planning phase models are used to optimise the design configuration. It is
not necessary to include the financial components such as funding, taxation and accounting
in this phase of model formulation.
In the planning phase, the model needs to contain the project finance components such
as the accounting, the funding and the taxation calculations. The model should be developed
in such a way that the user sets the ratio of local to foreign costs and the model calculates
the periodic construction cost drawdowns in the different currencies. The user also sets the
initial debt to equity ratio and the model calculates the funding drawdowns (loans and equity).
During the negotiating phase, the model should be developed in such a way that the user
sets the construction draw downs and the software calculates the ratio of local to foreign
currencies. The user also sets the funding (loan and equity) drawdowns and the model
calculates the initial debt to equity ratios in each currency.
During the construction and operating phases, the model should be similar to the one
above, but the user introduces the actual accounting figures for past periods. The actual
figures are used for two purposes:
to calculate more accurate loan coverage ratios over the remaining periods starting with
an audited not an estimated position; and
to calculate more accurate key criteria such as the internal rate of return (IRR) and net
present value (NPV) with actual figures for the former periods and not estimated figures.
4 Model best practice

There are no internationally recognised standards for the development, layout and formulae
for use with project finance or PPP models. In the absence of such standards, the following
guidelines are often adopted:
separate inputs from calculations and results;

use only one unique formula in each row or column;
make it read like a book, from front to back, top to bottom and left to right;
use multiple worksheets so you can insert rows and columns into the model;
use each column for the same purpose throughout the model;
calculate in nominal terms and convert to real terms where necessary;
include basic charts of the cash flows so that you can see what effect your changes are
havinga picture is worth a thousand words;
258

Financial models*
no external links to other spreadsheets;

keep formulae simple;
use range names (but not excessively);
use styles;
include a documentation sheet to explain assumptions made;
no hard coded inputs in formulae;
make all calculations visible, do not hide any;
use the data validation routine to ensure that the user inserts figures between predetermined
limits;
make the model flexible;
make the model accurate;
avoid circular references;
minimise visual basic for applications (VBA) code;
include cross checks and a test module; and
include a single summary page with all key input and results.
5 Model flexibility
A well-designed model will contain the following basic input parameters which the user can
change by simply inserting a different input number or series of numbers:
start date;
construction schedule;
revenues;
production/availability;
operating costs;
project life;
accounting date;
exchange rates;
inflation rates; and
interest rates (in real terms).
A model designed for use in the planning phase will also have the following input parameters:
capacity;
capital cost;
ratio of foreign to local currency costs; and
initial debt to equity in the local and foreign currencies.
6 Modules within a model

Exhibit 20.1 illustrates a suggested layout for a model. The layout presented in the figure
has the advantage of separating the construction phase costs in the first module from the
259

Exhibit 20.1
Suggested Layout for a Model
Capital cost Project evaluation Project finance
The user supplies Design Market survey Funding

the basis for: Capital cost Operating costs Taxation
Construction schedule Working capital Accounting
The model Capital cost Project cash flows Loan schedules, taxes,
produces: Construction schedule Evaluation criteria Accounting statements
Draw down of funds For example, project IRR, Evaluation criteria
NPV, payback For example, equity IRR,
NPV, payback
Draw down Project analysis Financial (equity) analysis

120 100 200 200
110 90 150 150
100 100
80 100
90
70 50 50
80
Cash flows
Cash flows
Cash flows
70 60 0 0
60 50 50 50
50 40 100 100
40 30 150 150
30
20 200 200
20
10 10 250 250
0 0 300 300
Dec 11 Dec 12 Dec 13 Dec 14
2011
2015
2019
2023
2027
2031
2035
2039
2011
2015
2019
2023
2027
2031
2035
2039
Period ending
Years Years
Revenues Operating costs Equity Loan Debt service Tax
LC FC Capital cost Working capital Dividends Revenues Operating costs
Source: John Macgillivray

18/06/2012 07:50
Financial models*
operating phase costs in the second module. The second and third modules clearly separate
the project from the equity cash flows.
7 Functional currency
The functional currency is the currency in which the local legal and fiscal authorities will
accept the company accounts. It is usually the local currency but not necessarily the currency
in which the model displays the projections. The following entries on the balance sheet should
be carried forward from one year to the next in the functional currency:
assets;
un-depreciated assets;
equity and reserves; and
tax credits.
Some countries have a high local inflation rate resulting in a low recovery of the capital cost
over the life of the project (that is, the depreciation). This effect can produce higher taxa-
tion levels than would otherwise be the case. In order to compensate for this, governments
will sometimes allow a foreign currency to be used as the functional currency. This happens
occasionally in the oil and gas industry.
If the model displays the projections in a currency other than the functional currency it
must contain appropriate adjustments to the depreciation calculations. Otherwise the corpo-
rate tax calculations will be incorrect.
8 Inflation and exchange rates

When inflation rates in the country where the project is located are different from those
found in the countries of the various entities providing finance for the project, this can have
a significant effect on the future exchange rates of the various currencies. In such cases it is
necessary to predict and apply varying exchange rates over the life of the project. This can
be done by assuming a constant purchasing power parity between the currencies.
9 Currency adjustments
When an account (such as a loan, a bank account and a sinking fund) is held in a currency
that is not the same as the functional currency, the opening balance for any period is not
the same as the closing balance for the previous period because it has been converted at a
different exchange rate. It is therefore necessary to include a currency adjustment to account
for this.
The balance sheet should contain the accumulated currency adjustments during the
construction phase. Either the balance sheet or the profit and loss statements should account
for the currency adjustments during the operating phase.
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Project Financing
10 Interest rates
Interest rates can be found in many areas of a project finance model. The project pays out
interest on all loans and any preferred equity. It receives interest on the balance held in
bank accounts and sinking funds.
Interest rates may be fixed or variable meaning that they will increase as inflation
increases. The model should contain a proper linkage between interest rates and inflation
and it should use the Fisher equation to determine the nominal from the real interest rate:
i = (1+ r) (1 + p) 1
where
i = nominal interest rate
r = real interest rate
p = inflation rate
Interest rates are usually quoted on an annual basis but applied half yearly or more frequently.
They should be converted to a semi-annual rate (or other) with the following formula:
ie = [(1 + ia)1/n 1] n
Where the subscripts e and a denote the semi-annual and annual interest rates, respectively,
and n is the number of times the interest is paid per year.
In any particular period, the interest rates should be calculated on the basis of the
opening balance for loans and for sinking funds. The reason for this is that the changes to
the funds are made at the end of the (usually six month) period when the loan coverage
ratios are calculated.
In the case of the bank accounts, the interest earned is calculated on the basis of the
average of the opening and closing balance. This may pose problems with any escrow
accounts and generate circular references on a spreadsheet, which may require algebraic
solutions to overcome them.
11 Revenues
Revenues for a product sold on the open market will depend on the effective price for the
product and the size of the market. The effective price, more popularly referred to as the
netback price, is the amount received after deducting all the costs associated with delivering
one unit of a product to the marketplace. Such costs would include, for example, production
costs, transportation costs, importing costs and royalty fees.
In other cases, the revenue may be based on the sum of a capacity payment and an
operations and maintenance payment. The capacity payment is designed to recover the proj-
ects fixed cost plus a return to the investor. It may be payable over the life of the project
or concession or over a shorter defined period. The operations and maintenance payment is
designed to cover the periodic operating and maintenance costs including fuel price in the
case of a power plant. The capacity payment may or may not be index linked; the operation
and maintenance will inevitably be index linked.
262

Financial models*
12 Operating costs
Operating costs can conveniently be decomposed into fixed and variable costs. Fixed costs
are wholly or substantially constant regardless of the production rate or availability of the
project. Such costs include wages, maintenance, insurance and local taxes. Variable costs
are substantially and directly dependent on the production of the project and include items
such as feed, fuel, catalyst and chemical consumptions.
13 Working capital
Working capital is the capital needed on a day to day basis for the operation of a business.
It is defined as the difference between current assets and current liabilities.
Current assets are the entitys most liquid assets and defined as assets that can be turned
into cash in one operating cycle or one year, whichever is longer. Current assets include:
inventories including feed and/or fuel, product and spare parts;

operating cash usually expressed as a percentage of annual operating costs;
goods in process; and
accounts receivable for each of the products/markets.
Current liabilities are obligations due within one year or one operating cycle (whichever is
longer) and include:
accounts payable for each of the operating costs;

current portion of long-term indebtedness; and
short term bank loans.
It is important in modelling that the periodic calculations of the working capital and the
calculation for the initial working capital be included. These are the funds the project
company will need to bridge from start-up to receipt of a strong cash flow stream to meet
its obligations and grow. The periodic figures are used in the calculation of the projects
IRR, discussed below, and in the balance sheets. The initial working capital is used in the
calculation of the project funding and may be required in local and foreign currencies.
14 Discount rate
The calculation of a projects net present value requires the use of an appropriate discount
rate. There are various financial models that project how the appropriate discount rate for
the equity component should be calculated. The well-known capital asset pricing model
(CAPM) asserts that the discount rate for equity should be:
Equity discount rate = risk-free rate + beta equity risk premium
The risk-free rate is usually the yield on government debt for an equivalent period. A projects
beta is its systematic risk relative to the market and is typically estimated using regression
analysis. A beta of one means that, on average, the project has the same risk as themarket.
263

Project Financing
Although the CAPM has come under attack since its introduction in the 1960s, it is still
typically used in the analysis of capital projects. Holding aside the criticism of the CAPM on
theoretical grounds and the lack of empirical evidence, the implementation of the model is
not straightforward. Assumptions have to be made about the inputs: the risk-free rate, the
equity risk premium and beta. The CAPM provides little guidance as to what the risk-free
rate means. Typically it is a government bond rate but there is still the issue of the maturity
that should be used for the debt. Should it be a short-, intermediate- or long-term rate? The
equity risk premium is the subject of considerable debate in the finance literature. Empirical
evidence of the historical risk premium in the United States and the United Kingdom shows
considerable variation. Many practitioners today tend to use between 3% and 4%, although
structural changes in financial markets since 2008 are likely to alter this view.
Beta is another controversial input that must be estimated. Although it sounds simple to
estimate a companys beta using historical price data, the application to projects of the type
discussed in this book or even corporate capital projects is not simple. It involves identifying
a publicly traded company that is substantially in the same industry and using the beta of
that company as a starting point. The beta must be adjusted for differences in financial
structures; more specifically differences in leverage.1 To adjust for this, some companies
calculate project betas for their internal investment portfolios rather than using market betas
which, as we have said, may belong to diversified companies with a different product mix
and thereby reflect betas that might not be good analogies. An example might be a large
integrated oil company looking at a new exploration project. Market betas may be available
for other integrated companies or for smaller exploration companies. The former may have
a different business mix while the latter may have a share price driven by considerations
other than oil exploration. In this instance, an examination of the companys own portfolio
might be considered to generate a better beta for evaluating future investments.
15 Weighted average cost of debt

The weighted average cost of debt (WACD) is used in the calculation of the loan and project
life coverage ratios and as a component in the calculation of the weighted average cost of
capital. The loan documentation will usually define the method of calculating the WACD. In
the absence of a definition, sum the weighted interest for each loan to produce the weighted
average cost of debt.
16 Weighted average cost of capital

The discount rate for the calculation of the equity NPV with a mix of equity and loans is
calculated as the weighted average of capital (WACC). The formula for the WACC is:
WACC = d WACD (1 corporate tax rate) + (1 d) equity discount rate
Where d is the percentage of debt at the start of the operating phase. The corporate tax rate
is the marginal tax rate faced by the sponsor. The calculation assumes that the sponsor is
in a tax regime where interest payments are tax deductible.
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Financial models*
17 Key project selection criteria

The key approaches typically used for project evaluation and selection and their advantages
and disadvantages are summarised in Exhibit 20.2.2
Exhibit 20.2
Key project selection criteria
Criterion Advantages Disadvantages
Net present value (NPV) Takes into account the time Can produce different results and thence
value of money different selection decisions dependent on
discount rate used
Internal rate of return (IRR) Takes into account the time 1Can lead to incorrect decisions with
value of money mutually exclusive investments
2More than one IRR can result when a
project has cash flows when there is more
than one change in sign such as a project
with projected negative cash flows at the
end of a projects life
3Assumes cash flows can be reinvested at
the computed IRR
Modified internal rate of 1Takes into account the time Can lead to incorrect decisions with mutually
return (MIRR) value of money exclusive investments
2Allows for the incorporation of
reinvestment rates for interim
positive cash flows
Payback Simple concept easy to calculate 1Does not take into account the time value
of money
2Ignores cash flows beyond the payback date
Profitability index (PI) Takes into account the time 1Can lead to incorrect decisions with
also called the value to value of money mutually exclusive investments
investment ratio (VIR) and 2Can produce different results and thence
benefit cost ratio (BCR) different selection decisions dependent on
discount rate used
Source: John Macgillivray
18 Controlling the project during its life span

The key criteria described above are applied to the debt and the equity cash flows at the
initial decision phase. As the project progresses, however, the various stakeholders use
ratios to ensure it remains in a healthy state. These were discussed in Chapter 8. Lending
institutions usually measure the ability of borrowers to satisfy the contractual payments by
calculating coverage ratios for a given period (usually calculated annually or semi-annually)
each one defined as:
265

Project Financing
Net operating revenue

Coverage ratio =
Value associated with the loan
In a debt service coverage ratio (DSCR), the denominator is the loan amount outstanding at the
end of the period. In an interest cover ratio, the denominator is the interest paid during theperiod.
A coverage ratio may be expressed for the prior period, the last two (or more) periods,
the next period or the next two (or more) periods. The model may also need to calculate
the average debt service coverage ratio (ADSCR) and the minimum for all future periods.
A loan life coverage ratio is calculated similarly for each period. In this case, the numer-
ator is the NPV for the future net operating revenues over either the remaining life of the
loans (the loan life coverage ratio) or over the remaining life of the project (the project life
coverage ratio). The loan agreement may allow the balances in the escrow account and the
debt service reserve account to be added to the numerator.
The loan agreement will have one or more financial covenants which refer to the coverage
ratios. Some of these covenants will impose restrictions on the payment of dividends (cash
traps). Other covenants will divert funds into reserve accounts (cash sweeps) and sometimes
trigger the mandatory payment of senior loans. The wording for these covenants is critical
and must be modelled accordingly. Some can be readily modelled in a spreadsheet, others
are difficult and can produce circular references.
19 Funding
The model should take account of the anticipated loan drawdown and repayment schedules
for the project loans or other financing mechanism described elsewhere in this book.
20 Taxation
There are numerous levels of tax which local, state and federal authorities can impose on a
project company. Some are based on property values, others on income (profit) and others
on interest and dividends.
In profit-based taxes regimes, capital allowances can vary from one tax authority to another.
Each tax authority will have its own basis for calculating profits and some may allow inflation
for the un-depreciated portion of the capital cost. Some tax authorities may allow the company
to carry forward tax losses for a limited number of years; others may allow a similar carryback.
Project finance and PPP projects can be subject to one or more of the following bases.
Bonuses (oil and gas).

Royalties (mineral extraction, oil and gas).
Production sharing or concession agreement tax such as a petroleum revenue tax (PRT)
(oil and gas).
Local taxes.
Import duties.
Sales tax (for example, value added tax (VAT)).
Interest withholding.
266

Financial models*
Corporate tax.
Dividend withholding.
Environments tax such as carbon tax or an emissions cap-and-trade.
Sales taxes are usually recoverable from the government but there may be a delay, in some
countries this may take more than six months. This delay can cause a funding problem and
needs to be taken into account in the model.
21 Sinking funds
The project may contain one or more of the following sinking fund requirements in its
financing arrangement which should be included in the model.
Debt service reserve account: used to pay the debt service on certain specified loans when
the cash flow is too low.
Major maintenance account: used, for example, in the dry docking of ships and the
resurfacing of a toll road.
Abandonment account: used at the end of the project life, for example, in the
decommissioning of offshore platforms.
Additional investment account: for example, used to add an additional lane on a toll road
when the level of service falls below a specified amount.
Preference shares: used to pay dividends to preference shareholders when there are
insufficient funds from the current cash flow to do so.
Note that the target amount for the debt service reserve account is usually based on the debt
service for the next one or more operating periods. It should take account of the reduced
debt service resulting from loan prepayments and any extended debt service period resulting
from cash shortfalls.
22 Bank accounts
There are usually two types of bank accounts.
Operating Accounts: an account for making payments for day to day operating costs. It
is usually located onshore and denominated in the local currency.
Escrow Accounts: an account for disbursing loan repayments, payments to and from sinking
funds, dividends. The order is set in the waterfall of accounts. Sometimes escrow accounts
may be located offshore to the project and may be denominated in a foreign currency, that
is, one different from the local currency of the country in which the project is located.
23 Waterfall of accounts
The waterfall of accounts is also known as the cash waterfall or the cash cascade and
examples are shown in Exhibits 20.3, 20.4 and 20.5.
267

Project Financing
The project cash flows are paid into an escrow account from which they are distributed
to a current account for day to day operations of the project including the working capital
and for tax payments. Surplus funds are distributed to make payments on senior commercial
loans, mezzanine loans, standby loans, sinking funds and dividends, usually in that order.
There may be a loan prepayment provision which can occur before or after any dividends
are paid to shareholders. If the prepayment occurs after the dividends, the loans will only
be prepaid when cash traps limit the dividend payment and allow funds to reach this last
item in the waterfall. Loan interest is paid before loan principal.
A shortfall of funds may be made good initially by the funds in any debt service reserve
account. Any further funds may come from one or more of the following sources:
additional equity;
additional loans say from a standby loan;
credit from a feed/fuel supplier;
additional equity;
additional loans say from a standby loan; and
credit from a feed/fuel supplier.
24 Additional equity
In a non-recourse project finance the sponsors do not provide any guarantees to the lenders.
In a limited recourse project finance, the sponsors will provide some level of support when
there is a cash shortfall. The following are some examples.
Dividend clawback: the sponsors make up any deficiency up to a limit set by the amount
of dividends already paid.
Interest guarantee: the sponsors make up any deficiency in the interest payable on the
senior loan(s).
Cash deficiency guarantee: the sponsors make up any deficiency in the debt service payable
on the senior loan(s).
Note that for modelling purposes there must always be a source of funds even in very difficult
economic scenarios. Something has to give way in the model. There cannot be a negative balance
in a bank account. The loan agreement may specify the form of support, for instance, an equity
guarantee such as an equity clawback. If the loan agreement does not specify the source of addi-
tional funds, the model should typically contain a hypothetical standby loan facility. The question
then arises about the position in the waterfall where the additional funds are injected. Operating
costs and working capital should always be funded. Sometimes a major maintenance fund is
included and at others the interest and principal on senior commercial loan(s). It is important
that the model addresses this issue and the developer records the reasoning for the choicemade.
In a non-recourse project finance there is no sponsor guarantee and no equity top up.
All loans are usually in the waterfall of accounts. See Exhibit 20.3.
In a limited-recourse project finance, there will be some sponsor support and additional
equity injection if there is a shortage of funds during the operating phase. If the sponsors
268

Exhibit 20.3
Waterfall of accounts for a typical non-recourseloan
Revenues
Deposit account
Current account
Operating costs
Working capital
Tax
Tax outstanding
F C Loan: interest paid

F C Loan: principal
L C Loan: interest paid
L C Loan: principal
Export Credit: interest paid
Export Credit: principal
Standby Loan: interest paid
Standby Loan: principal
Major maintenance fund
Debt service reserve account
Dividends
Prepayment
Source: Promoter Software Ltd

Exhibit 20.4
Waterfall of accounts for a typical limited-recourse loan
Revenues
Deposit account
Current account
Operating costs
Working capital
Tax
Tax outstanding

F C Loan: principal
L C Loan: principal
Dividends
Prepayment
Equity

Exhibit 20.5
Waterfall of accounts where the reserve account is above the main waterfall
Revenues
Deposit account
Current account
Operating costs
Working capital
Tax
Tax outstanding

F C Loan: principal
L C Loan: principal
Dividends
Prepayment
Equity

Project Financing
provide an interest guarantee, for instance, one or more of the loans will have an assured source
for its interest payment and it will appear above the waterfall of accounts. See Exhibit 20.4.
Debt service reserve accounts are usually located in the waterfall, but some sinking funds
such as a major maintenance fund may be located with the operating costs and has to reach
its target regardless of the available funds. See Exhibit 20.5.
There are many variations on the cash flow diagrams presented in Exhibits 20.3, 20.4
and 20.5. It is important to understand the intended flow of cash in any project financing and
the modeller should have a clear idea of the diagram as applied to the project beingstudied.
When modelling a project, it is often said that the key calculation is the one for the cash
flow available for debt service (CFADS). This is usually true for non-recourse project financ-
ings. But some projects have one or more loans and/or sinking funds above the waterfall
of accounts and always payable as for the operating costs. This would be the case with a
limited recourse project. A more accurate statement would define the key calculation as the
cash flow available for the waterfall of accounts (CFAWAC). In Exhibit 20.3 the CFADS
and CFAWAC are the same and coincide. In Exhibits 20.4 and 20.5 they differ anddiverge.
25 Dividend cash trap

There are usually covenants in the loan documentation which restrict the payment of dividends
dependent upon certain criteria. The criteria are typically calculated based on the accounting
statements or loan projections. They effectively dictate the dividend policy.
In a given project there may be one or more cash traps set up so that dividends (which
are outflows of funds from the project) may only be payable once these targets are met.
The following are examples:
the debt to equity ratio (no payment of dividends when the debt to equity ratio is above
a certain figure);
the loan coverage ratio (either a periodic or a life coverage ratio, for instance no payment
of dividends when the DSCR projected for the next two periods is below a certain level
and the historical DSCR for the previous two periods is below another level);
the proportion or amount of cash available for dividend payment (for instance, only 50%
of payments in the first two years of commercial operation); and
the legal requirement in some jurisdictions that the dividends may only be paid out ofprofits.
26 Loan prepayment
Loan prepayment is a cash sweep for senior loans. However, not all loans permit prepay-
ments or there may be a specified period of time during which prepayments may not be
permitted (that is, a lockout period). These conditions allow the debt finance providers to
receive some certainty about their returns rather take all the upfront risk, but be refinanced
out at the earliest available opportunity.
A prepayment may be specified:
at the end of the waterfall when a cash trap prevents payment of dividends;
272

Financial models*
in the waterfall before the dividend payment if a coverage ratio is either below a low
level (in which case all cash available is diverted to prepayment) or above a high level
(in which case the excess cash is shared with the dividends); or
at the start of the waterfall when the project is in default (say a coverage ratio is below
a certain level) and all available cash flows are diverted to prepayment.
Prepayment of part of a loan will have an effect on the remaining payments. The calcula-
tions are done using one of the following methods:
order of maturity: the loan repayments for the next period(s) are affected;
inverse order of maturity: the loan repayments for the last period(s) are affected; or
pro rata: the reduction is spread through the remaining periods.
27 Loan repayments
If the repayment of the loan interest and principal are above the waterfall of accounts, then
the model would normally make provision for the following line entries:
interest rate;
opening balance;
loan drawdown;
repayment;
closing balance;
currency adjustment (if there are loans in currencies other than the functional currency);
interest paid; and
fees.
If there is a prepayment, there will be an entry for it. The balances, repayments, interest paid
and currency adjustments must be calculated taking into account the effect of theprepayment.
If the repayment of the loan principal is within the waterfall of accounts, then the model
would normally make provision for the following additional line entries to cover the case
where there is a shortfall of funds: principal brought forward, repayment due, repayment
made and principal carried forward to next period.
If the interest on the loan is within the waterfall of accounts, then the model would normally
make provision for the following additional line entries to cover the case where there is a shortfall of
funds: interest brought forward, interest due, interest paid, interest carried forward to nextperiod.
28 The accounting statements

The International Financial Reporting Standards (IFRS) allows companies to present their main
accounting statements in more than one format. For instance, the balance sheet may be presented by
classification, by order of assets or by net assets. Similarly, the funds statements may use the direct
method or indirect method for determining the cash flows and may just show the sources and uses of
funds or break them down into funds generated from operations, from investing and fromfinancing.
273

Project Financing
It is considered good practice to include the balance sheet in a model because it acts as
a check on the model and because some balance sheet ratios may be used in the calculation
of the cash traps.
29 Break-even analyses
The model may be used for carrying out a variety of break even calculations predicted for
each period over the operating life of the project. These can be carried out on the price and
capacity (the latter needs a VBA routine in Excel). The following two break-even values are
usually calculated:
Profit = operating costs + depreciation + interest paid
Cash = operating costs + debt service
30 Foreign exchange savings

Despite the fact that a project may sometimes prove to have marginal economics, the host
government may be interested in encouraging it because it produces a significant net inflow
of foreign exchange. The model should calculate this inflow on a periodic basis through the
life of the project by:
adding the following components inflows into and/or savings in outflows out of the country:
construction phase:
foreign loan drawdown; and
foreign equity inflow;
operating phase:
earnings from exporting the product;

subtracting the following outflows:
construction phase:
import of equipment and materials;

operating phase:
import of catalysts, chemicals, feedstock materials;

foreign loan debt service; and
dividends paid to foreign shareholders.
In practice, there are other indirect effects. Consider, for example, the case where the project
uses equipment and materials purchased locally from dealers who themselves import theitems.
31 Scenario analysis
There are many occasions when the user wants to carry out a what if analysis by varying
several inputs at a time and preserving the input and results as a separate case or scenario.
Typical examples are:
planning phase: different project capacities and configurations;
274

Financial models*
negotiating phase: different bids from competing contractors and financiers;

construction phase: a budget case set at the start of construction; and
operating phase: a high and a low case for different product prices, demands and
utilisation factors.
In a spreadsheet this can be accomplished by:
inserting a hook into each important variable in the main input sheets so that the model
uses the figure for the selected scenario rather than the figure for the base case; and
inserting a scenario worksheet in which the user can set the various scenarios and choose
the case from a drop down box.
Exhibit 20.6
Sensitivity analysis: sample spider diagram
30
28
Internal rate of return nominal terms: percent
26
24
22
20
18
16
14
12
10
8
6
4
2
0
70 80 90 100 110 120
Percent base case
Capital cost Operating costs Production

Schedule Product price
275

Project Financing
32 Sensitivity analyses
In a sensitivity analysis, a simple automated routine can be used to change one input at
a time. It then recalculates the model and records the results. At the end of the routine it
produces a spider diagram, an example of which is shown in Exhibit 20.6.
Although a sensitivity analysis is easy to perform, it has the following shortcomings.
It fails to take into account the probability of the occurrence of the event. For example,
sensitivity analysis may indicate that the projects NPV will drop below zero if the capital
cost increases by 25%; however, it offers no insight into the probability that this event
will occur.
It ignores the correlations or interactions among the variables in the analysis. For example,
the effect of a longer construction schedule on the viability of the project can be assessed
in isolation but a longer construction schedule is also likely to adversely impact the
construction costs which, in turn, will have a separate effect on the viability.
The practice of varying the values of sensitive variables by standard percentages does
not necessarily bear any relation to the observed or likely variability of the underlying
variables. For example, although using plus or minus 30% as the extreme limits for the
production rate may be realistic it does not necessarily make sense to do so for the price
of the product, if the product is, for instance, crude oil, in the last year of the analysis.
33 Risk analysis
Developers of major projects regularly carry out a risk analysis of the estimated project costs
and schedule. The exercise follows an onerous procedure in which experts in different fields
assess the risks. The results of this exercise are recorded in a series of risk registers and
are used as input to a Monte Carlo simulation analysis in a schedule package.3 The Monte
Carlo analysis produces a histogram showing the number of occurrences on the vertical axis
against the schedule range on the horizontal axis.
Similar analyses can be done with a financial model. The deterministic model as described
in this chapter is converted to a stochastic model after a review of the upper and lower limits
on all inputs. Once they have been selected, a routine inserts random numbers chosen to lie
between these limits and the model is recalculated. This is repeated several thousand times.
The model keeps a record of the results for each calculation. At the conclusion it prepares
a series of histograms for all results including the equity NPV, IRR and the maximum addi-
tional funds needed during the operating phase and calculates selected confidence limits as
shown in the example in Exhibit 20.7.
34 Tornado diagrams
A tornado diagram displays the impact on a selected result when changing a single key
parameter first with a low limit and then with a high limit. These limits are typically the
same as those figures contained in the inputs for the Monte Carlo analyses.
The tornado diagram displays the results in a sequential order, with the variable having
the largest impact shown at the top of the diagram, as shown in Exhibit 20.8. The order
276

Financial models*
Exhibit 20.7
Sample histograms for equity IRR in constant terms
170
100
160
150 90
140
130 80
Number of occurrences
120
70
110
Cumulative
100 60
90
80 50
70 40
60
50 30
40
30 20
20 10
10
0 0
8.0 2.0 4.0 10.0 16.0 22.0 28.0
Percent
Number of occurences
Cumulative
of the variables may also change depending on which of the project selection approaches
shown in Exhibit 20.2 is used. So, for instance, the variable order shown for the IRRs may
be different from the variable order for the NPVs.
While a tornado diagram can be more informative than a spider diagram generated by
employing sensitivity analysis, it is more time consuming to develop properly.
35 Cross checks
The model should have a worksheet devoted to a series of cross checks which help to ensure
the models integrity. For instance, it should contain a function to check that the balance
sheets balance and a function to verify that the ending cash on the cash flows statement
equals the sum of the balances for the escrow account and the sinking funds. Moreover,
there should be functions to check that table subtotals throughout the model add up both
horizontally and vertically to the same total number.
277

Project Financing
Exhibit 20.8
Example of a tornado diagram for an ammonia-urea plant
Capital cost
Product price: urea, bagged
Product price: ammonia
Project life
Schedule
Product price: urea, bulk
Demand: urea, bagged
Demand: urea, bulk
Demand: ammonia
Inflation: Utopia
Inflation: US
Production: granular urea plant
Production: ammonia plant
Inflation: Japan
Production: bagging plant
Cost: natural gas
Inflation: UK
7 5 3 1 1 3 5 7 9
Equity IRR constant terms: percent
36 Testing the model

The model should contain a VBA procedure for carrying out a series of automatic tests if
written in Excel, or the equivalent procedure for other packages. The tests insert a series
of numbers into the following main input parameters, calculate the model and check to see
whether the cross check results described above are correct.
Construction period.
Project life.
Accounting period.
Factors such as the capital cost, operating costs, capacity payments and availability.
There are third-party tools to audit models. As a first step, however, the modeller should
use the automatic tests described above. In addition to these tests, banks may require a third
party to audit the model.
278

Financial models*
37 Modellers review of the legal documentatio

The loan agreement will contain important information for modelling the project, so it is
vital that the modeller review the lenders documentation before it is finalised. The modeller
(and legal consultants) should look out for the following.
The functional currency if there is more than one currency.

The waterfall of accounts and how any major shortfall in cash will be made good (standby
loan, equity support). If there is a standby loan or equity support, at what point in the
waterfall does it support the shortfall?
If there is an interest guarantee from the shareholders (or debt service guarantee), to
which loan(s) does it apply?
How is the target for the debt service reserve account adjusted for prepayments? (A lender
may feel that the original targets should remain, but the borrower may feel that as the
project progresses successfully, the reduction in loan balance warrants a reduction in the
target figure.)
How are currency adjustments to be handled during the operating phase, through the
profit and loss account or through the balance sheet?
38 Version control
Model files are typically used by a variety of different people all of whom may be interested
in making changes to the input. Files change hands and may be modified by different people.
It is important to keep track of the changes and to ensure that there is a single master model
and that this file is readily identifiable.
39 Audit trails
Comprehensive models for large and complex projects need to take their input data from a
variety of sources in different fields. They may need information from technical specialists,
market analysts, cost estimators, financiers and taxation specialists. Some of the inputs may
come from in-house sources, while others from reports produced by outside consultants.
It is invariably necessary to keep track of who entered or updated the basis for the
model and when that individual made the change. In addition, it may be appropriate for the
user to record some explanatory notes, perhaps on the source of the information.
40 Complex models
Some projects will contain more than one party for whom the model should calculate a set
of cash flows.
Multiple countries
Some projects will contain elements which are located in more than one country. This is
the case with, for instance:
279

Project Financing
a liquefied natural gas project consisting of the gas development, the liquefied natural gas
plant, the shipping and one or more unloading terminals;
an international cable telecommunication company with one or more landing stations
in different countries. The company owning the cable in international waters may be
registered in a third country with a favourable tax regime;
an international pipeline project; or
a rail or road bridge or tunnel linking two countries.
In these cases there will usually be a special purpose vehicle in each of the countries, each
with its own revenues, costs and accounting statements. Typically, a single model which
incorporates the accounts for each company in separate worksheets is produced, but of
course, this adds complexity to the model.
Multiple points of view

Some projects should be viewed from more than one perspective. This is the case, for
instance, with:
a lease agreement where the lessor invests in and the lessee operates the project; or
a service agreement for an oil and gas development. The international oil company invests
in the project and operates it for a unit fee, say, $10 per barrel produced.
In these cases, one party invests in the project and the other pays rent to utilise the project
over all or part of the projects life. The revenues for the investing party are the operating
costs for the other party. The model should illustrate the cash flow for both parties and
determine the NPV and other key criteria for each.
41 Using VBA
It is common for users and auditors of project finance and PPP models to specify that the
model should not contain any VBA code. The reason for this requirement is that the code
is more difficult to audit than the formulae within the spreadsheet cells. However, there are
occasions when some code is necessary as outlined below.
User defined functions

Microsoft Excel contains an IRR function in which the formula assumes that all cash
flows are received on an annual basis. It also contains a function named xIRR that
calculates the IRR whenever the intervals between cash flows are not yearly. Excel contains
an MIRR function for the modified IRR in which the user specifies a reinvestment rate.
This function assumes that all cash flows are on a yearly basis. However, Excel does not
contain an equivalent xMIRR function for cash flows received more than one time per
year. The user can overcome this limitation by creating the function as a User Defined
Function with VBA.
280

Financial models*
Test code
As explained earlier in this chapter, the modeller will find it useful to develop a simple VBA
procedure to test the model. This test procedure should be used whenever the modeller makes
any significant changes to the model.
Analyses
Sensitivity, capacity break even, Monte Carlo analyses and tornado diagrams can all be
generated readily with relatively simple VBA code.
Iterative calculations
There are a number of occasions when the formulae in a spreadsheet produce circular refer-
ences (for example, those mentioned earlier in this chapter under Interest rates). These may
be overcome by VBA code or by setting the iteration option in the calculation settings to
overcome the circular reference. The latter solution is not recommended because it obscures
additional circular references which the developer could inadvertently introduce. The following
formulae frequently produce circular references:
setting a desired ratio of local to foreign currency costs (in a planning phase model);
setting a desired initial debt to equity ratio when there is more than one country and the
inflation rates in each differ (in a planning phase model); and
calculating dividend payments when these are restricted by debt service cover ratios to be
calculated for future periods.
42 Alternatives to spreadsheets
Modellers that do not want to develop a model using a spreadsheet in the manner described
in this chapter can use specific software that is available to produce models in a wide variety
of industries.
* This chapter is contributed by John Macgillivray, Managing Director of Project Planning

and Management Ltd.
1
For a more detailed explanation of how this is done, see Chapter 16 in Fabozzi, FJ, Peterson, PP, and Polimeni,
R, The Complete CFO Handbook: from accounting to accountability, 2008, John Wiley & Sons.
2
For a more detailed discussion of each of these criteria and their advantage and disadvantages, see Chapter 13
in Fabozzi, FJ, and Peterson, PP, Financial Management and Analysis, 2003, John Wiley & Sons.
3
For a discussion of Monte Carlo simulation and software available, see Pachamanova, DA, and Fabozzi, FJ,
Simulation and Optimization Modeling in Finance, 2010, John Wiley & Sons.
281

Chapter 21
Financial modelling for different industries*
It is useful to examine the characteristics of projects in different industries and to highlight

the key features which affect the cash flows and the financial model. Consequently, in this
chapter we describe a number of industries that are often the subject of project financings
and public private partnerships (PPPs). The description is followed by a list of characteristics
which set each industry apart from other industries.
1 Oil and gas development projects

Oil and gas development (as opposed to exploration) projects consist of wells and equipment
plus one or more of the following: platform, pipeline and terminal. Such projects:
are technically complex, particularly if the project is offshore;

contain significant amounts of equipment and material which may need to be imported;
produce oil and gas products which are sold on the open market;
have a production profile which usually increases rapidly and then declines gradually as
the reservoir is depleted;
earn foreign exchange generated from the sale of the product in international markets;
are subject to complex taxation calculations (bonuses, royalties and production sharing
or petroleum tax in a concession); and
have higher rates of return than projects in other industries. Each development project has
to cover the cost of other unsuccessful exploration projects which might outnumber them
by 10 to one. The costs of these exploration programs are sunk and are not included in
the investment decision (though they may be included in taxation calculations).
Typical project cash flows are illustrated in Exhibit 21.1. The revenues will typically be held
at a plateau level for several years as determined by the capacity of the processing equipment
and pipelines. It may increase in the early years if the project is commissioned before all the
wells are drilled. This is often a decision favoured by financiers because the cost of many
of the wells can be funded from the early cash flows. The operating costs will typically be
much smaller than the revenues. The installation must typically be decommissioned at the
end of the fields economic life.
There is some further discussion on specific oil and gas project financing in Chapter28.
2 Downstream petrochemical
Downstream petrochemical applies to ethylene and benzene, toluene, xylene (BTX) based
petrochemicals, methanol, nitrogen based petrochemicals (ammonia and urea), other fertilisers
282

Exhibit 21.1
Typical cash flows for oil and gas development projects
Revenues Operating costs Capital cost Working capital
(for example, phosphates), pulp and paper, gas processing (for example, liquefied natural
gas plants and liquefied petroleum gas plants), metallurgical and a broad range of industrial
plant. Such projects:
are technically complex but the designs are usually well proven. New technologies will
have difficulty finding suitable insurance cover and funding;
may contain a sequence of plants each one producing a product which is used as a
feedstock for the next plant on the same site. Some of the product may also be sold. This
design complexity can complicate the model;
contain significant equipment and material which may need to be imported;
produce products usually sold on the open market;
some product prices may follow a cyclical pattern, for instance, in the pulp and paper
industry;
283

Project Financing
have a production profile which usually increases rapidly to the design capacity where it
stays for the duration of the project;
have an annual maintenance shutdown which will reduce revenues and variable operating
costs for about a month; and
are subject to straightforward taxation calculations.
Typical project cash flows are illustrated in Exhibit 21.2. The revenues are essentially constant
in real terms over the projects life. However, two competing effects will result in a pattern
that differs from that shown in the exhibit. If the local and more profitable market is
expanding in size, then the revenues will increase over time. However, if the commodity
price is declining, then the revenues will decrease. In practice, both effects play a part in
altering the pattern.
The first two or three years of a downstream petrochemical project will typically show a
utilisation below the ultimate figure, as managers and operators become more familiar with
and better able to operate the plant. At the end of the projects life, the plant may be sold
for scrap, thereby providing additional cash flow for the project.
Exhibit 21.2
Typical cash flows for downstream petrochemical projects
284

3 Oil refineries
This category includes both crude oil and condensate refineries. Such projects:
are technically complex but the designs are usually well proven;
produce large volumes of the product;
produce products which are sold on the open market (crude oil is sometimes processed
on a toll basis);
generate small profit margins;
have annual maintenance shutdown which will reduce revenues and variable operating
costs for about a month; and
Typical project cash flows are illustrated in Exhibit 21.3. The cash flows are similar to a
downstream project but the costs and revenues dwarf the amount of the capital investment.
The working capital is a significant part of the initial investment.
It is often more instructive to view the marginal rather than the full cash flows. The
marginal cash flows are the full cash flows reduced by the cost of the crude oil feedstock.
In view of the small margins and technical complexity of a refinery, it is important that
the design basis for the model is determined by specialists who set the optimum cut points,
yields, feed and product densities, capital and operating costs. These results are then used
as inputs into the financial model.
4 Pipelines
Pipelines include any project in which gases or liquids are transported by pipeline. It usually
applies to oil and gas pipelines, both onshore and offshore and to multi-product pipelines
onshore. It sometimes applies to water projects. The project typically consists of the pipeline
(usually buried underground if onshore), the pumping (or compressing) facilities, any storage
facilities and the supervisory control and data acquisition system. Such projects:
are technically simple (unless in deep water or in high mountains or a multi-product

pipeline with multiple product tanks);
contain some equipment and material which may need to be imported;
earn their revenues from a throughput agreement with a take-or-pay clause;
have their tariffs negotiated with escalation and indexation clauses and split into capacity
(fixed) and operating (variable) elements;
sometimes take title to the product and sells it at the other end;
do not usually earn foreign exchange unless it is a cross border pipeline; and
Typical projects cash flows are illustrated in Exhibit 21.4. The revenues are typically constant
over the projects life unless the pipeline is transporting the products from an oil or gas field
285

Project Financing
Exhibit 21.3
Typical cash flows for oil refinery projects
in which case the profile will be the same as the profile for the field. The operating costs
are minimal with variable costs mainly composed of the pumping (or compressing) costs.
5 Railways
Railways include light railways, metro/underground, commuter, fast inter-city railways and
freight rails and may be PPP projects. A typical railway project will consist of the trains
only, the track only or both. Such projects:
are technically simple, although signalling and scheduling can be complex;

may contain rolling stock which needs to be imported;
usually supply a captive market;
do not usually generate foreign exchange;
are subject to straightforward taxation calculations;
286

Exhibit 21.4
Typical cash flows for a pipeline
produce a passenger/freight volume which usually increases gradually to the design capacity
where it stays for the projects duration unless further investments are made in rolling
stock; and
are often based on a concession.
Typical railway project cash flows are illustrated in Exhibit 21.5.
6 Toll roads
Highway toll roads, bridges and tunnels are included in the industry category referred to as
toll roads and may form part of a PPP. A toll road may include service areas which will
generate additional revenues. Such projects, often operating under concession structures:
are technically simple but may become a little more complex if the terrain is difficult (for
example, bridges and tunnels);
287

Project Financing
Exhibit 21.5
Typical cash flows for railway projects
have a capital cost that is very dependent on terrain and rights of way, and can be
difficult to predict;
contain little equipment and material which may need to be imported;
need a reasonably high volume of traffic to make them economically viable;
have traffic forecasts which are difficult to predict;
serve a market which is price elastic. The usage will depend on the toll rate and the model
should include a formula for the usage which contains an elasticity factor;
are subject to road resurfacing and/or additional lanes which may be required during the
life of the project/concession;
contain revenues which usually come from tolls paid by road users but can be from the
government based on availability or a combination of the two;
have varying degrees of government support. Sometimes the government will pay the
concessionaire capacity and operations and maintenance costs. At other times the
concessionaire will pay the government;
288

may be partially funding by a section of the highway which is opened to the public before
the entire project is completed; and
contain straightforward taxation calculations.
Typical project cash flows for toll road projects are illustrated in Exhibit 21.6. The revenues
typically increase over the life of the project. They may reach a plateau if the demand exceeds
the design capacity. There may be a stepwise increase in the revenues as the projects operator
increases the tolls. The operating and maintenance costs are usually a small fraction of the
revenues. There will be significant additional costs due to:
resurfacing at intervals which depend on the type of usage (typically 15 to 30 years); and
expansion for the addition of extra lanes in order to ensure a specified level of service.
The interval will depend on the rate at which usage increases.
A highway is usually designed for a specified level of service (LOS). If the demand is expected
to increase with time, the model should estimate the date when an additional lane is needed
Exhibit 21.6
Typical cash flows for toll road projects
289

Project Financing
to ensure that the specified LOS is maintained. In order to do this, the model needs to
contain the formulae to generate the speed flow curve with LOS criteria (see Exhibit 21.7).
The model should then be able to produce a chart illustrating the vehicle density over time
as shown in Exhibit 21.8 and the predicted dates when the operator must invest in additional
lanes. The information will also be used to calculate the required target for the sinking fund
to handle this major additional investment.
7 Telecommunication submarine cables

This category includes domestic and international telecommunication cables and one or more
landing stations. The telecommunication cable industry is a rapidly evolving industry with
many technical changes. Such projects:
are technically complex;
Exhibit 21.7
Speed-flow curves with level of service criteria in a toll-road project
130
120
110
100
90
Average car speed kph
80
70
60
50
40
30
20
10
0
200 600 1000 1400 1800 2200
Capacity passenger cars/hr/lane
90 kph 100 kph 110 kph 120 kph
LOS A LOS B LOS C LOS D LOS E
290

Exhibit 21.8
Vehicle density over time in a toll-road project
24
LOS D
22
20
18
LOS C
16
Vehicles/km
14
12 LOS B
10
8 LOS A
6
0
2011 2014 2017 2020 2023 2026 2029 2032 2035
Year

have revenues that come from a combination of leases, indefeasible rights of use (IRUs)
and other sources;
have revenues which are difficult to forecast because demand increases rapidly and prices
fall equally rapidly. The expected lives of such projects may be short to account for this
uncertainty in the market;
are subject to ongoing investment for additional circuits at the landing/termination
station(s);
have an ever present risk of sea damage to cables;
include a deepwater cable which if located in international waters will be owned by a
company incorporated in a tax haven; and
Typical project cash flows are illustrated in Exhibit 21.9. The revenues typically vary over the
projects life, the result of increasing demand offset by correspondingly decreasing prices. The
291

Project Financing
operating costs are minimal but there is an ongoing capital investment in additional circuits.
Exhibit 21.9 illustrates this and the relatively short life assumed for analysis purposes. It also
illustrates the capacity limit reached before the end of the projects life, with a consequent
reduction in the subsequent annual revenues.
8 Power projects
Included in the power industry is any power project producing electric power as its main
product. Possible fuel sources include natural gas, fuel oil and coal in conventional power
and uranium in a nuclear power plant. Power plants based on renewable energy such as
wind, solar, tidal and hydroelectricity have no fuel. Such projects:
are technically complex when large, but simple if small;

may be base load or swing load;
produce power sold in a closed market;
Exhibit 21.9
Typical cash flows for submarine cables projects
292

produce power that cannot usually be exported so as to generate foreign exchange;

generate revenues which are either: (i) governed by negotiated tariffs with escalation and
indexation clauses and tariffs split into capacity (fixed) and fuel (variable) elements; or
(ii) from a power supply which the operator bids for on an hourly or other basis in the
case of a merchant power plant;
have a large variation in fuel price;
are subject to an annual maintenance shutdown on conventional power plants which will
reduce revenues and variable operating costs for about a month per year;
produces by-products such as low pressure steam and desalinated water where there is a
suitable local market;
may have to provide for a future large decommissioning cost as in the case of a nuclear
power plant; and
are subject to straightforward taxation calculations but may have to pay environmental
taxes (for example, carbon tax and cap-and-trade) or receive subsidies (in the case of
renewable energy).
The revenues for a base load power plant with a power purchase agreement (as shown
in Exhibit 21.10) will typically have a capital cost recovery element and an operating and
maintenance component. The capital cost component may be repaid over the projects life
or over a shorter period.
The cash flow for a renewable energy will have a larger capital cost (per MWh) but
much smaller operating costs since they use no fuel.
9 Ships
This category includes all forms of shipping, particularly larger ships such as oil tankers,
oil-bulk-ore carriers, bulk and chemical carriers, reefers and cryogenic ships. It also includes
ferries as well as drill ships and exploration rigs. Such ships or rigs:
are technically simple, although liquid natural gas (LNG) tankers require specialist
metallurgy and refrigeration systems;
generate revenues from time charters or the spot market;
are relatively easy to finance if the ships are dedicated to a project on a long-term time
charter, not otherwise;
are subject to operating costs mainly consisting of the fuel (usually marine diesel);
are dry docked at regular intervals, usually every two to three years during which time
the ships incur the costs of dry docking and do not generate any revenues. The length
and cost of the dry docking may increase over the life of the ship;
are registered in a country where taxes are low or non-existent and where regulations
allow ships to be manned by foreign and usually cheaper labour (flags of convenience
such as Panama or Liberia); and
are subject to little or no taxation calculations.
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Exhibit 21.10
Typical cash flows for power plant projects
Typical project cash flows for projects in this industry are illustrated in Exhibit 21.11.
10 Buildings
Building projects cover a wide range of industries including schools, hospitals and prisons
all typically found in PPPs which we discuss in Chapter 30. Such projects:
are technically simple but may become a little more complex if it is a hospital with major
diagnostic equipment;
contain little equipment and material which may need to be imported;
do not usually generate foreign exchange;
are often based on a concession in which the operator is paid an availability and an
operating and maintenance element; and
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Exhibit 21.11
Typical cash flows for ships
Typical project cash flows for projects in this industry are illustrated in Exhibit 21.12. The
revenues will typically be constant over the life of the project. The operating and maintenance
costs will vary considerably from one project to another.
11 Airports
Airport projects consist of one or more of the following elements: airside facilities (such as
the runway(s) and hangers) and the landside facilities (such as terminal buildings and car
parks). Such airports:
are technically simple, although some items such as instrument landing systems and radars
are complex;
contain relatively small amount of equipment which may need to be imported;
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Project Financing
Exhibit 21.12
Typical cash flows for a building
generate revenues from a wide variety of sources such as: (i) airside: landing fees, aircraft
parking fees, fuel fees and utilities; and (ii) landside: passenger fees, car parking fees and
shop leases;
generate revenues from one of two methods: compensatory or residual cost. In the
compensatory method the airport operator sets the fees and takes the risks. In the residual
cost method the airlines share the costs after taking credit for passenger side revenues; and
Typical project cash flows for projects in this industry are illustrated in Exhibit 21.13. The
revenues increase in line with the growth in airline travel which is in the region of 5% per
year. The operating costs will also grow at a similar rate.
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Exhibit 21.13
Typical cash flows for an airport
* This chapter is contributed by John Macgillivray, Managing Director of Project Planning

and Management Ltd.
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Chapter 22
Overview of risk management
A key component to a successful project is risk management. This activity is critical not only
in controlling a projects operation but is what potential lenders look closely at in assessing
the ability of the project sponsor to manage a project. It is essentially what lenders refer to
as management quality.
1 Types of risk
Risk management for a project begins with the project sponsors identification of the relevant
risks and then moves on to the risk retention decision. This decision refers to how the project
sponsor chooses to manage an identified risk. A project sponsor can choose from one of the
following courses of action with respect to an identified risk:
retain the risk;

neutralise the risk; or
transfer the risk.
Each identified risk can be handled in a different way.
Risk retention
An analysis of the expected benefits and expected costs must be performed by the project
sponsor in order to assess which of the identified risks should be retained. Aggregating all of
the projects identified risks that are to be retained gives the projects retained risk. Because
of the potential adverse impact of the retained risk on a projects cash flow, the project
sponsor must decide on whether a retained risk should be unfunded or funded.
When the potential losses that have been identified for a retained risk are only funded
as they are realised, it is said that there is an unfunded retained risk. If the project sponsor
establishes either a cash account or other funding source that can be drawn upon in order
to cover the estimated losses from an identified risk that is retained, it said that the project
manager has a funded retained risk. The term risk finance is used to describe the manage-
ment of retained risk.
Neutralising risk
When a project sponsor elects not to retain an identified risk, it can either neutralise the risk
or transfer the risk. A risk management strategy calling for the mitigation of the outcome
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of an expected loss from an identified risk without transferring that risk to a third party is
called risk neutralisation. Such a risk management strategy involves:
implementing a plan to decrease the probability of the identified risk occurring; or

pursuing a course of action to reduce the severity of the loss should the identified risk
be realised.
Risk neutralisation strategy for some identified risks for a project may be a natural outcome
of the business in which it operates or financial factors affecting the project.
Projects business risk: suppose that a project company anticipates annual production of
X units but production interruptions due to equipment failures are estimated to result in
an annual reduction in revenue of 10 million to 20 million and this amount is material
relative to its required cash flow needed to meet operating and funding expenses. A project
company can introduce improved production processes to reduce the upper range of the
potential revenue loss.
Projects financial risk: suppose that a project company operating outside of the Eurozone
has cash inflows and outflows in euros. This project company therefore has currency risk.
But this risk has offsetting tendencies because the cash inflows are exposed to a depreciation
of the euro relative to the project companys local currency while the cash outflows are
exposed to an appreciation of the euro relative to the project companys local currency.
If, for example, the expected future cash inflows and outflows over a certain time period
are 20 million and 14 million, respectively, then the project companys net currency
exposure is a 6 million exposure to the depreciation of the euro relative to the local
currency. That is, there is a natural currency hedge of 14 million.
Risk transfer
The project sponsor may decide to transfer certain identified risks to a third party. Risk
transfer management can be accomplished by:
using contracts with a third party that is willing to take on the identified risk of the
project company; and
embedding that risk into a structured financial transaction.
The vehicles for accomplishing this include:
traditional insurance policies;

trade credit insurance;
financial guarantees;
structured finance;
derivatives; and
alternative risk transfer.
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In this chapter, we discuss each of these vehicles available to project sponsors for risk transfer
management. Some of these vehicles have already been discussed in previous chapters; others
will be discussed in the following chapters.
2 Traditional insurance policies

Traditional insurance policies underwritten by an insurance company the oldest form of
risk transfer vehicle specifies that the insurer agrees to make a payment to the insured if a
defined adverse event is triggered. To obtain this protection, an insurance premium is paid by
the insured to the insurance company. Commercial policies available for project companies
cover a wide range of property and cover acts such as property damage, liability insurance
(for example, public liability and construction liability), business interruption insurance and
political risk insurance.
We will discuss political risk insurance below, developing the introduction of the idea
in Chapter 5. Before doing so, it is important to note that the line between many types
of insurance and the next form of risk transfer vehicle that is also provided by insurance
companies, guarantees, is sometimes a thin one. Insurance companies provide performance
bonds and construction completion bonds. Insurance companies also provide guarantees of
indemnity provisions of contracts. Some types of insurance policies, such as political risk
insurance and business interruption insurance, are tantamount to guarantees.
Political risk insurance

When organisations engage in a risk assessment of their investment activities, one of the
categories of risk that is not easily mitigated is that of doing business overseas the risks to
cash flows arising from changes in legislations, war, expropriation and the like. To manage
the vulnerability of cash flows to potential events in those categories, project sponsors and
suppliers typically look first to government sources for political risk insurance as a support
mechanism for exports.
In the United States, as one example, the Overseas Private Investment Corporation
(OPIC) was created as a government agency to provide insurance and financing for projects
and construction in less developed friendly countries and areas. Its purpose is to promote
economic growth in developing countries by encouraging US private investment in those
nations. Other industrial countries have similar government agencies that provide political
risk insurance often as part of their export insurance offering.
Political risk insurance is available from private companies as well as government sources.
The coverage and amounts of private insurance available vary from time to time. Generally,
the rates are high and the amounts of insurance coverage available are limited. However,
the willingness of private insurance companies to insure against political risks is growing,
and the availability and terms of such insurance for a project should be investigated where
the need arises.
A discussion of the specific forms of political risk insurance offered by various govern-
mental agencies is beyond the scope of this chapter, which focuses on general risks to
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consider and the forms of cover potentially available. Instead, as an illustration, we describe
the multilateral OPIC programs.
OPIC insurance program as an exemplar

The multilateral OPIC insures eligible US investors in qualified projects in less-developed
friendly countries or areas against loss due to specific political risks. There is no requirement
that the project in which the insured investment is made be a project owned or controlled
by US investors. However, the law requires that insurance be issued only to eligible inves-
tors. OPIC may thus insure an investment by an eligible investor in a project controlled
by foreign interests, but it is only the investment which is insured, not the entire project.
Eligible investors are defined as:
citizens of the United States;

corporations, partnerships, or other associations created under the laws of the United
States, or any state or territory of the United States, which are substantially beneficially
owned by US citizens; or
a foreign business at least 95% owned by investors eligible under the above.
The project has to be located within a country where OPIC is authorised to do business.
Projects should use the private insurance sector as the first option and may need to produce
evidence that their project cannot be insured by the private sector. There are a number
of specifically excluded project types such as large dams, projects involving deforestation
and relocation of populations greater than 5,000 people. There are also tests for potential
job losses in the US and compliance with International Labour Office (ILO) conditions for
the workforce.
OPIC insures investment only in countries with which there is a bilateral agreement,
terms of which are available on the website or from OPIC and regularly updated. The OPIC
policy is to insure new investment projects that meet the following criteria laid out in the
OPIC website:
are environmentally and socially sustainable;

respect workers rights;
have no negative impact on the US economy; and
encourage positive host country development effects.
The risks that OPIC currently insures against are grouped as follows:
currency inconvertibility;
expropriation/improper government interference;
political violence;
specialty coverage; and
product development.1
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OPIC programs are available to cover US private investments in over 150 countries which
have been determined to be less-developed friendly countries and areas, and with which the
United States has agreements for the operation of the OPIC program. The list of eligible
countries is available from OPIC on request.
Currency inconvertibility: OPIC inconvertibility coverage is designed to assure that earnings,

capital, principal and interest, and other eligible remittances such as payments under
service agreements, and technical assistance fees can continue to be transferred into US
dollars to the extent transferable under exchange regulations and practices in effect at the
time the insurance was issued. The blockage which entitles the insured to exchange local
currency for dollars through OPIC may be either active (for example, failure of authorities
denying access to foreign exchange on the basis of new, more restrictive regulations), or
passive (for example, failure of authorities to act within a specified period usually 60
days on an application for foreign exchange). The insurance also protects against adverse
discriminatory exchange rates but is explicitly not designed to protect against devaluation
of the foreign currency.
Expropriation insurance: OPIC insurance contracts define the insurable event of
expropriation action to include not only classic nationalisation of a project or the taking
of property, but also a variety of situations which constitute creeping expropriation.
These include abrogation, repudiation and impairment of contract terms. An action,
taken, authorised, ratified or condoned by the project host country government is
considered to be expropriatory if it has a specified impact on either the properties
or operations of the foreign enterprise, or on the rights or financial interests of the
insured investor. Insurance contracts typically provide that for an action to be considered
expropriatory it must continue for at least six months. Important limitations in the
definition of expropriatory action include exceptions for proper regulatory or revenue
actions taken by host governments and actions provoked or instigated by the investor
or foreign enterprise.
Of increasing relevance, as arbitration in a neutral country is a chosen mechanism for
dispute resolution, is the arbitral award default and denial of justice coverage for US debt
and equity investors, which can offer protection for the insured from non-payment of an
arbitral award by a host country government. Also covered may be losses resulting from
corruption within the host government. In the event of expropriatory action, compensation
by OPIC is based on the original amount of the insured investment, adjusted for retained
earnings (or losses) and accrued interest (and for any prior recoveries of investment) as of
the date of expropriation. The coverage does not permit an equity investor both to retain
his ownership interest and to be compensated by OPIC for government actions resulting
in lost profits or reduced investment values.
War, revolution and insurrection insurance: compensation is provided under war, revolution
and insurrection coverage (war coverage) and terrorism for loss due to bellicose actions
occurring within the projects host country. There is no requirement that there be a
formal declaration of war. Coverage extends to losses from actions taken to hinder,
combat or defend against hostile action during war, revolution or insurrection. Coverage
is also available for civil strife (including politically-motivated terrorism and sabotage)
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for an additional premium. Insurance cover is for damage to tangible assets and to
business income.
Levels and cost of coverage: OPIC insurance contracts generally require the insurance
premium to be paid annually in advance. Premiums are computed for each type of
coverage on the basis of a contractually stipulated maximum insured amount and a
current insured amount which may, within the limits of the contract, be elected by the
investor on a yearly basis. The current insured amount represents the insurance actually
in force during any contract year. The difference between the current insured amount
and maximum insured amount for each coverage is called the standby amount. A
major portion of the premium is based on the current insured amount, with a reduced
premium rate being applicable to the standby amount. For expropriation and war
coverage, the insured must maintain current coverage at a level equal to the amount
of investment risk.
Private sector coverage

There is also a thriving private sector market in political risk insurance and associated
in-country intelligence and training for expatriate staff. The latter have grown out of small
consultancies often associated with former military personnel and moving into this area when
personal protection and security services for clients required more detailed support. Some of
these entities will also undertake additional support in specific situations, for example, where
hostages have been taken or evacuation becomes necessary.
Political risk insurers are often brokers who can tailor an insurance package to a specific
situation, and also negotiate directly with underwriters in the various insurance markets.
Project related business may just be a part of their portfolio which could also include
political risk insurance for contracts and asset portfolios for clients such as commodity
brokers, banks and contractors as well as manufacturers, distributors and retailers. Typically
a good private sector provider may be part of a larger insurance group and certainly have
a global network to feed information efficiently. Services such as political and economic
intelligence may be bundled with or in addition to risk coverage services. Specialist industry
intelligence may also be available. It is no surprise that there has been significant consoli-
dation in this area over the last 10 years with large information and intelligence groups
challenging the integrated value chain model of insurance groups that have traditionally
provided cover and information.
Linked to the discussion on captive insurance companies described later in this chapter,
for shipowners, there are also War Risk Insurance Clubs, such as Hellenic War Risks, set up
to offer mutual insurance but now considering how to manage the growing threat of piracy,
as a newer form of asset expropriation. These were mentioned in Chapter 12.
3 Trade credit insurance

Trade credit insurance or export insurance insures against risk of non-payment by a customer
attributable to either: (i) insolvency; (ii) bankruptcy; or (iii) protracted defaults (that is,
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non-payment after a specified period of delinquency). As explained in Chapters 5 and 12,

these policies provided by private insurance companies and governmental export credit
agencies can be customised to cover losses on foreign sales due to pre-delivery costs, the
non-delivery of prepaid goods, and the failure of another party to honour a letter of credit.
Although we discussed political risk insurance in the previous section under traditional insur-
ance, one can argue that it is really a form of trade credit insurance.
4 Financial guarantees
Financial guarantees provide for a payment by an insurer to the policy beneficiary if: (i) a
loss is incurred on a financial obligation insured; and (ii) the loss is attributable to a specified
event that causes the default. The payment on the insured loss can be equal to the entire
amount of the loss or for a partial amount of the loss.
A financial guarantee can be classified as either: (i) a pure financial guarantee; or (ii) a
financial surety bond (also referred to as an insurance wrap). The difference between these
two forms of financial guarantee is the identity of the beneficiary of the policy. The policys
beneficiary in a pure financial guarantee is the credit protection buyer. In the case of a
financial surety bond, the policys beneficiary is not the credit protection buyer but a third
party. In the case of project financing, the credit protection buyer is the project company
that has issued a financial obligation to the third party.
We provide a more detailed discussion of financial guarantees in Chapter 23.
5 Structured finance
Fabozzi, Davis and Choudhry define structured finance as follows:
...techniques employed whenever the requirements of the originator or owner of an

asset, be they concerned with funding, liquidity, risk transfer, or other need, cannot be
met by an existing, off-the-shelf product or instrument. Hence, to meet this require-
ment, existing products and techniques must be engineered into a tailor-made product
or process. Thus, structured finance is a flexible financial engineering tool.2
The vehicles used in structured finance transactions include:
securitisation;
leasing; and
structured notes.
Notice two key motivations for the use of structured finance from the above definition:
funding and risk transfer.
Here we will limit our discussion to an explanation of securitisation and its potential
use and structured notes that can be used in project financing.
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Securitisation
Securitisation is the process of: (i) pooling of assets; (ii) creating different bond classes that
are backed by the pool of assets; and (iii) de-linking of the credit risk of the pool of assets
from the credit risk of the originator. Let us look at each of the three aspects ofsecuritisation.
The assets that can be pooled and then used as collateral in a securitisation are either
existing assets/existing receivables or future assets/receivables. The distinction is critical. The
underlying principle in a securitisation is that the pool of assets that is the collateral for a
securitisation does not require additional work or operational effort in order to generate
the cash flow needed to satisfy the liabilities. A good example is the securitisation of receiv-
ables from the sale of equipment manufactured by a project company. The equipment has
been produced and sold. The asset is the receivable. When those receivables are pooled, the
proceeds are collected as they are received and then used to pay off the liabilities.
In contrast, in a securitisation involving assets/receivables to arise in the future referred
to as future flow securitisations a receivable is not yet generated. Fabozzi and Kothari
explain what types of future flows are securitisable as follows:
The essential premise in a future flow securitisation is if a framework exists that will
give rise to cash flows in the future, the cash flow from such framework is a candidate
for securitisation. If the framework itself does not exist, the investors would be taking
exposure in a dream; their rights would probably be worse than for secured lending.
For example, if the cow exists, but not the milk, the milk can be securitised, as
whoever owns the cow would be able to milk it. If both the milk and cow do not exist,
it is not a proper candidate for securitisation.3
The financing of toll roads in Mexico via securitisation of future toll payments is an example
of a future flow securitisation.
Once the assets have been pooled, the next step is creating the bond classes (or tranches)
to be issued. This phase, referred to as structuring the transaction, involves determining the
capital structure (that is, priorities of the bond class) and, based on the target rating sought
for each bond class, determining the amount of credit enhancement needed. Credit enhance-
ment is needed to absorb losses from defaults of the pool of assets.
There are two forms of credit enhancement in a securitisation structure: external and
internal.4 External credit enhancement is guarantee by a third party. It includes monoline
insurance and letter of credit. The former was a popular form of credit enhancement prior
to the US sub-prime mortgage crisis in 2007. Few structures in recent years carry monoline
insurance. Internal credit enhancement includes:
creating a capital structure with bond classes having different priorities in the distribution
of the cash flow generated from the pool of assets and allocation of losses incurred by
the pool of assets. This results in subordinate bond classes providing credit support for
more senior bond classes;
utilising excess spread the difference between the interest rate on the pool of assets and
the weighted cost of funds from the liabilities issued to absorb losses; and
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using collateral with a value in excess of the liabilities to absorb losses referred to
as overcollateralisation.
The amount of credit enhancement is referred to as sizing the transaction.

Credit enhancement necessary for the existing assets will be quite different from that of
future assets. With existing assets as the asset pool, rating agencies can estimate the likelihood
of default because the borrowers in the asset pool are known. In contrast, with future flows
it is necessary to evaluate the credit quality of future borrowers as well as the likelihood
that sufficient sales will not be generated so as to create an asset pool of sufficient size to
support the liabilities.
Projects to be financed in the early stages before production begins would be future flow
securitisations. The question that arises is why a project sponsor would want to undertake a
future flow securitisation. The benefits associated with an existing asset securitisation (such
as its use in risk management and reduction in funding costs) do not typically apply for
some types of future flow securitisations. Risk management in a securitisation means that
the risks associated with an asset originated are transferred to another party. This does not
occur in a future flow securitisation because there is no asset to transfer at the time of the
securitisation. So the potential reduction in funding cost that is attributable to the third
phase of the securitisation process (discussed in the next paragraph) cannot be achieved,
that is, the project company credit risk cannot be de-linked from the credit risk of the pool
of assets, because the latter does not exist yet.
The third phase of a securitisation is de-linking of the credit risk of the pool of assets
from the project companys credit risk. The benefit here is that the pool of assets is legally
transferred to another entity a special purpose entity (SPE) in exchange for cash and
it is that entity that owns the pool of assets and issues the bond classes. The advantage is
that creditors need only look to the credit of the pool of assets not the project company.
Consequently, in a properly structured securitisation, the bankruptcy of a project company
would mean that the creditors of the project company do not have a claim on the pool of
assets sold to the SPE. Once again, for certain types of future flow securitisations where
receivables have not been created, there is no such benefit.
Structured notes
A structured note is a debenture bond which at issuance is linked to a derivative. The
following is a key attribute of structured notes:
they are created by an underlying swap transaction. The issuer rarely retains any of
the risks embedded in the structured note and is almost hedged out of the risks of the
note by performing a swap transaction with a swap counterparty. This feature permits
issuers to produce notes of almost any specification, as long as they are satisfied that
the hedging swap will perform for the life of the structured note. To the investor, this
swap transaction is totally transparent since the only credit risk to which the investor is
exposed is that of the issuer.5
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Two examples of structured notes that can be used for risk control purposes are commodity-
linked notes and credit-linked notes that we described in Chapter 13. With a commodity-linked
note, the interest rate paid is tied to the performance of some commodity. The principle is
that if a project companys revenues depend on the price of a commodity it produces, then
the project company can protect its funding costs by having its interest rate depend on that
commoditys price. In a credit-linked note, the interest rate or the maturity value is tied to
the performance of a pool of assets. A credit-linked note is a form of credit derivative which
we describe later in this chapter.
6 Derivatives instruments
There are capital market products available to project sponsors to transfer risks that are not
readily insurable by an insurance company or other financial institution. Such risks include
risks associated with an adverse movement in exchange rates, funding costs and commodity
prices. The capital market instruments that can be used to provide such protection are called
derivative instruments.
A derivative instrument is a contract that derives its value from some underlying asset
or some reference rate. Some contracts give the party to a derivative transaction either
the obligation or the choice to buy or sell a financial asset, currency or commodity.
Examples of derivative instruments include options contracts, futures contracts, forward
contracts, cap and floor agreements and swap agreements. Moreover, there are derivatives
that can be embedded within a financing instrument. Two examples are callable bonds
and credit-linked notes.
The existence of derivative instruments provides opportunities for controlling various
risks associated with a project. The risks that can be reduced or mitigated are those associ-
ated with funding risks, revenue risks and operating risks. For this reason, risk control is
not a separate activity in project finance but rather integrated with the financing activity,
and thereby the degree of project leverage. Lenders are concerned with a projects risks.
Contracts that can be employed to eliminate or mitigate those risks will provide greater
comfort to lenders and will result in more favourable borrowing terms and the potential
for more leverage.
It is often claimed that in a global financial market with imperfections due to regula-
tions and/or capital market restrictions, opportunities may arise to reduce a projects funding
costs. Too often those promises made to sponsors of projects to convince them to use certain
derivatives are unfounded, masking risks with which sponsors should be concerned. The true
beneficiary is the derivative salesperson and his or her firm, not the sponsor. Several well-
publicised financial fiascos involving the use of derivatives have made some participants in
the project finance arena shy away from using them. The needless use of various types of
interest rate swaps in the financing of municipal revenue projects in the United States is an
excellent example. These fiascos, however, are not the result of derivatives per se. They are
the result of either the lack of understanding of the risk/return characteristics of derivatives
or, more commonly, the improper utilisation of derivatives to bet on interest rates, commodity
prices or exchange rates rather than to control risk.
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Risk-sharing versus insurance type derivatives

Derivative instruments can be broadly classified as risk-sharing and insurance arrangements.
In a risk-sharing arrangement, the two parties to the agreement seek to eliminate a risk by
foregoing the potential benefits associated with a favourable price movement. Risk-sharing-type
derivative instruments also referred to as linear payoff derivatives and symmetric payoff
derivatives include futures, forward and swap contracts. Other contractual agreements such
as off-take agreements and contracts for differences fall in the category of risk-sharing type
derivative instruments. Futures and forwards are the subject of Chapter 24 where we also discuss
off-take agreements and contracts for differences. Swaps are the subject of the Chapter 25.
The other broad category of derivatives comprises insurance-type arrangements. In this
type of arrangement, one party pays the counterparty a fee to insure against a specific risk.
It could be to insure against a price decline for something that will be sold in the future
or a price increase for something that will be purchased in the future. Or, it could be to
protect against an adverse interest rate or currency movement. Insurance-type derivative
contracts are referred to as nonlinear payoff derivatives or asymmetric payoff derivatives.
These types of contracts include options, caps and floors and are the subject of Chapter26.
Credit derivatives
Credit derivatives are financial instruments that are designed to transfer the credit exposure of
an underlying asset or assets between two parties. Project sponsors may have an opportunity
to use a credit derivative to transfer credit-risky assets that might have been generated by the
project company, or to synthetically create a funding vehicle that reduces their funding costs.
However, there has not been a reported use of credit derivatives for either of thesepurposes.
Credit derivatives include credit default swaps, asset swaps, total return swaps, credit-
linked notes, credit spread options and credit spread forwards. By far the most popular credit
derivative is the credit default swap (CDS) and they come in two varieties: single-name CDS
and CDS index. The former is the more likely vehicle to be used by a project sponsor in
creating a synthetic funding vehicle. However, banks have used CDS to transfer credit risk
on their portfolio of project loans. First, we describe what a single-name CDS is.
Credit default swaps

A CDS is probably the simplest form of credit derivative for transferring credit risk. A CDS
is an over-the-counter (OTC) instrument so there is counterparty risk. There is a standardised
document for CDS trades developed by the International Swaps and Derivatives Association
(ISDA). The documentation specifies the reference obligation which is the specific debt obli-
gation for which protection is being sought. There are two parties to the trade: a protection
buyer and a protection seller. The former party pays a fee, the swap premium, to the latter
party in exchange for the right to receive a payment conditional upon some event of the
reference obligation. The protection buyer pays the swap premium periodically (typically
quarterly) over the tenure of the CDS. However, that payment ceases if during the tenure
of the CDS some credit event occurs. As explained below, the documentation will specify
308

the credit events. The mechanics of a single-name CDS are then, as follows, should a credit
event occur. The protection buyer pays the accrued swap premium upto the credit event
date and no further payments are made. Then the protection seller must compensate the
protection buyer for the loss due to the credit event. How that loss is determined and how
the payment is made to the protection buyer are set forth in the documentation.
The most important section of the documentation for a CDS is the agreed definition by
the parties to the contract of each credit event that will trigger a payment from the protec-
tion seller to the protection buyer. Definitions for credit events are provided by the ISDA and
the different types of credit events have changed over time since they were first published
by the ISDA in the 1999 ISDA Credit Derivatives Definitions. The publication provides a
list of eight possible credit events that attempt to capture every type of situation that could
cause the credit quality of the value of the reference obligation to decline:
bankruptcy;
credit event upon merger;
cross acceleration;
cross default;
downgrade;
failure to pay;
repudiation; and
restructuring.
The parties to a CDS trade may include all of these events, or select only those that they
believe are most relevant.
Subsequent supplements and revisions of these definitions followed. Earlier supplements
to the definitions dealt with the most controversial of all the credit events restructuring.
This type of credit event favoured lenders who sought credit protection by allowing them
to restructure a clients loan and at the same time be compensated for doing so under the
restructuring definition. This led to the 2003 ISDA Credit Derivative Definitions which
provided for four definitions of restructuring: (i) no restructuring; (ii) full restructuring, with
no modification to the deliverable reference obligations aspect; (iii) modified restructuring
(which is typically used in North America); or (iv) modified modified restructuring (addressed
issues that arose in the Europe market). For debt obligations involving municipalities, the
ISDA has provided definitions that are specific to this sector.
Use of CDS by banks

A bank may maintain a project loan in their portfolio or sell that loan if it wants to shed
the credit risk exposure in the market. For a portfolio of project loans owned by a bank,
transferring the credit risk can be done in one of two ways. First, a bank can sell a port-
folio of bank loans to a third party, a special purpose vehicle (SPV), that can use the loans
as collateral for a debt offering using the securitisation technology. The SPV can then issue
debt obligations with different priorities on the cash flows from the pool of project loans.
The structure that is created is called a collateralised loan obligation.
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Project Financing
An advantage of transferring the credit risk synthetically is that it can be done without the sale
of the project loans. This approach may be beneficial for legal reasons because permission might
be needed from the borrower to sell the project loan or there may be difficulties in transferring
loans in different countries. Risk transfer is accomplished by the bank entering into a single-name
CDS where it is the protection buyer and the specific project loan is the reference obligation.
Alternatively, a bank can create a synthetic collateralised loan obligation where rather than
selling a portfolio of project loans to the SPV, it enters in a CDS on the portfolio of project loans.
7 Alternative risk transfer

Alternative risk transfer involves the creation of products to transfer the increasingly complex
risks identified by companies that cannot be dealt with by traditional insurance. These prod-
ucts combine elements of traditional insurance and capital market instruments to achieve a
customised solution to the risk transference problem. For this reason, alternative risk transfer
is sometimes referred to as structured insurance and insurance-based investment banking.
Three forms of alternative risk transfer that can be employed by project sponsors are
insurance-linked notes, contingent insurance and captive insurance companies, previously
discussed in Chapter 12.
Insurance-linked notes
Life insurers and property and casualty insurers have been able to bypass the conventional
reinsurance market and reinsure against losses by issuing securities in the capital markets. They
have done so by issuing insurance-linked notes, more popularly referred to as catastrophe-
linked bonds or cat bonds. However, the use of capital markets to transfer insurance risk
to the capital markets is not limited to insurance companies. Non-insurance entities such as
project companies can create insurance-linked notes for the same purpose. Two examples of
the use of insurance-linked bonds by a non-insurance company to protect against earthquake
damage rather than using traditional insurance are Tokyo Disneyland, Oriental Land Co
in 1999 (US$200 million issue) and Vivendi Universal for its California studios (Universal
Studios) in 2002 (a 3.5-year US$175 million issue).6
Contingent insurance
In Chapter 26 we will discuss a capital market derivative instrument called an option.
Contingent insurance is an alternative risk transfer vehicle that is an option granted by an
insurance company to another party granting the right to enter into an insurance contract
at a designated future date. The insurance contract terms that can be entered into at the
future date are specified at the time the contingent cover policy is purchased.7
Captive insurance companies

To cover risks that are difficult to insure, a common practice used today for risk management
is the establishment of an insurance company by a parent company for the specific purpose
310

of insuring against difficult-to-cover risks identified by the parent company. These insurance
companies are called captive insurance companies or simply captives.8 Basically, captives
can be utilised to insure against the retention risk that we described earlier as well as risk
transfer. Captive insurance and captive finance companies are also discussed in Chapter 12.
1
OPIC website: www.opic.gov/insurance.
2
Fabozzi, FJ, Davis, H, and Choudhry, M, Introduction to Structured Finance, 2006, John Wiley & Sons, p. 1.
3
Fabozzi, FJ, and Kothari, V, Introduction to Securitization, 2008, John Wiley & Sons, p. 188. It should be noted
in our milk and cow example that the investor takes on the risk that the cow can produce milk and is notdry.
4
For a further explanation on the various forms of credit enhancement, see endnote 3 above, ch. 5.
5
Peng, SY, and Dattatreya, R, The Structured Note Market, 1995, Probus Publishing, p.2.
6
Mathias, A, Are Cat bonds changing course? Environmental Finance Insurance, April 2003.
7
For a more detailed discussion of contingent insurance, see Culp, CL, Structured Finance and Insurance: the ART
of managing capital and risk, 2006, John Wiley & Sons, ch. 26.
8
For a further discussion of captive insurance companies, see Culp, CL, The ART of Risk Management, 2002,
John Wiley & Sons, ch. 18.
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Chapter 23
Guarantees
The objective of many project financings is to ensure that the cash flow generated by the
project company is sufficient to pay off all debt and produce a suitable return to shareholders.
This will normally be the underlying basis of the project model used to solicit debt and invite
equity investments. However, should that not be the case, then the project companys asset
values will offer some protection though lenders are cautious about asset support alone, not
least as the position of becoming a debtor in possession may confer ownership rights but
comes with a number of other obligations and considerable potential downside for reputa-
tion. Just as we saw that surety of cash flow through contract forms can increase certainty
for lenders, so supplementary support in the form of guarantees from shareholders or other
key stakeholders can also enhance the creditworthiness of the project, and in turn affect the
pricing of the risk.
Guarantees are the life-blood of most project financings because project companies have
high debt to equity ratios. Guarantees enable promoters to shift the financial risk of a project
to one or more third parties. Although they may permit off-balance sheet financing depending
on the form and nature of the guarantees, it is important to consider which balance sheet
is the off -balance sheet in that statement. Guarantees provide a basis for shifting certain
risks inherent in a project financing transaction to interested parties that may have no desire
either to become directly involved in the projects operation, or to directly provide capital
for the project but are happy to assume a contingent liability. By assuming the commercial
risks of a project financing through a guarantee rather than a loan or contribution to capital,
a third-party guarantor sponsor may show its indirect obligation towards the project as off-
balance sheet, while achieving its objective of getting the project built. However, this is an
area that directly conflicts with regulatory pressure for disclosure so it is important to seek
up to date and expert advice.
Direct and indirect guarantees will be noted by the rating services particularly where
the guarantees are substantial and where ratios and interest coverage may be affected as
will positive cash flows and benefits which may result from the project.
While guarantees are essential to project financing, guarantees can also give lenders a false
sense of security. Lenders cannot assume that guarantees will be easy to enforce. The value
of a credit judgement about a guarantor or the tangible value of that guarantee depends on
the integrity and financial standing of the guarantors. A guarantor seeking to avoid payment
has many defences and a lender must take special pains to preserve its rights against the
guarantor. A lender should not waive any of its rights against the borrower without the
guarantors consent.
The guarantee agreement should have clear triggers for enforcement. It should not
require exhaustion of all remedies by a lender against a borrower before the guarantee can
be enforced.
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Guarantees
1 Guarantors
Owner guarantors
The obvious guarantor of a project financing transaction is the owner of the project. In
some project financing situations, an under-capitalised subsidiary, special purpose vehicle
(or special purpose entity) is set up to own and operate a project which has insufficient
capital or operating history to support borrowings on the merits of its own credit standing.
Therefore, lenders must be provided with a guarantee from an entity with satisfactory cred-
itworthiness. This means the parent must provide the guarantee, unless the circumstances of
the project make it possible for the parent to substitute a satisfactory third-party guarantor.
Where a parent company guarantees debt of a controlled subsidiary, the debt will appear
on its consolidated balance sheet. However, there are contingent and indirect guarantees
and undertakings that the owner may assume, with less impact on its financial statements.
These, combined with guarantees of other parties, can result in the support for the debt of
the project company making the credit risk more acceptable to lenders. Furthermore, such
debt may be off-balance sheet for the parent or sponsor.
Third-party guarantors
Third-party guarantees are attractive to owners or sponsors who are not guarantors because
their provision can substitute for the sponsor or owner of the project acquiring an indirect
exposure to the project. Third-party guarantors nearly always receive direct or indirect
benefits from a transaction as consideration for and motivation for their undertaking. To
some degree, it could be argued that any guarantor is a sponsor.
Candidates for third-party guarantors

Third-party guarantors generally may be divided into five groups: suppliers, sellers, users,
contractors and interested government agencies.
Suppliers: a supplier may see a need for the product, provided further processing is
performed on the product. Therefore, a supplier may be motivated to provide a guarantee,
if necessary, to a third-party owner and/or operator of the project in order to get a
processing plant constructed and operating. In another instance, the supplier may see the
market for its product disappearing because the user of its product is unable to compete
without drastic modification or remodelling of its processing facilities. Again, the supplier
might be motivated to provide a guarantee in order to bring these changes about and to
preserve its market.
Sellers: a seller may have plant or equipment surplus to its needs, with little prospect of
selling the plant or equipment except to an under-capitalised company which the seller feels
has good prospects. In such circumstances, a guarantee by the seller may be necessary to
enable the purchaser to obtain financing. The seller realises cash. The purchaser achieves
a project financing and the project goes ahead.
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Project Financing
Exhibit 23.1
Project company supported by owner sponsors guarantee
Sponsor
company
1 Stock
2 Loan Project 3 Lease

guarantee company guarantee
2 Loan 3 Lease
Leasing
Lender
company
Summary
1 Sponsor company establishes a thinly capitalised special purpose company to own and operate aproject.
2 Sponsor company provides direct and indirect guarantees for loans to the projectcompany.
3 Sponsor company provides direct and indirect guarantees for leases to the projectcompany.
Users: the user of a product or a potential project may be motivated to financially aid
or guarantee debt required to finance the project in order to get the project built and
ensure a needed supply. The same situation would be present where transportation needs
are required by a user who is motivated to provide credit support for transportation of
a product in or out of its facilities.
Contractors: contractors are interested in getting projects built because they are in the
construction business. For some types of projects, such as toll roads or hospitals, they also
may hope to be the operator, often via specialist subsidiary companies. (See Chapter 30.)
The prospect of this business may induce them to assume some risk and offer guarantees
regarding construction of the facility and its operation.
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Guarantees
Interested government agencies: government guarantees may be necessary in order to finance

a project. The nature of the economic and political risks may be such that guarantees are
not available from other sources.
Social embeddedness: the role of the sponsor or other stakeholders in local society can
also give rise to informal support for projects because of the social capital associated with
individuals. So, powerful families in many societies or, to choose one national example
often cited, guanxi, or reliance on personal connections in China may offer support to
a project. However, this is normally not documented and like any form of social capital
is ephemeral lenders have found that in recent years, these types of assurances have
been less reliable. An example of this would be membership of a well-known European
ship-owning or Middle Eastern merchant family. A lender might assume that the family
as a whole would come to the financial rescue of a minor member in order to prevent
a stain on the family good name. Whilst this could be the case, it equally well may not
be consequently, a lender should only rely on support of this nature as a very small
part of a stronger package.
Objectives of third-party guarantors

Governments and international agencies are motivated by economic, political and social needs
of the exporting country or user country. Private companies profit by:
construction of a project, such as a dock, storage facility, railroad or pipeline, which is

needed in connection with a guarantors or sponsors existing operations, even though
owned by a third party;
assuring a source of supply of petroleum, gas, electricity, ore, semi-manufactured goods,
or agricultural products (this type of guarantee is described in more detail later in this
chapter);
selling a product to be used in the project;
selling a service in connection with the construction of the project;
selling a service or product to the project after completion;
acquiring an equity interest in the project;
construction of the project as a contractor; and
operating a project after completion.
Typical third-party guarantors

Third-party guarantors include the following:
overseas manufacturers of products to be used in the project;

users of products or services to be produced or provided by the project;
suppliers of services or products to be used in the project;
contractors which will build and/or operate the project;
an agency of non-national governments interested in getting a project built;
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Project Financing
an agency or agencies of the host government interested in getting the project built,
including the central bank;
an agency of a state government interested in getting the project built;
foreign government export agencies and national interest agencies supporting exports of
products to be used in the project;
the World Bank; and
area development banks: African Development Bank, Asian Development Bank, Inter-
American Development Bank and European Bank for Recovery and Development (EBRD).
Commercial guarantors
Commercial guarantors provide guarantees for a fee and include:
banks;
insurance companies; and
investment companies.
Banks letters of credit

Bank guarantees usually take the form of letters of credit. A letter of credit is a contract
that specifies payment by a bank usually using a draft under pre-specified conditions. It may
be used to guarantee the loan of an under-capitalised project company, where a responsible
sponsor guarantees the bank against loss using its letter of credit. The fee for a letter of
credit is a function of the administrative costs and the net loan spread the bank would
expect to realise from lending to the sponsor. The bank is merely a conduit of the credit of
the sponsor which, for one reason or another, does not wish to provide a direct guarantee.
For example, the cost of borrowing using the letter of credit may be less than the cost of
borrowing with a guarantee of the sponsor. However, recently defined capital adequacy
requirements for US banks, Japanese banks and European banks will tend to reduce avail-
ability and increase the price in the future.
There are two basic types of letters of credit provided by banks:
commercial letters of credit; and

standby letters of credit.
Commercial letters of credit are intimately related to a specific movement of goods. Standby
letters of credit, on the other hand, serve as security devices. This discussion is concerned
with the use of standby letters of credit in project financing situations.
Standby letters of credit (also called standby LCs) differ from actual guarantees, but
serve similar functions. Standby letters of credit are frequently used as performance bonds
and also may be used as support for the issuance of commercial paper (see Chapter 17).
An important difference between the commercial and the standby credit is that commercial
letters of credit trigger a payment once the documents are presented and it is expected that
this would normally be the case; standby letters of credit are only expected to be drawn
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Guarantees
upon in specified circumstances, again against the production of specified documents, but it
is expected that this would not normally be the case. The newer forms of standby letters of
credit possess risk characteristics tenor in particular that differ substantially from those
for which the instrument was designed. Such undertakings have the potential of converting to
direct loans to the party on whose behalf they are issued. This emphasises the credit nature
of letters of credit, which constitute a part of the overall credit exposure to a customer by
a bank. As such, therefore, they have attracted guidelines from regulators.
As one such example, the US Comptroller of the Currency has established five stan-
dards as sound banking practices for US banks in issuing letters of credit and as a means
of distinguishing them from guarantees.1
1 Each letter of credit should be conspicuously entitled as such.

2 The credit should have an expiration date or specified term.
3 The banks undertaking should be limited in amount.
4 The banks obligation to pay should only be on the presentation of specified documents
and should not involve the bank in disputes of fact or law between the account party
and the beneficiary. (One way to look at this is to say that banks deal in documents, not
the underlying transaction.)
5 The customer should have an unqualified obligation to reimburse the bank for moneys paid
under the credit. (Thus this means that the amount of the letter of credit counts towards
the exposure of the bank to the customer unless it is adequately collateralised by cash.)
The same ruling goes on to specify that standby letters of credit should only be used:
1 to repay money borrowed by or advanced to or for the account of the account party;
2 to make payment on account of any indebtedness undertaken by the account party; or
3 to make payment on account of any default by the account party in the performance of
an obligation.
Since banks providing standby letters of credit do not expect them to be drawn against as a
normal event, banks sometimes argue that standby letters of credit are contingent liabilities.
Whilst fees are earned by banks without using assets, issuing standby letters of credit can
improve a banks return on assets, but banks (and federal regulations) treat standby letters of
credit as equivalent to loans in determining the total amount of related credit outstanding to
a particular customer. As a result, most American banks have established internal limits for
the total standby letters of credit they will issue as well as other irrevocable commitments.
Standby letters of credit are also used as bid or performance bonds. Many public as
well as private tenders will specify a bid bond as one requirement, normally for a specified
amount representing a good-faith binder on the part of the banks customer submitting a
contract bid. If the bank customer is successful in bidding on a contract, a performance bond
is likely to be required. A performance bond effectively ensures contract performance against
specified documentation, often independently assessed (for example, architects certificates)
and typically involves a substantially larger amount. A bank is not legally bound to issue
the performance letter of credit merely because it issued the bid bond, but often they go
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Project Financing
together. An advance payment bond is a related type of bond and is an undertaking that
may be given to obtain advances against a contract.
One area to watch is that large project tenders or bids may involve construction compa-
nies quickly exhausting their credit limits, and on the other side, banks quickly exhausting
their exposure limits to one project, or country (for a group of projects) during the bidding
stage (more on this below in Guarantees and bonds under construction contracts and in
Chapter 14 on construction financing).
Insurance companies
Some insurance companies will provide a guarantee similar to a bank letter of credit.
Other guarantees provided by insurance companies include performance bonds and
construction completion bonds. Insurance companies also provide guarantees of indemnity
provisions of contracts. Some types of insurance policies, such as political risk insurance and
business interruption insurance, are tantamount to guarantees. The line between many types
of insurance and guarantees is sometimes a thin one.
Political risk insurance is discussed later in this chapter and in Chapter 22.
Investment companies
Investment companies will sometimes provide debt or performance guarantees. The price
charged for the guarantee will be commensurate with the risk assumed.
2 The coverage of guarantees

Commercial risk
The repayment and performance of a loan agreement is the most common assumption of
commercial risk in a project financing. Other commercial risks are discussed below. Most
types of commercial risks must be covered by guarantees from the sponsoring party or from
some responsible third party.
Completion
Completion of the project facility and its operation must be at a cost and rate consistent
with specifications. Completion guarantees that specify that the project will be completed and
operating in accordance with specifications are designed to cover this risk. The contractor
sometimes assumes this risk and using a reliable contractor helps to minimise this risk (so
back to our risk check list in Chapter 5). Start-up specialists can be employed to bring
expertise to start-up problems.
Cost overrun
Any cost overrun must be borne by the sponsor or by some party with whom the sponsor
has contracted. In view of the bad cost overrun experience in recent years, contractors are
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Guarantees
reluctant to assume overrun risk on out of the ordinary projects, except at a substantial
premium. On the other hand, while a fixed price contract may not be available at the start
of a project; such a contract may later be available if the subcontractor bids can be obtained
on a fixed price basis. Sometimes this risk can be covered by provision for escalation or for
adjustment to take-or-pay contracts to cover additional cost. Sometimes cost overrun risk
can be covered by a completion bond issued by an indemnity company. Lenders can share
in the cost overrun risk by providing standby credit for such a contingency, with provision
for repayment of any cost overrun.
Perhaps the most interesting development in recent times has been the idea of risk sharing
and gain sharing in contracting as discussed in the Andrew Field example in Chapter 2.
Contractors have traditionally been very competitive and the spirit of collaboration in this
project was widely discussed in the media and in the literature as novel and indeed not
always easy for all parties. What the gain sharing approach achieves is teamwork to get a
project delivered the project can fall at its weakest point so there is an incentive to quality
assure across all members however, the danger is also in perceptions around collaboration
and the possibility to unite and hold the sponsor to ransom over cost increases.
Delay
The cost of delay has a compounding effect on a project. Interest costs on the debt continue
to rise unabated and the vital project cash flows are delayed. Provision can sometimes be
made for coverage of this risk through the construction contract, or by the choice of a reli-
able contractor able to overcome the delay problems. Provision also can be made to adjust
take-or-pay contract revenue to cover any increase in costs resulting from the delay.
Cost of raw material and energy

The economic strength of a particular project is often dependent on its ability to obtain some
product or service at a certain price. The project may be able to borrow money and may
be able to partially or wholly finance itself, provided it has assured input cost for key input
products or services. Assumption of this cost risk by a third-party guarantor may be essen-
tial to finance the project and may even obviate the need for other guarantees. Examples of
products where the source and availability may be guaranteed at a maximum price include:
natural gas, oil, electricity and raw ore. Put-or-pay contracts or deliver-or-pay contracts can
be used to cover this risk.
Market for product

An assured sale price of the product or service of a project, once produced, may be essential
to the economics of a project. This risk can be covered by unconditional take-or-pay contracts,
through-put contracts, tolling contracts or cost-of-service agreements. The risk can also be
covered by conditional take-and-pay contracts in which an established contract sale price
will be paid, provided delivery is made, as discussed in Chapters 2, 10 and 11.
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Project Financing
Many energy projects will be difficult to finance without some financially responsible
party assuming the risk of the sale price. Since governments are deeply involved in energy
price control, a government may be the only party willing to assume the commercial risk
of radical, new and expensive energy sources.
For example, the production of oil from shale2 or from tar sands at a price which makes
economic sense at the start of such a project may not make economic sense at the conclusion
of the project, if the price of competing oil has in the meantime declined. The economic
feasibility of the construction of gas and oil transmission pipelines may also change if it is
based on future market prices of the end-products. The same would be true when producing
gas from coal or methane from deep wells to compete with natural gas.
Political risk
The political risk of doing business in some countries may make it difficult or impossible
to obtain capital for development of a project to be located in that country, in the absence
of an assumption by some responsible party of the political risk inherent in the transac-
tion. While the risk immediately apparent is expropriation or seizure of the project by the
government in which the project is located, protection is also needed against more subtle
methods of a government taking over control. Creeping expropriation is as effective as an
act of nationalisation of a project. In many instances, political risks must be assumed by a
government agency, or some politically friendly country, or international financing agency,
if the project is to proceed.
In recent years, arbitrary blanket moratoriums (or threats of such moratoriums)
on repayment of foreign debt by certain countries have placed a new dimension on
political risk.
Casualty risk
Casualty risk can be covered by a well-planned insurance program, and prevention advice
obtained from specialists in this area.
War risk
While many of the risks in any project may be assumed by non-government guarantors
and interested parties, war risk may be beyond the scope of risks which such parties or
commercial insurance companies are willing to assume. In such a case, a government
guarantor may be necessary to support the transaction. Although this risk may be remote,
it is also the kind of risk which a lender is usually unwilling to assume. But it must be
considered, in order to obtain the financing of a project located in an area of the world
subject to such a risk.
Destruction of facilities in the Middle East in recent years and the need to ensure worker
safety and evacuation have provided some companies with first hand current experience of
the consequences when war risks are realised.
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Guarantees
Acts of God
Insurance coverage can often be obtained against all but the most remote kinds of casualty
risks. However, gaps sometimes exist in the insurance coverage available to a project. These
gaps must be covered for the project to be financed. Often, therefore, it becomes necessary
for an interested party to assume special casualty risks not covered by insurance.
3 Types of guarantees
Guarantees are normally considered to be direct, unconditional guarantees by a guarantor,
under which it assumes the responsibility to perform all the obligations of the guaranteed
party. In many cases, this is the only kind of guarantee which will suffice to support the
transaction. Note this differs from the standby letter of credit, where the payment is trig-
gered by specified events recorded in documents submitted to the bank.
In many cases, however, the guarantee need not be all-encompassing in order to provide
sufficient support for the transaction to be financed. Guarantees may be limited both in
amount and time. They may be indirect, contingent or implied. In a given situation, some-
thing less than a full unconditional guarantee of all obligations of the guaranteed party may
be sufficient to support the transaction from the standpoint of the guarantor. This may be
very important for the guarantor, since the impact on its credit standing and financial state-
ments may be considerably lessened by a guarantee that is tailored to provide the necessary
support for a transaction, but that does not constitute an unconditional obligation to pay
or perform under any circumstances.
Limited guarantees
Guarantees may be limited in amount, in time, or in both.
Guarantees limited in amount

Guarantees may not be required to cover 100% of the lenders credit exposure in order to
be effective. They may take the form of deficiency guarantees or first-loss guarantees up to
a certain amount. A lender may feel comfortable lending to a project company, provided it
is of the opinion the project will have only limited deficits under the worst of circumstances
and it has an agreement that such deficits (in an amount satisfactory to the lender) will be
made up by the guarantor.
Another kind of guarantee limited in amount is provided through a joint venture, in
which the liability for any obligations is limited to joint liability rather than joint and several
liability. Each joint venture party is liable only up to an amount based on the proportion of
its shareholding and not for the entire liability of the joint venture, thus preserving its credit
standing. The basis of the calculation would be specified in the joint venture agreement.
Yet another kind of guarantee that is limited in amount exists for cost overruns. A
lender may be willing to finance a project, provided the costs are as predicted. A lender
does not want to find itself trapped into having to finance a larger amount simply because
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Project Financing
costs overrun and no other source of funds is available. In situations involving such risk, the
potential overrun risk is covered by interested parties to the transaction. Once the possible
cost overrun is covered, the balance of the project may be readily financeable on its merits.
For example, the project may have a firm unconditional take-or-pay contract sufficient to
cover debt service on the contract price, but not sufficient if there is a cost overrun. However,
no lender wants to find itself in a position where it has a half finished project and no choice
but to lend more or to walk away, so a robust scenario analysis and a realistic approach
to the probability and amount of cost overruns is necessary before finalisation of the deal.
A similar guarantee is the guarantee by the sponsor of payment of operating expense,
where the gross revenues of a project are allocated to debt service and are insufficient to
cover both operating expense and debt service.
A pre-committed pool of funds by the sponsor is yet another kind of guarantee limited
in amount. In such an arrangement, the lender must be satisfied that the pre-committed pool
of funds is sufficient to cover contingencies which would otherwise be covered byguarantees.
Guarantees limited in time

While a prospective guarantor may be reluctant to enter into a direct guarantee of the long-
term debt of a particular project, it may feel very comfortable in guaranteeing the project
during its start-up period.
The projections for a project may indicate to prospective lenders that the project will
generate adequate cash flows to service the project debt, provided the project performs to
specifications. However, depending on the complexity of the project, this performance may
not be assured for several months or years after completion of the project. In other words,
there is a start-up risk.
Lenders, on the other hand, may feel comfortable lending to the project only if it performs
to specifications. Therefore, a bridging guarantee which will expire after the project performs
as specified for a certain period of time, may be a sufficient form of guarantee to cover
risks in the transaction not otherwise addressed. When combined with other undertakings
by interested parties, there should be sufficient credit support for the financing of the project
up until the point when the project is strong enough to perform and generate cash flows in
accordance with expectations. This guarantee is called a completion guarantee.
A completion guarantee is essentially a guarantee limited in time, since it guarantees
the project will be completed in a certain time frame and will perform at a certain rate of
efficiency. It expires not on completion of construction but after the expiration of a period
of time sufficient to ensure that the project will in fact perform as represented. If the lender
is otherwise satisfied with the projected cash flows and the economics of the transaction, the
completion guarantee may obviate the necessity for a long-term direct guarantee.
Indirect guarantees
The most common indirect guarantees involved in project financings to assure a stream of
revenue are take-or-pay contracts, through-put contracts or long-term unconditional transpor-
tation contracts, which provide a guaranteed stream of revenue to a project. These guarantees
322

Guarantees
have been accepted by the accounting profession as being indirect for purposes of balance
sheet accounting and, therefore, may be included only in footnotes to the balance sheet.
However, take-or-pay contracts, through-put tolling agreements, cost-of service agreements,
or unconditional transportation contracts sufficient to support a project financing, constitute
a very definite unconditional obligation to pay revenue to a project for a period of time,
usually sufficient to amortise debt associated with the project.
Another kind of indirect guarantee to a project financing is a price support for produc-
tion. This support may be provided by a third-party user. It may also be provided by an
interested government agency. A deficiency guarantee to make up the difference between
take-or-pay revenues dedicated to debt service and the amounts required for debt service is
another approach.
The economics of the project may depend upon an assured price of a raw material or a
service to be used by the project. This risk can be covered by a long-term put-or-pay contract
from a supplier, which is an indirect guarantee of price by the supplier. In a put-or-pay
contract, the supplier provides the raw material or service at a certain price, or subsidises
the price if the project company acquires the raw material or service from a third party at
a higher price because the original supplier is unable to perform.
Contingent guarantees
Lenders do not want to be equity risk-takers, even though such risks are remote and very
contingent. Consequently, it is often necessary for some interested party to a project to
assume remote contingent risks in order to get a project financed. The assumption of such
risks may have relatively small impact on the footnotes of the balance sheet of the contingent
guarantor, if it appears at all.
Contingent guarantees may take many forms. The contingency may not be deemed to
occur except in the case of a number of events, such as the failure of other interested parties
to the transaction in performing or paying after reasonable efforts by a lender to enforce
performance or collection. Nevertheless, the contingent guarantee of a strong credit may be
necessary to support the transaction where other parties to the transaction are of question-
able financial strength.
The contingent guarantee may take the form of some event beyond the control of the
parties. It may be an unlikely event, such as a change in price, an action of government, or
some uninsurable act of God. However, lenders will regard the assumption of such risks to be
the task of the owners, interested parties, governments, or sponsors, rather thanthemselves.
Implied guarantees
Implied guarantees are not really guarantees at all. They are merely undertakings or sets of
circumstances which make it likely, from the lenders standpoint, that the guarantor will
provide support to the transaction. Implied guarantees are popular with guarantors because
they are non-binding and do not have to be reported on financial statements.
A comfort letter which carries implication of support is the most common form of an
implied guarantee. The term comfort letter covers a broad spectrum of undertakings. A
323

Project Financing
comfort letter is often nothing more than an agreement to supervise the project company
and to see that it is properly managed. Comfort letters are sometimes referred to as letters
of responsibility. How much comfort that gives is a lenders subjective decision.
In the past, in the United States, comfort letters included undertakings to provide funds
to a project company or subsidiary if it got into difficulty. Sometimes this was expressed as
an agreement to maintain the working capital at a certain level, which was tantamount to a
full guarantee. Until several years ago, when the accounting rule was changed in the United
States, such an undertaking in a comfort letter was not considered a guarantee for financial
accounting purposes. However, today such an undertaking is regarded as a guarantee.
In Europe, on the other hand, broad undertakings in comfort letters are sometimes not
considered to be guarantees. Some European sponsors of a project may be able to use a
strongly worded comfort letter without reporting it as a guarantee. A letter of awareness
from a parent merely states the parent is aware of the loan and confers no obligation.
In the case of a strong credit participating with weak credits in a joint venture where
the project is essential to the strong credit, the mere participation of the strong credit carries
implications of support, because it is believed that the strong lender has carried out sufficient
due diligence, hence the presence of World Bank guaranteed portions of loans may encourage
lenders in to the non-guaranteed tranches.
A project company, the debt of which is not guaranteed by the parent, but the name of
which is similar to the parents name and associated with the parents name, carries implied
guarantees of performance. This is particularly true where the parent agrees to hold 100% of
the stock of the project company and not change the name of the project company during
the term of the loan. However, there are sufficient cases where parents have walked away
to flag up that this is not to be relied on.
When the parents loan agreements contain cross default provisions which will create
an event of default in the event of the default in the loan of a subsidiary, lenders may feel
comfortable with a loan to a subsidiary project company, provided they control the terms
of the parents loan agreement.
Guarantees of all types will continue to be a popular support of project financings so
long as the balance sheet impact is less than a loan.
Example of a project financing support by a user sponsors guarantee

Supplier supported by sponsors guarantee: an independent supplier of crude oil,
feedstock or LNG, with limited access to capital, finances a project by obtaining loans
guaranteed by a sponsor seeking an assured source of supply, in return for an agreement
to supply the sponsor. Typical projects include storage facilities, refineries, reforming
facilities, pipelines.
Tax, credit, debt rate and balance sheet: the supplier claims depreciation deductions against
its income tax. The credit supporting the transaction is the sponsors credit. The suppliers
debt rate reflects the sponsors credit. The loan is shown as senior debt on the suppliers
balance sheet. This debt could be structured as subordinated debt, since creditors will rely
on the guarantee of the sponsor in any event.
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Guarantees
If payment of the loan and accrued interest were limited to proceeds from production,
the loan might be considered to be contingent debt, shown in a footnote and not shown
as a general obligation of the supplier.
Covenants: if the guaranteed debt is structured as subordinated debt for the supplier, such
debt may avoid senior debt and lease restrictions. The supplier might form an unrestricted
subsidiary to borrow and build the plant to remove the project from loan restrictions.
The language of the sponsors loan agreement would determine amount of guarantees
permitted and whether the example guarantee would count.
Advantages for the sponsor:
may be off-balance sheet except for footnotes;
outside loan covenants restricting debt or lease;
an essential facility is built without the sponsor participant being required to pay the
cost of the project; and

capital is preserved for other uses.
Disadvantages for the sponsor:

lack of absolute control over the facility;
guarantees must be shown in a footnote to the balance sheet; and
use of guarantees affects the credit standing of a sponsor, even though carried as a
footnote to the balance sheet. Other forms of project financing may be more appropriate
for a sponsor with a need for greater leverage.
Completion guarantees
The greatest period of risk in a project financing is during the construction and start-up
phases of the project. Many projects are supported during these phases by the completion
guarantee mentioned earlier in this chapter and which is supplied by the sponsor or spon-
sors of the project. This type of guarantee may apply to both the short-term lenders during
construction and to term lenders or lessors who have agreed to take out the short-term
lenders on completion of the project.
The completion guarantors undertake to complete the project within a certain time
period and to provide funds to pay all cost overruns. The completion guarantee also contains
appropriate guarantees as to title to the properties, minerals and structures.
Completion, under a completion guarantee, involves more than a mere completion of the
construction of the facility. The test of completion often includes requirements of achieving
certain specified amounts of production and efficiencies at certain specified costs. This is
especially true where direct sponsor guarantees cease upon completion and the take-out term
lender must rely on the operation of the project alone, or the operation of the project and
revenue from take-or-pay contracts to service the term debt or lease. The term lender or
lessor wants to be sure that the project will work to the efficiencies represented and assumed
in the financial projections which formed the basis for the loan or lease.
The completion guarantor can protect itself by selecting financially responsible contractors
and negotiating provisions into the construction contract which meet the terms required by
the completion guarantee. In some instances, the lenders may be satisfied with the ability,
financial standing and reputation of the contractor to perform without additionalguarantees.
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Project Financing
Exhibit 23.2
Project financing supported by sponsor guarantee
Sponsor
company
1 Loan 1 Lease
guarantee guarantee
Supplier
company
1 100% Leasing
Lender
ownership company
Project
2 Loan 3 Lease
company
Summary
1 The sponsor is interested in having a certain facility which will provide a needed product or service. It
does not want to own or operate the facility. The sponsor, therefore, arranges for a supplier to build and
own the facility and agrees to guarantee a loan and a lease in connection with theproject.
2 The project company arranges a loan from a lender, backed by a guarantee from thesponsor.
3 The project company arranges a lease from a leasing company, backed by a guarantee from thesponsor.
The completion guarantor can also seek to protect itself by purchasing bonds and
insurance against delays and failure to complete. These kinds of guarantees are usually not
acceptable to a lender as a substitute for a completion guarantee, although they may offer
some protection (if carefully drawn) to the completion guarantor.
Lenders have, in some instances, been willing to limit the liability of the sponsor to a
pre-committed pool of funds or amount. In such a situation, the lender must be satisfied that
the pre-committed pool of funds is sufficient to cover all contingencies. The Woodside project
in Australia was an example of pre-committed funds substituted for completion guarantees.
326

Guarantees
Guarantees and bonds under construction contracts

There are a number of types of guarantees and bonds used to guarantee completion and
performance under construction contracts. These include:
bid bonds;
performance bonds;
advance payment guarantees or bonds;
retention money guarantees or bonds; and
maintenance bonds.
Third-party guarantors of bonds include surety companies and banks.

In the United States, performance bonds are generally issued by surety companies and it
is quite common for such bonds to be for 100% of the contract price. The obligation of the
surety company (if properly drafted) is to perform under the contract. A breach of contract
by the beneficiary of the bond constitutes a defence. Surety bonds can create a false sense
of security for a beneficiary. Such contracts must be carefully drafted to achieve the degree
of protection sought. Generally, lenders are apprehensive about relying on surety bonds for
loan repayment.
Surety bonds in international transactions are drafted as unconditional obligations to
pay a sum of money to the beneficiary on demand where, in the opinion of the beneficiary,
the contractor has failed to perform. Sometimes these contracts are written by international
surety companies. More often, they are written by banks as unconditional letters of credit
payable on simple demand without proof of non-performance. Such bonds do not require
performance of the contract. Rather, they are for a cash payment equal to a fraction of the
contract price, which typically ranges from 5% to 30%. Banks deal in documents, but the
risk here is of calling the bond, producing the document for the bank and then an argument
ensuing between contractor and client, in to which the bank is enmeshed, with consequent
legal and other costs for the bank.
Surety bonds, as commonly used in the United States and international contract guarantee
bonds backed by bank letters of credit, which are used in many international transactions
are compared in Exhibit 23.3.
A surety bond or a letter of credit is only as good as the financial strength and integrity
of the guarantor, which must be an institution satisfactory to the beneficiary. Organisations
such as the Surety Information Office or specialist insurers can offer more detail.
Bid bond
A bid bond is required of bidders on a contract, to make sure that each bidder is serious, will
accept the award of the contract if offered and will proceed with the execution of thecontract.
Performance bond
The purpose of the performance bond is to provide additional funds in the event the contractor
fails to perform, for any reason. The existence of such a bond is also an endorsement
327

Exhibit 23.3
Comparison of surety bond and standby letter of credit
Factor Surety bond Standby letter of credit

Obligations To perform the contract To pay a sum of money
Coverage 100% of contract or rightful claims Specified in the letter of credit can
be 5% to 30% of contract price
Call On default On demand
Commitment Conditional following investigation Unconditional
Format Guarantee Letter of credit
Exhibit 23.4
Guarantee by a sponsor company using a surety bond versus a letter of credit
Debt
Lender
service
Loan Loan
Notes
proceeds agreement
Project Security Security

company agreement trustee
Debt
service
Sponsor Guarantee
company agreement

Guarantees
of the credit and confidence of the guarantor in the ability and professional standing of
the contractor.
Advance payment guarantee

The purpose of the advance payment guarantee is to protect the sponsors if payments are
advanced to assist the contractor in purchasing and assembling the materials, equipment
and personnel necessary to get the construction started, as opposed to payments made on
completion of certain stages.
Retention money bonds

It is common practice for the beneficiary for whom a project is being built to retain or hold
back a portion of the progress payment which would otherwise be due, in order to provide a
fund to cover unforeseen expenses due to any contractor mistakes in the construction. Since
most contractors prefer to receive the progress payments as quickly as possible, they substi-
tute a retention bond for the amount of the funds retained, to receive immediate payment.
Maintenance bonds
The purpose of the maintenance bond is to provide a source of funds for correcting defects
in the construction or the performance of the project, which are discovered after comple-
tion of the actual construction. Typically, the performance bond and the retention bond are
converted to maintenance bonds upon the completion of the contract.
Guarantee to support an off-balance sheet construction loan

A public utility desires to build a generating unit. The time required for construction of
the plant runs for several years and the utility does not wish to penalise earnings by incur-
ring interest expense to finance construction during those years. A non-profit corporation,
independent of the utility, agrees (for a management fee) to form a subsidiary to act as the
construction company to build the plant. (This type of special purpose company is called
a construction intermediary.) The construction company appoints the utility as its agent to
construct the plant. The construction company borrows funds needed to construct the plant,
based upon the guarantee and commitment of the utility to complete the plant and take out
the lenders upon completion. Typical projects include any large equipment project facility.
(See Chapter 14 for a more complete discussion of construction loans and Chapter 30 for
more on the use of a variant form of this in public private partnerships.)
Income tax: interest deductions during construction are lost. However, interest expense
may be capitalised into the price of the plant with later tax deductions for depreciation
and interest based upon the capitalised cost.
Rate base and debt rate: investment in the construction is kept out of the rate base.
329

Project Financing
Capitalised interest is usually included in the rate base. The debt for the construction
company is a function of the credit of the utility.
Variation: a lessor might be substituted for the construction company. The lessor could
then elect to capitalise interest, claim tax credits and depreciation on the capitalised
costs and pass most of the resulting savings through to the lessee. The lessee would
accomplish its objective of excluding interest expense from its profit and loss statement
during construction.
Advantages: (i) if the utility, by owning the property during construction, would have to
expend interest, such expense could be avoided; and (ii) borrowing capacity or the ability
of the utility to borrow short-term debt may be increased.
Disadvantage: loss of tax deductions and perhaps credits during construction.
Deficiency guarantees
A deficiency guarantee is a guarantee limited in amount to the deficiency suffered by the
creditor in the event of default, re-possession and resale. A deficiency guarantee is usually
expressed as covering the first loss suffered by a lender in the event of default repossession
and resale. Generally included in the lenders loss are lost interest, expenses of resale and
the unpaid loan balance.
A limited deficiency guarantee is a deficiency guarantee with a maximum limit of exposure
for the guarantor. A 25% deficiency guarantee is a deficiency guarantee with a maximum
exposure of 25% of the amount financed.
Alternatively, the limit might be expressed as a dollar amount. A limited deficiency guar-
antee can be used very effectively in project financing in situations in which the collateral
for the loan or lease is marketable and has substantial value. If, for example, the original
cost of equipment is US$100, the amount of the outstanding balance US$75, the limited
deficiency guarantee 25% of original cost, and the property is repossessed and sold for
US$55 (after expenses), the guarantor would be liable for US$20. If resold for US$45, the
guarantor would be liable for US$25.
In the case of a lease, the lessor might have the option to either sell or re-lease in the
event of default. The stipulated loss schedule of the lease plus unpaid past due rents with
interest would be used to determine the actual loss.
A limited deficiency guarantee is often reduced over the term of the loan or lease in
proportion to loan amortisation or the lease termination schedule. This makes the guarantee
less onerous to the guarantor. From the standpoint of a guarantor, a limited deficiency guar-
antee can often accomplish the same result as a full guarantee, but with much less impact
on the guarantors balance sheet footnotes and credit.
Other types of deficiency guarantees cover cost overruns or revenue deficiencies and are
also discussed in this chapter.
Undertakings which provide comfort to lenders but are not really guarantees
Sponsors can sometimes make representations to lenders, or agree to undertakings which are
not guarantees yet give a lender sufficient comfort to proceed with a loan to the beneficiary of
330

Guarantees
Exhibit 23.5
30% deficiency guarantee on a 10-year level principal payment note
(a) Which remains 30% (b) Which is reduced in proportion

Cost throughout life of loan Cost to outstanding loan balance
1.2 1.2
US$1,000,000 US$1,000,000
1.0 1.0
30%
30%
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
0 0
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Years Years
such representation or undertaking. Use of such undertakings instead of guarantees is popular

since they may not be reflected on the sponsors balance sheet. Examples are as follows.
1 Short-term advances of a sponsor or parent might be channelled through the subsidiarys

bank account (subject to offset) to provide the sponsors balances which would have to
be maintained in any event.
2 A parent with a spotless credit standing might agree to continue to hold 100% of the
stock of the borrower until the loan was retired (keep well agreement).
3 If the subsidiarys name was a derivative of the parents name, the parent might agree
not to change the name of the subsidiary while the loan was outstanding. (See above for
why this might not be as strong a support as envisaged.)
4 In the case of a supplier where a take-or-pay contract might provide the needed support,
an agreement by the sponsor to deal only with the benefactor company for procuring the
needed service or product might be sufficient if the sponsor requires minimum amounts
of such service or product for a period of years which bears some relationship to the
term of the loan or lease.
331

Project Financing
5 Comfort letters in which a parent undertakes to supervise closely the management of a

subsidiary without responsibility for the subsidiary meeting its contractual obligations. As
discussed earlier in this chapter, this type of letter is usually given little weight bylenders.
6 Cross-default clauses with some other contract or loan agreement which the sponsor cannot
afford to permit to default and controlled by the lenders relying on the comfort letter.
Where one or more joint venture parties are involved with a joint venture party whose credit
is weak, lenders or lessors may be convinced that the nature of the project and importance
to the strong venture parties is such that the strong venture parties cannot afford to abandon
the project, but will be compelled to support the obligations of the weak credit venture
parties, if any are unable to meet their obligations. However, this is also not without risk.
Governments can provide subsidies and undertakings which are not guarantees, but are
sufficient in nature to provide credit support. Price supports are indirect guarantees. For
example, development of solar energy production in some countries will require long-term
government guaranteed prices for production.
Cost-of-service tariffs by public utility commissions which permit actual costs of product
to be melded into utility rates will provide credit support to a transaction, if such tariffs
cannot be changed at the whim of a politically sensitive commission.
Foreign governments can provide support to a project by affirmations and acknowledge-
ments of policies on such matters as currency movement, permissible methods of operating
a business within the country, allocation of the countrys resources to the project, providing
infrastructure support and taxation.
Loan to a corporate joint venture supported by the implied guarantee of a

cross-default clause
A sponsor company needs a plant to supply it with a certain product and wishes to finance
the plant off-balance sheet. The sponsor does not wish to enter into a take-or-pay contract.
A joint venture corporation is formed with an operating company, which has unique technical
skills to operate the proposed plant, but has limited financial resources. The sponsor and the
operating company each own 50% of the stock of the joint venture company.
Nominal capital contributions are made to the joint venture corporation by the sponsor
and operating company. A loan to the joint venture company is arranged, which contains
provisions whereby the operating company agrees to surrender to the lenders 10% of its stock
in the joint venture corporation in the event that the loan is in default for any reason. The
lenders have a right to put that stock to the sponsor company which also agrees that at
all times during the loan it will retain stock evidencing its 50% interest in the joint project.
Other provisions of the loan agreement assure that the 50% stock ownership of the
sponsor will remain in effect throughout the term of the loan, so that any shares put to the
sponsor by the lenders will give the sponsor control of the project and require recording the
defaulted loan on its balance sheet.
The sponsor has other long-term loan agreements which contain cross-default clauses
which will place such loans in default in the event any company controlled by it has a loan
in default. The joint venture company falls within this definition if the sponsor owns more
332

Guarantees
Exhibit 23.6
Keep-well agreement by sponsor company for subsidiary
2 Keep-well
Lender
agreement
3 Loan 1 Loan 4 Debt

3 Notes
proceeds agreement service
Project company Sponsor

(subsidiary of 2 Keep-well
agreement company
sponsor)
Summary
1 The project company enters into a loan agreement with alender.
2 A keep-well agreement is entered into between the sponsor and the project company; the sponsor also
enters into an agreement with the lender to keep-well the projectcompany.
3 The notes are signed and delivered by the project company to the lender and the loan proceeds paid to
the projectcompany.
4 Debt service is paid to the lender by the projectcompany.
than 50% of its stock. The lenders to the joint venture rely upon the supposition the sponsor
will support the joint venture company rather than permit its long-term loan agreements to
go into default. A typical project could include any processing plant or facility.
Income tax: income tax benefits will flow to the joint venture company.
Debt rate, balance sheet impact and loan covenants: the debt rate is based upon the
likelihood the sponsor company will assume the obligation of the project company, rather
333

Project Financing
than have its loans go into default. The value of the project itself will help support the
debt rate. The loan to the joint venture company will be off-balance sheet so long as the
sponsor does not have control of the company. The loan to the joint venture company
will be outside the loan covenant restrictions of the sponsor company, unless a default
occurs and the stock of the project is put to the sponsor by the lenders.
Variation: the tax benefits might be better used by a third-party leasing company, or by
the sponsor entering into a leveraged lease agreement with the joint venture company for
the facility. In the case of such a lease by the sponsor, additional questions are raised as
to control for financial accounting purposes.
Advantages:
the sponsor avoids a direct guarantee of the project loan;
the loan to the project is off-balance sheet and outside the loan covenants of the sponsor;
the sponsors capital is preserved for other uses; and
technical expertise for the operation of the project plant is obtained.
Disadvantages:
a higher debt rate may result from the indirect nature of the sponsors support; and
credit support may have to be provided to a less than 100%-owned subsidiary.
Project financing supported by third-party guarantor

The ideal project from the standpoint of a promoter/sponsor is a project company which is
owned by the sponsor, provides a service or product or a profit opportunity from construc-
tion or operation desired by the sponsor and is financed directly or through the guarantee
of a third party.
Credit and debt rate of the project: the credit is the credit of the guarantor and the project
company. The debt rate is the debt rate of the third-party guarantor.
Balance sheet and loan covenants of the owner: the effect on the owners balance sheet
is as debt, unless special steps are taken to avoid that result. The sponsor/owner may not
want to own a large equity interest outright at the time the project has a large outstanding
debt, because the debt will show on the owners balance sheet. The owner might hold a
small interest during developing years, control the project through a long-term management
contract and achieve a substantial interest later through warrants and options. The effect
of the loan on the sponsor/owners loan covenants is also as debt if the loan is a direct
liability. The owner may be able to avoid this result by using an unrestricted subsidiary
to hold title, or using subordinated debt, or borrowing non-recourse. Control can be
maintained using a long-term management contract.
Objective of the guarantor or the sponsor: governments and international agencies are
motivated by economic, political and social needs of the exporting country or usercountry.
Private companies profit by:
construction of a project (such as a dock, storage facility, railroad or pipeline) needed
in connection with guarantors or sponsors existing operations even though owned by

a third party;
334

Guarantees
assuring a source of supply of petroleum, gas, ore, semi-manufactured goods, or

agricultural products (this type of guarantee is described separately in more detail);
selling a product to be used in the project;
selling a service in connection with the project;
selling a service or product to the project after completion; and
acquiring an equity interest in the project.
Examples of third-party guarantors:

US and foreign manufacturers of products to be used in the project;
users of products or services to be produced or provided by the project;
suppliers of services or products to be used in the project;
an agency of the US government interested in getting a project built;
an agency or agencies of the host government interested in getting the project built,
including the central bank;

an agency of a state government interested in getting the project built;
foreign government export agencies and national interest agencies supporting exports
of products to be used in the project;

the World Bank;
area development banks:
African Development Bank;

Asian Development Bank;
Inter-American Development Bank; and
EBRD.
Advantages to owner and third-party sponsor not a guarantor:
loan is non-recourse if borrowing is by an independent subsidiary;
project may be kept off-balance sheet and outside loan covenant restrictions;
capital is preserved for other uses;
credit sources are preserved for other uses;
a needed facility is built without the sponsor being required to use its credit to support
the project;
borrowing cost may be lower as a result of guarantors credit; and
if the project is located in a foreign country, the project might not be financeable
in the absence of a guarantee from the host government, an international agency or

a US government agency. Such a guarantee provides comfort to the lender against
nationalisation or expropriation of the project. Host governments might try to avoid
payment of a bank loan, but cannot afford to ruin their credit standing with international
agencies, Eximbank, or other export-import banks.
Disadvantages:
lack of control over the facility by sponsor; and
debt must be shown on-balance sheet of owner if the company receiving the guarantee
is 50% controlled.
335

Project Financing
Exhibit 23.7
Third-party guarantor
Third-party
guarantor
(government,
supplier or
user)
1 Guarantee 1 Guarantee
Project
company
2 Loan 2 Lease
Leasing
Lender
company
Summary
1 A third-party guarantor which does not own or control the project company enters into a guarantee
agreement whereby it guarantees loan obligations and/or lease obligations of the projectcompany.
2 On the basis of the guarantee, a lender and/or a leasing company enter into a loan or lease, respectively,
with the projectcompany.
Direct and indirect guarantees against nationalisation, expropriation and

political risk
A generous share of the mineral resources of the world is located in developing countries
which sometimes lack political stability satisfactory to potential lenders or investors. Users
of such minerals (and their financial advisers) are faced with the problem of raising capital
needed to develop such vital sources of supply. The political risk involved in owning, oper-
ating or financing a project in a foreign country can assert itself in many ways. Risks in
financing such a foreign project include the following.
336

Guarantees
1 Expropriation, nationalisation or confiscation.

2 Currency:
currency convertibility;
current devaluation;
import restrictions in currency;
export currency restrictions or taxes on dividends and capital distributions; and
export currency restrictions or taxes on debt service.
3 Increased taxes on the property, project, production or income. Increased taxes on

imports or on exports.
4 Labour:
availability of local labour;
work permits for imported labour; and
ability to deal with local labour unions.
5 Resources:
availability and price of local supplies, materials, machinery and products;
allocation of local resources to the project such as electricity, gas, oil, coal;
availability of roads, docks, railroads, airports, transportation; and
ability to import needed materials, machinery and raw material.
6 Export restrictions or taxes on product; political embargos.

7 Police and property protection.
8 Local government interference or harassment through licences, regulation, taxes,
police, militia.
9 Local and federal government regulatory agencies which can interfere with the project such
as labour and resource allocation agencies, as well as environmental protectionagencies.
10 Enforceability of contracts. The lack of an effective system of laws and courts within a
country which will be available to enforce contracts and to provide protection against
unwarranted claims is obviously very important. This includes the ability to collect
damages under a foreign court system after a favourable court decision is rendered. Today,
investment opportunities are attractive to potential markets in the former Communist
world but hampered by the uncertainty of collection of claims, payment of dividends
and enforcement of partnership or joint venture contracts.
11 Safety of personnel. Projects cannot be operated without good management. Extortion
and threats to personal safety and kidnapping executives or members of their family for
ransom has become a serious deterrent to investment in some developing countries. The
host country must be able and willing to protect the project enterprise and its personnel
from criminal activities.
12 Terrorism. Foreign projects are attractive targets for terrorists seeking to make a political
statement. Where war risk insurance is available, coverage of terrorist acts should also
be covered. Political violence insurance may also be available for this contingency.
13 Loss due to war, revolution or insurrection.
Some of these risks may be addressed and protected against in a number of ways.
1 A concession agreement with the host government or letter of understanding which covers
337

Project Financing
the risks outlined above. Such a concession agreement should contain firm dates as to
its time limits.
2 A guarantee by the host government against expropriation or nationalisation.
3 A guarantee by the central bank of the host country may provide protection against many
of the risks including currency and foreign exchange restrictions.
4 Insurance from the Overseas Private Investment Corporation (OPIC), or other government
agencies, may be available to companies against expropriation, nationalisation, confiscation
or loss due to war, revolution or insurrection, as discussed in Chapter 22.
5 Insurance against political risk provided by private insurance companies.
However, in instances of political instability, the assumption of the obligations and commit-
ments entered into by previous governments is not automatic. Other more subtle measures
to protect against the outlined risks include those shown below.
1 Multinational sponsorship. A loan to the project either backed by a guarantee or partici-

pated in by an international agency such as the World Bank or one of the area development
banks. (A developing country which might be willing to nationalise a project and thus
cause a default on a loan from a US, Japanese or European financial institution would
be foolish to purposely cause a default on an international agency obligation and thus
lose financial support from the agency and similar agencies.)
2 A loan to the project backed by a guarantee from and/or participated in by the US, the
Japanese or a European Export-lmport bank. (A developing country which might be
willing to nationalise a project and thus cause a default on a loan from a financial insti-
tution will be reluctant, if not foolish, to default on a loan from a government agency
of a major country, with resultant loss of aid from other foreign sources and serious
diplomatic ramifications.)
3 Use of a variety of loans and/or guarantees from a number of government export agen-
cies of various industrial nations. The same considerations are present as in a default on
an export-import bank loan.
4 Loan to the project in which a broad range of international banks participates, some of
which have other loans to the obligor or guarantor, with cross-default clauses. (A devel-
oping country which might be willing to cause a project to default on a loan from a US
bank, will be unlikely to ruin its international credit by refusing to pay amounts due to
a broad spectrum of international banks.)
5 Heavy involvement of nationals from the host country as investors or co-lenders.
6 Investment in the project by influential foreign banks and investors.
7 An investment by the World Bank, EBRD, or one of the area development banks. While
the investment may be small, the transaction can be structured to require the vote of
the international agency for majority voting decisions, thus balancing the interests of the
sponsor and the host country investors where neither alone has majority control.
8 A co-financing a loan in which a private bank syndicate closely associates its loan to a
foreign project with a loan to the same project by the World Bank or EBRD or an area
development bank. Payments under the loan to the private bank syndicate are paid to the
World Bank or EBRD or an area development bank as a collection agent. Financial reports
338

Guarantees
on the project, which are required by the commercial lenders, are also run through the
World Bank or EBRD. Payments are made to coincide with payments under the World
Bank or EBRD loan. The World Bank or EBRD loan contains a cross-default clause in the
event the commercial bank loan is not paid. This arrangement puts considerable pressure
on the borrower to give the same priority of repayment to the private bank syndicate
loan as to the World Bank or EBRD loan. The same procedure could be used with an
area development bank.
9 A complementary financing a syndicated loan made by an area development bank or
EBRD. Instead of a separate commercial bank loan and development bank loan, one large
loan is made by the development bank or EBRD, which is then partially sold on a non-
recourse basis to the commercial bank syndicate. However, any default on the commercial
bank loan portion is in effect a default on the area development bank or EBRD loan.
Thus, the commercial bank receives the same priority in repayment as an area develop-
ment bank or EBRD.
US Eximbank financing and loan guarantee programs

The Export-Import Bank of the United States (the US Eximbank) and other Exim banks
provide direct financing and loan guarantee programs which can be used to finance the cost
and installation of US manufactured products in projects located outside the home country.
These programs offer wide ranges of financial support programs, including loans and
guarantees of loans made by others. The loan and guarantee programs cover a high percentage
of the national export value. This was discussed further in Chapters 11 and 22. The national
Exim banks role is to promote national exports, but not at the expense of prudent lending
practices. The Exim bank must find reasonable assurance of repayment on each transaction
it supports. Factors considered are the creditworthiness of the buyer, the buyers country
and the exporters ability to perform. While the purpose of the Exim bank is to encourage
exports, it will not take imprudent credit risks. If the borrower is not a substantial company,
the bank may require a guarantee from a responsible bank, host country bank, or host
government. This will increase the financing cost by the amount of such guarantee fee, ifany.
However, several Eximbanks including the US Eximbank have established a sepa-
rate Project Finance Division to provide financing to projects which rely upon cash flows
for payment.
Shipping company financing the purchase of a foreign flag ship by a non-

recourse loan
A shipping company sponsor with limited credit and limited access to capital seeks to finance
a foreign-built, foreign flag ship, by a non-recourse loan based on the collateral of the ship
and the charter. Title to the ship is held by a wholly owned subsidiary of the sponsor.
Shipyard financing, shipyard guarantee, or foreign export credit programs may provide
considerable sources of support. Such outside financing may wrap around shipyard financing
or be exclusive and must be secured by a first mortgage on the ship (junior to the shipyard
in a wrap-around structure).
339

Project Financing
A long-term bareboat charter to a very strong credit with a hell-or-high water clause
which provides sufficient cash flow to service debt and pay operating costs, will provide credit
support for possibly 80% financing, though this structure is less common today.
The shipping company obtains a bareboat charter for the ship from a very strong credit
with hell-or-high water obligations for 15 years, which provides adequate cash flows to
service the debt, pay any operating expenses and provide a contingency fund. The charter
must contain adequate safeguards against rising operating costs and taxes, including possible
withholding taxes. The obligation to pay is unconditional and not excused by failure of
the ship to operate, or labour dispute, or the owner to perform. In the event of total loss
of the ship, the obligation to pay continues until insurance is paid (the charter insurance).
Thus, the obligation of the charter party to pay supports the transaction, and the credit
decision is being made about the charter party for a projected period of 15 years, clearly
also making assumptions about the charter market for that time. This is just one reason
why the percentage of the asset value lent has come down from the heady days of 100%
or even 110% (including the first years interest as well) of previous years.
Sources of funds include international bank syndications and the international bond
market. US insurance companies have very limited amounts available for offshore loans.
In the case of the international bond market, collateral consists of a first ship mortgage
held by a trustee for the benefit of note or bondholders, plus an assignment of the charter
and the right to receive payments under the charter. An international bank syndication is
often an agency loan arrangement with the same collateral held by the agent.
Debt rate, balance sheet and covenants: the debt rate will be somewhat higher than the
debt rate of the chartering party. When available, the international bond market is fixed
rate. Bank syndications are usually floating rate although occasionally are fixed. Typically,
off-balance sheet financing for the parent is achieved by holding title to the ship through
an unrestricted subsidiary and structuring the loan non-recourse to the parent.
Advantages:
the loan may be non-recourse to the sponsor if the borrowing is by an independent
subsidiary;
the loan may be outside loan covenants of the sponsor restricting debt or leases if
structured non-recourse to the sponsor;

capital is preserved for other uses; and
the project might not be otherwise financed due to absence of outside credit support.
Disadvantages:
higher borrowing costs; and
borrowing will show as debt on a consolidated balance sheet. However, foreign flag
shipping companies infrequently publish or rely on consolidated balance sheets.
Take-or-pay, through-put and put-or-pay contracts

Take-or-pay contracts
Take-or-pay contracts were mentioned in earlier chapters, including Chapter 2 and are indi-
rect guarantees. A take-or-pay contract is an unconditional contractual obligation to make
340

Guarantees
periodic payments in the future for fixed or minimum amounts or quantities of products,
goods or services at fixed or minimum prices.3 The obligation is either not cancellable or is
cancellable only with the consent of the other party, or in the event of some remote contin-
gency. If lenders are relying upon a take-or-pay contract for repayment of their loans, the
payments must be in an amount sufficient to both service the debt needed to finance the
project or facility which will provide the contracted services or product and to pay fixed
and variable operating expenses of the project. The obligation to make minimum payments
is unconditional and must be paid whether or not the service is actually furnished or the
product actually delivered. The payments are usually subject to escalation due to increased
operating costs of the facility.
The obligation to take-or-pay may be in a variety of forms. Minimum payments suffi-
cient to service debt plus payments for product or service as delivered or performed are one
method. Another method provides for payment for certain minimum amounts of service or
product whether or not delivered, with credit against future obligations to pay where larger
payments than required are made.
The unconditional nature of the obligation to pay by the take-or-pay obligor is absolute
and not limited by total destruction of facilities, acts of God, nuclear explosion, confiscation,
condemnation and so on. The obligation is to pay, come hell-or-high water.
Provision is often made for payments to be made by the take-or-pay obligor to a
trustee that pays the debt service directly to creditors, thus assuring the creditors right to
such payments in the event of insolvency or bankruptcy of the supplier. For a borrower
with foreign markets and lenders, the payments by take-or-pay obligors may be to a trustee
outside the borrowers country.
The take-or-pay obligor can protect its interests by retaining rights to take over the
project in the event of failure by the supplier to perform. Any such take-over would be
subject to the take-or-pay obligor assuming or paying the debt used to finance the project.
Typical projects financed by a take-or-pay contract might be coal mines, refineries, reforming
units, petrochemical plants, terminals, pipelines, distribution systems, electricity generating
plants, co-generation plants.
A discussion of the terms which might be included in a typical take-or-pay contract for
coal appears later in this chapter.
Through-put contracts, tolling agreements and cost-of-service tariffs

Where the project is to provide a service, such as the transmission of a product through
a pipeline, the long-term take-or-pay contract for the transmission service is called a
through-put contract.
Through-put agreements take many forms. However, when used to support the financing
of the facility or pipeline, the obligation to make periodic payment for the service is
unconditional over the life of the loan and is regarded by the lender as a guaranteed
source of income. The obligor pays, whether the service is used or not. This type of
obligation is also sometimes called a tolling agreement, a cost-of-service tariff, or a
deficiency agreement.4
341

Project Financing
Put-or-pay contracts
Put-or-pay contracts or supply-or-pay contracts are provided by suppliers of energy, raw
material or products to a project which needs an assured supply of such energy, raw mate-
rial or product over a long period, at a predictable price, to meet production cost targets.
Under such contracts, the put-or-pay obligor must either supply the energy, raw material or
product, or pay the project company the difference in costs incurred in obtaining the energy,
raw material or products from another source.
Take-and-pay contracts
Take-and-pay contracts are similar to take-or-pay contracts, but differ in the very important
respect that they are not unconditional obligations to pay for product or service whether
or not delivered.
Rather, a take-and-pay contract is an obligation to pay for the product or service only
if it is delivered. It is, for example, an obligation to pay for coal if it is delivered to a rail
site; or an obligation to pay for energy if it is delivered to the fence (that is, the plant site);
or an obligation to pay for oil if it is delivered to the dockside.
Although long-term take-and-pay obligations can be helpful in providing support for the
financing of a project, since the obligation to pay is not unconditional, come hell or high
water, the obligation is not the equivalent of a guarantee and usually carries little weight
with lenders. However, where other risks in the project and in providing the service can be
covered by undertakings of a strong operator, for example, and insurance, the combination
of a take and-pay and such obligations may provide sufficient credit support for the project
so as to make lenders comfortable with the credit risk.
Confusion between take-or-pay contracts and take-and-pay contracts has resulted in
many prospective project financings failing before they get started. Take-and-pay contracts
are easier to negotiate than take-or-pay contracts. Consequently, a sponsor or promoter
sometimes negotiates a take-and-pay contract under the mistaken impression that such a
contract will provide adequate security for a loan to finance the facility. In some situations,
a take-or-pay contract might have been negotiated, had the sponsor or promoter aggressively
pursued that course originally.
Some promoters will argue with their bankers that there is no such thing as an uncon-
ditional take-or-pay contract and this is an area for debate for legal arguments. However,
there are numerous examples and though this structure may be rarer in some industries than
others, it has come into increasing use in recent years as users of products and services have
sought ways and means to get projects financed.
Take-if-needed
Another type of contract, much less desirable than even a take-and-pay contract, is a take-
if-needed contract which puts the supplier at the mercy of the users needs.
342

Guarantees
Comparison with ship charters

It may be helpful, in gaining perspective on a long-term take-or-pay contract or through-put
contract, to compare the obligation to a long-term bareboat ship charter. Such transactions
are quite common. Ships have been financed on the basis of such charters for many years.
Such a long-term ship charter, in which the charter party is obligated to pay come hell or
high water, is the equivalent of a guarantee so far as lenders are concerned. (The hell-or-
high water clause originated in unconditional ship charters.)
It is also useful to note that some long-term time charter obligations do not contain
hell-or-high water clauses. In such contracts, the charter party pays only if the service is
furnished. Thus the charter is merely the equivalent of a take-and-pay contract however, a
ship operator of good reputation and financial standing, with adequate insurance, may obtain
financing on the basis of such a contract.
Take-or-pay contract obligations of utilities subject to special scrutiny

Some utility commissions have affected the ability of utilities under their jurisdiction to
act as reliable take-or-pay obligors under long-term supply contracts, by arbitrarily cancel-
ling long-term supply contracts entered into by utilities when spot markets offered more
favourable pricing.
In the light of such experience, lenders will not regard a take-or-pay contract entered into
by such a utility as an unconditional obligation to pay, that is, the equivalent of guarantees
and adequate support for a long-term loan.
Perhaps the solution in such circumstances is to get the unconditional agreement of the
utility commission not to cancel the contract, with an opinion of the state attorney general
that such an arrangement is binding.
Take-or-pay obligations of pipeline companies

In recent years, take-or-pay contracts were put to test as a result of wide fluctuations in the
price of product, particularly gas. There were many instances of unilateral breaches, with the
injured party facing years of litigation to say nothing of being cut off from future business
dealings with the party breaking the contract. As a practical matter many of these breaches
of contract were settled, although some are still pending.
Needless to say, these disputes were not encouraging to potential lenders seeking to rely
on take-or-pay contracts.
Example of a project financing supported by a take-or-pay contract

A utility is building an electric generating plant and requires a long-term supply of coal. It
could acquire a mining property itself and construct a mine, but it already has heavy debt
obligations and faces future capital expenditure for additional generating facilities.
After investigating other alternatives, the utility enters into a long-term take-or-pay
contract with a coal operator, which then uses the take-or-pay contract as security for
financing the construction of the mine.
343

Project Financing
Rate base, tax, credit and debt rate: the take-or-pay obligation will impact on the sponsors
creditworthiness as it will show as a long-term liability. The amount paid for the service
or product is a clearly segregated cost. As far as income tax liabilities are concerned, the
supplier claims depreciation deductions. The credit support for the coal producers mine
finance is that of the take-or-pay contracting party and the contract. The debt rate depends
upon the credit rating of the take-or-pay sponsor and upon the form of debt instrument
used with the take or-pay.
Balance sheet and loan covenants: the supplier can use the sponsors take-or-pay contract
to support any of the following: bank lines of credit, leases, senior debt, subordinated
debt, notes also secured by first mortgage, or an instalment sale contract. These direct
obligations will show on the suppliers balance sheet or in its footnotes along with its
obligations under the take-or-pay contract. The borrowing secured by a take-or-pay contract
will appear as debt on the mine project companys balance sheet and may pass through
to the parent financials, even as just a footnote, depending on any additional support
the bank requires. However, loan covenant restrictions might be avoided if the debt is
non-recourse, or if the project is held by an unrestricted subsidiary and the supplier is not
a party or guarantor. The obligation to take-or-pay may not fall within the scope of loan
covenants restricting debt or leases. As regards the sponsors balance sheet, a take-or-pay
contract constitutes an indirect obligation. It is regarded as a supply obligation or rent
commitment and is disclosed under the commitments and contingent liabilities section of
the footnotes to the balance sheet.5
Completion of the project: a guarantee of completion of the construction of a project
to be financed by a take-or-pay contract is typically provided by a completion guarantee
from the sponsor or some third party. The completion guarantee covers cost overruns
and guarantees the project will be completed in a certain time frame and perform in
accordance with specifications. The completion guarantee runs to both the construction
lenders and to the term lenders.
Advantages:
a take-or-pay contract has a less negative impact on the sponsors credit than a guarantee;
the advantage over other advances is that an advance has an immediate impact upon
the cash and the balance sheet of the sponsor. The project may also be of such a size
that an advance would be greater than the sponsor could handle or afford to provide;
the sponsors take-or-pay obligation does not appear as debt on its balance sheet, yet
provides the necessary credit support;

the take-or-pay obligation of the sponsor is outside loan covenants restricting debt or
leases;
the supplier may be able to keep the borrowing off its balance sheet by borrowing
on a non-recourse basis through a subsidiary which uses the take-or-pay contract to

support the borrowing;
costs and cost of service segregated for rate-making purposes; and
the project might not be financed in absence of outside credit support.
Disadvantages:
a take-or-pay contract results in a somewhat higher borrowing cost;
the sponsor lacks absolute control over the facility;
344

Guarantees
Exhibit 23.8
Project financing supported by a take-or-pay contract
Sponsor
company
4 Payments 1 Take-or-pay
contract
4 Excess Project 3 Construction

Trustee Contractor
cash flow company contract
2 Loan or
4 Debt lease and assignment
service of take-or-pay
contract
Lender or
lessor
Summary
1 A sponsor company enters into a take-or-pay contract with aproject.
2 A project company arranges a loan or lease with a lender or lessor and assigns the take-or-pay contract
as security to the lender or lessor or to a security trustee acting forthem.
3 Proceeds of the loan or lease are used to finance the construction of theproperty.
4 Take-or-pay contract payments are made to the trustee which, in turn, pays debt service to the lender(s)
or lessor(s); any excess cash flow is paid to the projectcompany.
the take-or-pay contract shows as an indirect liability in the sponsor obligors balance
sheet footnotes; and
the transaction is complex.
Pipeline project financing supported by through-put agreement of users

A highly leveraged pipeline company with limited credit seeks to finance a pipeline project
by arranging a borrowing based on the assignment to the lender of a through-put contract
from sponsors seeking transportation of a product.
345

Project Financing
Under a through-put contract a group of sponsors of a pipeline enter into a long-term

contract to ship certain minimum amounts of gas, oil, or refined product through a pipeline
at periodic intervals at fixed prices determined by formula, but in total sufficient to pay debt
service and operating expense of the pipeline. Each sponsor is unconditionally obligated to
ship a certain minimum amount during each time period. If any sponsor fails to ship during
a time period, the sponsor must nevertheless pay for a minimum shipment. A sponsor who
pays but does not ship during a particular time period may receive a credit against future
shipments in excess of the future obligated shipments.
A sponsor who does not ship during a certain period may not be required to pay if other
revenues are sufficient to service debt and pay operating expenses. However, if revenues are
insufficient to service debt and pay operating expenses, the co-sponsors are unconditionally
obligated to make up the deficiency in proportion to ownership. The deficiency obligations
between the owners may be varied, based on factors such as past usage. However, the
sponsors have the unconditional obligation to provide sufficient revenues to cover operating
expenses and to pay the pipeline creditors. In the case of insolvency of one sponsor, the
other sponsors become liable for the insolvent sponsors obligations. The obligation of spon-
sors is often joint and several under a through-put contract. A typical project might include
pipelines, refineries reforming units or distribution systems.
Rate base, tax and credit: the cost of the project is included in the project company
base, if applicable. The cost of service to the sponsor company is segregated and usually
passed through to the consumer under approved rate structures. As regards income
tax, depreciation deductions are claimed by the pipeline company. The obligations of
the sponsors support the project. The debt rate is determined by the strength of the
sponsors credit.
Balance sheet and loan covenants: if the borrowing to finance the project is structured as
subordinated debt or as a non-recourse loan, or is housed in an unrestricted subsidiary,
the pipeline company may avoid senior debt and lease restrictions. A through-put contract
constitutes a long-term contract for services and may not fall within the scope of covenants
limiting debt or leases. It constitutes an indirect obligation and is disclosed under the
commitments and contingent liabilities section of the footnotes to the balance sheet.6
Variation: a transportation contract for transportation by ship of gas or oil for public
utilities may be structured to contain many of the characteristics of a through-put contract,
including clearly segregated cost of service for rate-making purposes. Such a contract may
be used to support the financing of the ship or ships used to provide suchtransportation.
Completion of the project: a guarantee of completion of the construction of a project to
be financed by a through-put contract is typically provided by a completion guarantee
from the sponsor or some third party. The completion guarantee covers cost overruns
and guarantees the project will be completed in a certain time frame and perform in
accordance with specifications. The completion guarantee runs to both the construction
lenders and to the term lenders.
Advantages:
the obligation may be off-balance sheet except for footnotes;
the obligation is outside loan covenants restricting debt or leases;
346

Guarantees

economies of a large-scale project are achieved by combining and concentrating financial
resources and technical skills;
an essential facility is built without the sponsor-participant being required to pay the
entire cost of the project;

costs are segregated for rate-making purposes; and
credit sources are preserved for other uses.
Disadvantages:
higher borrowing cost; and
lack of absolute control over facility.
Terms of a long-term take-or-pay, or put-or-pay, contract

A long-term take-or-pay contract for coal is typical of take-or-pay contracts for various raw
materials or services used in project financings. Such a contract can generally be described
as a long-term contract to purchase certain minimum amounts of coal at set time intervals
and at set prices with escalation.
The seller is usually motivated to enter into such a contract to provide a guaranteed
stream of revenue which can be used to finance the construction or expansion of a mine.
Such contracts are complex and reflect a variety of factors and concerns that the buyer
and seller must take into consideration. The buyer and the seller have different objectives.
The seller wants an assured source of revenue. The buyer wants an assured supply of raw
material feedstock at a reasonable price. The seller expects to realise a reasonable profit over
the term of the agreement. Negotiations of long-term coal supply agreements, therefore, are
aimed at balancing these different objectives.
Build own and transfer or build own and operate transactions

Build, own and transfer (BOT) and build, own and operate (BOO) types of structures have
been promoted in connection with a number of projects (for example, in Turkey). The
BOT and BOO structures are variations of take-or-pay contracts or through-put contracts
discussed earlier in this chapter. Exhibit 23.10 illustrates the structures of BOT and BOO
contracts. BOOT transactions are build, own, operate and transfer, a variation of a BOT
transaction. We provide a further discussion about the principles concerning BOTs, BOOs
and BOOTs in Chapter 30 where we cover private public partnerships because that is where
the structure is also used.
Puts and call as support mechanisms

No discussion of guarantees would be complete without the mention of put and call structures.
As explained in Chapter 26, puts and calls are types of options and as such offer support
mechanisms when the option contract is exercised. So, these mechanisms can be written to
specify periods of time for which they are valid (for example, up until a completion test is
met) and conditions under which they are valid (if a principal payment is missed). In this
347

Exhibit 23.9
Through-put contract to support a borrowing
Sponsor Sponsor Sponsor

company company company
1 Through-put 1 Through-put 1 Through-put

contract contract contract
Pipeline 3 Construction
4 Payments Contractor
company contract
2 Loan or
4 Excess lease and assignment
cash flow of through-put
contract
4 Debt Lender or
Trustee
service lessor
18/06/2012 07:50
Summary
1 Three sponsor companies enter into a through-put contract with a pipelinecompany.
2 The pipeline company enters into a loan or lease with a lender or lessor and assigns the through-put contract as security to the lender or lessor (or
to a security trustee acting for them).
3 Proceeds from the loan are used to build thepipeline.
4 Payments under the through-put contract are paid to the trustee; the trustee uses those payments for debt service and pays the excess cash flow to
the pipelinecompany.

18/06/2012 07:50
Exhibit 23.10
BOT and BOO transactions
Long-term
operating
contract Equipment
Contractor Payment supplier
under
operating Equipment
contract
Fixed price
Project
turnkey contract
Payment company Payment
to build project
Contract Long-term
to take production installation
Long-term
Exim Bank at a set price or loan to Exim Bank
financing
guarantee finance
of price equipment
Option
Concession Host to purchase
agreement government project after
X years
Guarantee Ownership Guarantee
Central bank

18/06/2012 07:50
Guarantees
context, a put is the right to sell the loan to another pre-specified party at a pre-specified
value and provided the conditions are met, the counterparty has a contractual obligation
to make the purchase. A call is a right to purchase the loan. So, we can see a call option
might be useful to a sponsors parent if there is an expectation that interest rates would fall
or the credit rating and thus the interest margin the market would require would fall. A
put, in contrast, would be valuable to a lender in the situation where the loan was about to
go into default and the sponsor might not want to trigger cross default clauses. We could
compare a put in a project finance structure with elements of a standby letter of credit
support structure. One significant difference is that the put may not require documentary
evidence, just non-payment of principal.
Put and call structures became popular because they exploited the accounting treatment
of such financial instruments and in some instances caused the obligation to disappear from
view. However, regulators are very sensitive to the need for transparency for stakeholders
and so this possibility is likely to become more limited as regulations and accounting stan-
dards tighten up.
1
Interpretive Ruling 7.7016 of the Comptroller of the Currency (61 Fed. Reg. 4865, 9 February 1996).
2
At the time of writing this book, the biggest perceived risk in the UK for this source of energy is that of increased
earthquake or tremor risk, believed to be a consequence of the fracking procedures that are needed to extract
shale oil.
3
FAS 47 defined a take-or-pay contract as follows:
Take-or-pay contract. An agreement between a purchaser and a seller that provides for the purchaser to pay
specified amounts periodically in return for products or services. The purchaser must make specified minimum
payments even if it does not take delivery of the contracted products or services.
Statement of Financial Accounting Standards No. 47, Disclosure of long-term obligations, March 1981,
Appendix B Glossary, p. 11: www.fasb.org/pdf/fas47.pdf.
4
FAS 47 defined a through-put contract as follows:
Through-put contract. An agreement between a shipper (processor) and the owner of a transportation facility
(such as an oil or natural gas pipeline or a ship) or a manufacturing facility that provides for the shipper
(processor) to pay specified amounts periodically in return for the transportation (processing) of a product. The
shipper (processor) is obligated to provide specified minimum quantities to be transported (processed) in each
period and is required to make cash payments even if it does not provide the contracted quantities.
5
FAS 47 provided the following example for financial reporting of a take-or-pay contract.
A subsidiary of F Company has entered into a take-or-pay contract with an ammonia plant. Fs subsidiary
is obligated to purchase 50% of the planned capacity production of the plant each period while the debt used
to finance the plant remains outstanding. The monthly payment equals the sum of 50% of raw material costs,
operating expenses, depreciation, interest on the debt used to finance the plant and a return on the owners
equity investment.
Fs disclosure might be as follows:
To assure a long-term supply, one of the companys subsidiaries has contracted to purchase half the output of
an ammonia plant through the year 2005 and to make minimum annual payments as follows, whether or not
it is able to take delivery (in thousands):
192 through 196 (US$6,000 per annum) US$30,000
Later years 120,000
Total 150,000
Less: Amount representing interest (65,000)
Total at present value 85,000
In addition, the subsidiary must reimburse the owner of the plant for a proportional share of raw material costs
351

Project Financing
and operating expenses of the plant. The subsidiarys total purchases under the agreement were (in thousands)
US$7,000, US$7,100 and US$7,200 in 19W9, 190 and 191, respectively.
6
FAS 47 gives the following example of a through-put contract.
27. C Company has entered into a through-put agreement with a natural gas pipeline providing that C will
provide specified quantities of natural gas (representing a portion of capacity) for transportation through the
pipeline each period while the debt used to finance the pipeline remains outstanding. The tariff approved by the
federal Energy Regulatory Commission contains two portions, a demand charge and a commodity charge. The
demand charge is computed to cover debt service, depreciation and certain expected expenses. The commodity
charge is intended to cover other expenses and provide a return on the pipeline companys investment. C Company
must pay the demand charge based on the contracted quantity regardless of actual quantities shipped, while the
commodity charge is applied to actual quantities shipped. Accordingly, the demand charge multiplied by the
contracted quantity represents a fixed and determinable payment.
28. Cs disclosure might be as follows:
C Company has signed an agreement providing for the availability of needed pipeline transportation capacity
through 1990. Under that agreement, the company must make specified minimum payments monthly. The aggre-
gate amount of such required payments at December 31, 191, is as follows (in thousands):
192 US$5,000
193 US$5,000
194 US$5,000
195 US$4,000
196 US$4,000
Later years US$26,000
Total US$49,000
Less: Amount representing interest US$9,000
Total at present value US$40,000
In addition, the company is required to pay additional amounts depending on actual quantities shipped under
the agreement. The companys total payments under the agreement were (in thousands) US$6,000 in 19W9 and
US$5,500 both in 190 and in 191.
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Chapter 24
Controlling risk via risk-sharing derivative

contracts: futures and forward contracts
A derivative instrument is a contract that derives its value from something else which can
be the price of a financial instrument (for example, stock price or bond price), a commodity
price, the exchange rate between two currencies, the value of a financial index (for example,
stock index or bond index), an interest rate, or an inflation rate. A derivative instrument can
even derive its value from the temperature in a region or the amount of rainfall in a region.
The something that the derivative derives its value from is simply referred to in the deriva-
tives industry as the underlying, and that is the terminology we adopt in this chapter. Some
contracts give the party to a derivative transaction either the obligation or the choice to buy
or sell the underlying. Examples of derivative instruments include options contracts, futures
contracts, forward contracts, cap and floor agreements and swap agreements. Moreover,
there are derivatives that can be embedded within financing instruments. Two examples are
callable bonds and credit-linked notes.
The existence of derivative instruments provides opportunities for controlling various risks
associated with a project. The risks that can be reduced or mitigated are those associated
with funding risks, revenue risks and operating risks. For this reason, risk control is not a
separate activity in project finance but rather integrated with the financing activity, and thereby
the degree of project leverage. Lenders are concerned with a projects risks. Contracts that
can be employed to eliminate or mitigate those risks will provide greater comfort to lenders
and will result in more favourable borrowing terms and the potential for more leverage.
It is often alleged that in a global financial market with imperfections due to regulations
and/or capital market restrictions, opportunities arise to reduce a projects funding costs. Too
often those promises made to sponsors of projects to convince them to use certain derivatives
are unfounded, masking risks that sponsors should be concerned with. The true beneficiary
is the derivative sales personnel and his or her firm, not the sponsor. Several well-publicised
financial fiascos involving the use of derivatives have made some participants in the project
finance arena shy away from using them. The needless use of various types of interest rate
swaps in the financing of municipal revenue projects1 in the United States is an excellent
example. These fiascos, however, are not the result of derivatives per se. They are the result
of either the lack of understanding of the risk/return characteristics of derivatives or, more
commonly, the improper utilisation of derivatives to bet on interest rates, commodity prices,
or exchange rates rather than to control risk.
In this chapter and the two that follow, we focus on the use of derivative instruments to
control certain risks associated with a project. Derivative instruments can be broadly classified
as risk-sharing and insurance arrangements. In a risk-sharing arrangement, the two parties
to the agreement seek to eliminate a risk by foregoing the potential benefits associated with
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a favourable price movement. Risk-sharing-type derivative instruments also referred to as

linear payoff derivatives and symmetric payoff derivatives include futures, forward and
swap contracts. Other contractual agreements such as off-take agreements and contracts
for differences fall in the category of risk-sharing type derivative instruments. Futures and
forwards are the subject of this chapter. We also discuss off-take agreements and contracts
for differences here having mentioned them in Chapter 22. Swaps are the subject of the next
chapter. The other broad category of derivatives includes the insurance-type arrangements
discussed in Chapter 22. In this type of arrangement, one party pays the counterparty a fee
to insure against a specific risk. It could be to insure against a price decline for something
that will be sold in the future or a price increase for something that will be purchased in
the future. Or, it could be to protect against an adverse interest rate or currency movement.
Insurance-type derivative contracts are referred to as nonlinear payoff derivatives or asym-
metric payoff derivatives. These types of contracts include options, caps and floors and are
the subject of Chapter 26.
There is also another important dimension of derivative instruments that is key to any
risk control strategy: exposure to counterparty risk. This is the risk that the counterparty
to a derivative trade will fail to satisfy its obligation. The exposure to counterparty risk
depends on whether the derivative is traded on an organised exchange or is created by a
dealer. For the former, after a trade is executed, the exchange (or its clearing house) becomes
the counterparty and stands in the position of the original counterparty to the trade. It is
commonly believed (based on the performance history of exchanges) that because of the
margin requirements required by exchanges there is minimal counterparty risk. In contrast,
there is considerably greater counterparty risk for dealer created or so-called over-the-counter
derivatives. This is true despite the high credit rating that the counterparty might carry when
the trade is initiated. Probably the best example is the case of derivative trades entered into
with Lehman Brothers prior to the banks failure. Fortunately, there are procedures that can
be employed to mitigate counterparty risk.
1 Futures contracts
Futures contracts are standardised products created by exchanges. A futures contract is an
agreement between a buyer (seller) and an established exchange or its clearing house in
which the buyer (seller) agrees to take (make) delivery of something at a specified price at
the end of a designated period of time. The price at which the parties agree to transact in
the future is called the futures price. The designated date at which the parties must transact
is called the settlement or delivery date.
There are financial futures, commodity futures and even weather futures. Financial futures
can be classified as stock index futures, interest-rate futures and currency futures. In a project
financing, interest-rate futures can be used to protect against funding costs and currency
futures to protect against foreign exchange rate fluctuations. Commodity futures contracts
are used to control the risk of adverse price changes for commodities that are either inputs
into the projects operations or the projects outputs (products sold). Weather futures are
used to control a variety of risks, particularly the risks faced by the producers of energy.
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Controlling risk via risk-sharing derivative contracts: futures and forward contracts
Mechanics of futures trading

A futures contract has a settlement date or a settlement month. This means that at a prede-
termined time in the contract settlement month, the contract stops trading and a price is
determined by the exchange for settlement of the contract. A party to a futures contract has
two choices for liquidating a position.
First, the position can be liquidated prior to the settlement date. For this purpose, the
party must take an offsetting position in the same contract. For the buyer of a futures
contract, this means selling the same number of identical futures contracts; for the seller of
a futures contract, this means buying the same number of identical futures contracts.
The alternative is to wait until the settlement date. At that time, the party purchasing a
futures contract accepts delivery of the underlying at the agreed upon price. The party that
sells a futures contract liquidates the position by delivering the underlying at the agreed-
upon price. Futures contracts settlements that are made in cash only are referred to as cash
settlement contracts.
Associated with every futures exchange is a clearing house which performs several func-
tions. One of these functions is guaranteeing that the two parties to the transaction will
perform. After a trade between two parties (that is, buyer and seller), the clearing house
takes the opposite position and agrees to satisfy the terms set forth in the contract. Because
of the existence of the clearing houses role, the parties to the trade need not worry about
the financial strength and integrity of the counterparty because the relationship between the
two parties ends. The clearing house interposes itself as the buyer for every sale and the
seller for every purchase. Thus a party to the trade is free to liquidate a position without
involving the original counterparty and without the worry that the original counterparty
may default. This is the reason why a futures contract is defined as an agreement between
a party and a clearing house associated with an exchange. Besides its guarantee function,
the clearing house makes it simple for parties to a futures contract to unwind their positions
prior to the settlement date.
When a position is first taken in a futures contract, the investor must deposit a minimum
dollar amount per contract as specified by the exchange. This amount is called the initial
margin and is required as a deposit for the contract. As the price of the futures contract
fluctuates, the value of the investors equity in the position changes. At the end of each trading
day, the exchange determines the settlement price for the futures contract. This price is used
to mark the investors position to the market, so that any gain or loss from the position is
reflected in the investors equity account.
The maintenance margin is the minimum level (specified by the exchange) by which an
investors equity position may fall as a result of an unfavourable price movement before
the investor is required to deposit additional margin. The additional margin deposited is
called the variation margin and it is the amount necessary to bring the equity in the account
back to its initial margin level. Any excess margin in the account may be withdrawn by the
investor. If a party to a futures contract who is required to deposit variation margin fails
to do so within a specified time period, the futures position is closed out.
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Interest-rate futures contracts

The three most commonly used interest-rate futures contracts for controlling interest rate
risk are the Eurodollar futures contact, the US Treasury bond futures contract and the US
Treasury note futures contract. We describe the salient feature of each contract below.
Eurodollar futures
Eurodollar CDs are US dollar-denominated CDs issued primarily in London by US and
non-US banks. The interest rate paid on Eurodollar CDs is based on the London interbank
offered rate (Libor), which is the interest rate at which one London bank offers funds to
another London bank of acceptable credit quality in the form of a cash deposit. The rate
is fixed by the British Bankers Association every business morning by the average of the
rates supplied by member banks.
The underlying for the Eurodollar futures contract is a reference rate, more specifically,
three-month Libor. The International Monetary Market of the Chicago Mercantile Exchange
(CME) and the Euronext International Financial Futures Exchange (LIFFE) are the exchanges
where Eurodollar futures contracts are traded. The face value of the contract traded is US$1
million and 500,000 of face value for CME and LIFFE, respectively. Both contracts are
traded on an index price basis. The index price basis in which the contract is quoted is
equal to 100 minus the annualised futures Libor. For example, a Eurodollar futures price
of 98.00 means a futures three-month Libor of 6%.
The minimum price fluctuation (tick) for this contract is 0.01 (or 0.0001 in terms of
Libor). This means that the price value of a basis point for the CME contract is US$25,
found as follows. The simple interest on US$1 million for 90 days is equal to:
US$1,000,000 (Libor 90/360)
If Libor changes by one basis point (0.0001), then:
US$1,000,000 (0.0001 90/360) = US$25
The Eurodollar futures contracts are cash settlement contracts. That is, the parties settle in
cash based on Libor at the settlement date.
Treasury bond and note futures

US Treasury bond futures contracts are traded on the CME. For the reasons to be explained,
the Treasury bond futures contract is a complex contract. Other countries that have a futures
contract on a government bond have modelled their contract after the US Treasury bond
futures contract.
The underlying instrument for a Treasury bond futures contract is US$100,000 par value
of a hypothetical 20-year, 6% coupon bond. The futures price is quoted in terms of par
being 100. Quotes are in 32nds of 1%. Thus a quote for a Treasury bond futures contract
of 9716 means 97 and 16/32nds, or 97.50. So, if a buyer and seller agree on a futures price
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of 9716, this means that the buyer agrees to accept delivery of the hypothetical underlying
Treasury bond and pay 97.50% of par value and the seller agrees to accept 97.50% of par
value. Since the par value is US$100,000, the futures price that the buyer and seller agree
to pay for this hypothetical Treasu (cash sweeps) ry bond is US$97,500.
The minimum price fluctuation for the Treasury bond futures contract is a 32nd of
1%. The dollar value of a 32nd for a US$100,000 par value (the par value for the under-
lying Treasury bond) is US$31.25. Thus, the minimum price fluctuation is US$31.25 for
this contract.
While the underlying for the contract is a hypothetical Treasury bond, it is not a cash
settlement contract. The seller of a Treasury bond futures who decides to make delivery rather
than liquidate his position by buying back the contract prior to the settlement date must
deliver some Treasury bond. The CME allows the seller to deliver one of several Treasury
bonds that the CME declares is acceptable for delivery. The specific bonds that the seller
may deliver are published by the CME prior to the initial trading of a futures contract with
a specific settlement date. The CME makes its determination of the Treasury bond issues
that are acceptable for delivery from all outstanding Treasury issues that meet the following
criteria: it must be a non-callable issue and must have at least 15 years to maturity from
the first day of the delivery month.
The delivery process for the Treasury bond futures contract makes the contract inter-
esting. At the settlement date, the seller of a futures contract (the short) is required to deliver
the buyer (the long) US$100,000 par value of a 6%, 20-year Treasury bond. Since no such
bond exists, the seller must choose from one of the acceptable deliverable Treasury bonds
that the CME has specified.
To make delivery equitable to both parties, the CME introduced factors for converting
the invoice price of each acceptable deliverable Treasury issue against the Treasury bond
futures contract. The factor is determined by the CME before a contract begins trading.
This factor, referred to as the conversion factor, is constant throughout the trading period
of the futures contract. The short must notify the long of the bond that will be delivered
one day before the delivery date.
The invoice price for the contract is the futures settlement price plus accrued interest.
However, as noted above, the seller can deliver one of several acceptable Treasury issues,
and to make delivery fair (cash sweeps) to both parties, the invoice price must be adjusted
based on the actual Treasury issue delivered. The conversion factor is used to adjust the
invoice price as follows:
Invoice price = Contract size Futures contract settlement price Conversion factor
+ Accrued interest
Suppose the contract settles at 9408 and that the short elects to deliver an issue with a
conversion factor of 1.20. The contract settlement price of 9408 means 94.25% of par
value. As the contract size is US$100,000, the invoice price is:
US$100,000 0.9425 1.20 + Accrued interest = US$113,100 + Accrued interest
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In selecting the issue to be delivered, the short will select from all the deliverable issues
the one that is cheapest to deliver. This issue is referred to as the cheapest-to-deliver issue
and is key in the pricing of the futures contract. The cheapest-to-deliver issue is determined
as follows. For each of the acceptable Treasury issues from which sellers can select, the
return that can be earned by buying that issue and delivering it at the settlement date is
calculated. Sellers can calculate the return since they know the price of the Treasury issue
and the futures price at which they agree to deliver the issue. The return so calculated is
called the implied repo rate. The cheapest-to-deliver issue is the issue among all acceptable
Treasury issues with the highest implied repo rate, since it is the issue that would give the
seller of the futures contract the highest return by buying and then delivering the issue (see
Exhibit 24.1).
Exhibit 24.1
Determination of cheapest to deliver issue based on the implied repo rate
Buy this acceptable issue: Deliver this issue at futures price Calculate return (implied repo rate)
Treasury issue #1 Deliver issue #1 Implied repo rate #1

Treasury issue #N Deliver issue #N Implied repo rate #N
Implied repo rate: rate of return by buying an acceptable Treasury issue, shorting the Treasury bond futures,
and delivering the issue at the settlementdate.
Cheapest to deliver is issue that produces maximum implied reporate.
Source: Frank J Fabozzi
As well as the choice of issue (sometimes referred to as the quality option or swap
option) the short position has two more options under CME delivery guidelines. The short
position can decide when in the delivery month delivery actually will take place. This is
called the timing option. The other option is the right of the short position to give notice
of intent to deliver, up to 8.00pm Chicago time after the closing of the exchange (3.15pm
Chicago time) on the date when the futures settlement price has been fixed. This option is
known as the wild card option. The existence of the quality, timing and wild card options
(collectively referred to as the delivery options), means that the long position can never be
sure which Treasury issue will be delivered or when it will be delivered.
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There are 10-year, five-year, and two-year Treasury note futures contracts, all traded on
the CME. The delivery process for each modelled after the Treasury bond contract in terms
of the options granted to the short. The par value for the 10-year, five-year and two-year
Treasury note futures contract is US$100,000, US$100,000 and US$200,000, respectively.
Currency futures
There are US-traded foreign exchange futures contracts for the major currencies traded on
the International Monetary Market (IMM), a division of the CME. The futures contracts
traded on the IMM are for the British pound, Japanese yen, the Euro, the Canadian dollar,
the Swiss franc and the Australian dollar. The amount of each foreign currency that must be
delivered varies by currency. For example, each British pound futures contract is for delivery
of 62,500 while each Japanese yen futures contract is for delivery of 12.5 million.
The maturity cycle for currency futures is March, June, September and December. The
longest maturity is one year. Consequently, these contracts are limited with respect to hedging
long-dated foreign exchange risk exposure by a project company.
Outside the US, currency futures are traded on the London International Financial Futures
Exchange, Singapore International Monetary Exchange, Toronto Futures Exchange, Sydney
Futures Exchange and New Zealand Futures Exchange.
Commodity futures
As the name suggests, commodity futures have some type of commodity as their underlying.
A common way to classify commodities is into hard and soft commodities. Hard commodities
include energy products, precious metal products and industrial metal products. Typically,
soft commodities are weather-dependent, perishable commodities from the agricultural sector
such as grains, soybeans, or livestock (for example, cattle or pigs).
Weather futures
Weather futures, traded on the CME, are index-based contracts that cover a wide range
of different types of weather events in different locations throughout the world. There is a
dollar amount associated with each index point. Unlike the other futures contracts, there is
no deliverable so these are cash settlement contracts. The weather events covered by these
contracts include the following: average temperature, cumulative average temperature, heating
degree days, cooling degree days, frost, snowfall and hurricanes. For example, the suite of
hurricane futures is an index based on the monetary damage a hurricane is likely to cause.
The regions of the world these weather futures cover are North America, Europe and Asia.
2 Forward contracts
A forward contract, like a futures contract, is an agreement for the future delivery of under-
lying at a specified price at the end of a designated period of time. Futures contracts are
standardised agreements as to the delivery date (or month) and quality of the deliverable,
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and are traded on organised exchanges. A forward contract differs in that it is usually non-
standardised (that is, the terms of each contract are negotiated individually between buyer
and seller), there is no clearing house, and secondary markets are often non-existent or
extremely thin.
Unlike a futures contract, which is an exchange-traded derivative, a forward contract is
an over-the-counter instrument.
Futures contracts are marked to market at the end of each trading day, while the deci-
sion to mark to market a forward contract is done by agreement between the two parties
at the outset of the transaction. Consequently, futures contracts are subject to interim cash
flows as additional margin may be required in the case of adverse price movements, or as
cash is withdrawn in the case of favourable price movements. For a forward contract that is
not marked to market, there are no interim cash flow effects because no additional margin
is required. Typically, forward contracts are marked to market and therefore do involve
interim cash flows.
Finally, the parties in a forward contract are exposed to credit risk or counterparty
risk because either party may default on the obligation. Credit risk is minimal in the case
of futures contracts because the clearing house associated with the exchange guarantees the
other side of the transaction.
Other than these differences, most of what we say about futures contracts applies equally
to forward contracts.
Long-term forward foreign exchange agreements

The market for forward contracts on foreign exchange is more frequently used than futures
contracts for hedging existing or anticipated currency exposures. They are available in
most major currencies for terms up to five years, or even longer terms depending on
market conditions. For longer-dated forward contracts, however, the bid-ask spread for a
forward contract increases, that is, the size of the spread for a given currency increases
with the contracts maturity. Consequently, forward contracts become less attractive for
hedging long-dated foreign currency exposure than currency swaps which we discuss in
the next chapter.
The cost/price of a forward contract generally reflects the prevailing exchange market
rate for the two currencies for identical maturities. Long-term forward foreign exchange
agreements can be used by project companies to decrease or eliminate the currency risk
arising from financial transactions denominated in foreign currencies, such as the following.
Long-term contracts
Project companies frequently make commitments to disburse or receive payments in foreign
currencies under long-term contracts or licensing and royalty agreements. Since these transac-
tions may be for periods of five years or longer, they create substantial currency risk, which
may be mitigated by entering into long-term forward foreign exchange agreements.
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Cost of foreign funds

It may be possible to borrow a foreign currency along with a long-term forward foreign
exchange contract for purchase of the same currency at a lower cost than borrowing in the
domestic capital market. Also, a project company with an existing loan at an attractive interest
rate may wish to limit its foreign exchange risk by a long-term forward exchangeagreement.
Forward rate agreement

A forward rate agreement (FRA) is a customised agreement between two parties (one of
whom is a dealer firm a commercial bank or investment banking firm) where the two
parties agree at a specified future date to exchange an amount of money based on a reference
interest rate and a notional principal amount. A notional principal amount is an amount by
which payments are benchmarked but there is no exchange of principal.
To illustrate an FRA, suppose that a project company and a bank enter into the following
six-month FRA with a notional principal amount of US$100 million: if three-month Libor
exceeds 5% six months from now, the bank pays the project company an amount determined
by the following formula:
(Three-month Libor six months from now 0.05) US$100,000,000 0.25
For example, if three-month Libor six months from now is 8%, the project company receives:
(0.08 0.05) US$100,000,000 0.25 = US$750,000
If three-month Libor six months from now is less than 5%, the project company pays the
bank an amount based on the same formula.
Project companies can use FRAs to hedge against adverse interest-rate risk by locking
in a rate.
3 Off-take agreements
In an off-take agreement the project sponsor and a customer enter into an agreement whereby
the project sponsor agrees to sell to the customer a designed amount of the product at a
predetermined price. The agreement is structured so that there are very few conditions under
which parties may terminate the contract prior to the contracts expiration date. Although
an off-take agreement is similar to a forward agreement, there are several differences:
in a forward contract both parties are obligated to perform; in an off-take agreement, the
amount that must be exchanged is contingent on production;
forward contracts are typically shorter term than off-take agreements; and
the forward contract does have some liquidity while an off-take agreement basically has
no liquidity.
Here are two examples of the use of off-take agreements in recent years.
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Enerkem Inc, headquartered in Quebec Canada, uses its proprietary thermochemical

technology to convert municipal solid waste into methanol, ethanol and other chemical
intermediates that form everyday products. It was constructing its first commercial plant in
Edmonton, Alberta. As part of its project financing, in September 2011, the firm announced
via a press release that it had entered into an off-take agreement with Methanex Corporation
for the sale of methanol that will be produced in its new plant.2
Paladian Energy is a uranium mining company. At the nearing completion of one its
projects, Langer Heinrich Stage 3 expansion, the company entered into off-take agreements
for the sale of its output with three new customers in the United States.3 Regarding these
agreements, the CEO John Borshoff stated:
Importantly, these agreements are in keeping with Paladins long-standing uranium

contracting strategy of developing a risk-managed portfolio of term sales agreements,
incorporating various delivery price mechanisms, including defined prices, as well as
market price exposure at time of delivery.
An off-take agreement is one type of power purchase agreement used by energy companies.
Another type is discussed next.
4 Contract for differences

In a contract for differences (CFD) a project sponsor seeks a counterparty that is willing to
buy the projects output at a specified price. Any difference between the market price at a
settlement date and the contractual specified sale price is settled via a cash payment. The
cash payment at the settlement date is as follows. If the market price exceeds the contractual
sale price, the project sponsor must make a payment to the counterparty. If, instead, the
market price is below the contractual sale price, the counterparty must make a payment to
the project sponsor. The contract term can be from five to 10 years.
An example is a 10-year CFD used for the Synder Wind Farm in Scurry County, Texas
by the project developer Enel North America in August 2007 when the project was under
construction. The counterparty, Fortis Merchant Private Banking, specified a fixed price from
the start of the agreement in 2008 to the contract expiration date, February 2018.4
5 General principles of hedging with futures and forward contracts

The major function of futures/forward markets is to transfer price risk from hedgers to
speculators. That is, risk is transferred from those willing to pay to avoid risk to those
wanting to assume the risk in the hope of gain. A market participant need not necessarily
want to transfer all of the risk to another party. Instead, a market participant may want to
control risk (that is, limit the exposure).
A hedge is a special case of risk control where the market participant employs futures/
forwards to try to eliminate the risk. Hedging in this case is the employment of a futures
transaction as a temporary substitute for a transaction to be made in the cash market. The
hedge position locks in a value for the cash position. As long as cash and futures prices
move together, any loss realised on one position (whether cash or futures) will be offset
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by a profit on the other position. When the profit and loss are equal, the hedge is called
a perfect hedge. In a market where the futures contract is correctly priced, a perfect hedge
should provide a return equal to the risk-free rate.
Risks associated with hedging

In practice, hedging is not that simple. The amount of the loss or profit on a hedge will be
determined by the relationship between the cash price (also called the spot price) and the
futures price when a hedge is placed and when it is lifted. The difference between the cash
price and the futures price is called the basis:
Basis = Cash price Futures price
If a futures contract is priced according to its theoretical value, it can be demonstrated that
the difference between the cash price and the futures price should be equal to the cost of
carry. The cost of carry is the net cost of financing a position. That is, it is the difference
between the financing rate and the cash yield from holding the underlying.
The risk that the hedger accepts is that the basis will change at the time the hedge is
removed. This risk is referred to as basis risk. Therefore, hedging involves the substitution
of basis risk for price risk; that is, the substitution of the risk that the basis will change for
the risk that the cash price will change.
When a futures contract is used to hedge a position where the asset, currency or commodity
whose risk is to be hedged is not identical to the instrument underlying the futures, it is
called cross hedging. Cross hedging is common in many hedging applications. Cross hedging
introduces another risk the risk that the price movement of the underlying of the futures
contract may not accurately track the price movement of the asset, currency or commodity
whose risk is to be hedged. This risk is referred to as cross-hedging risk. Therefore, the
effectiveness of a cross hedge will be determined by:
1 the relationship between the cash price of the underlying and its futures price when a
hedge is placed and when it is lifted; and
2 the relationship between the market (cash) value of the asset, currency or commodity to
be hedged and the cash price of the underlying for the futures contract when the hedge
is placed and when it is lifted.
The second of these two relationships listed above is paramount, so when cross hedging it
is important to identify an appropriate cash market instrument with a high price correlation
with the futures contract being hedged. For example, if the projects product is a mineral
that is not the underlying for a futures contract, then hedging with, say, corn futures would
not likely accomplish the goal of a hedge.
Short hedge and long hedge

To execute a short hedge, the hedger sells a futures contract (agrees to make delivery).
Consequently, a short hedge is also known as a sell hedge. By establishing a short hedge,
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the hedger has fixed the future cash price and transferred the price risk of ownership to the
buyer of the futures contract. A short hedge is used to protect against a decline in the future
cash price of an asset, a currency or a commodity. Hence, a short hedge in a commodity
futures would be used in the operation of a project to protect against a decline in the value
of the product sold. In the case of an interest-rate futures contract, a decline in the futures
price means a rise in the interest rate.
A long hedge is undertaken to protect against an increase in the price of an asset, a
currency or a commodity to be purchased in the cash market at some future time. In a long
hedge, the hedger buys a futures contract (agrees to accept delivery). A long hedge is also
known as a buy hedge.
Hedging illustrations
To illustrate hedging, we shall present several numerical examples from the traditional
commodities markets. The principles we illustrate are equally applicable to financial futures
contracts, but it is easier to grasp the sense of the commodities product example without
involving the nuances associated with financial futures contracts.
Assume that a mining company expects to sell 1,000 ounces of gold four months from
now and that the management of a jewellery company plans to purchase 1,000 ounces of
gold four months from now. The managers of both the mining company and the jewellery
company want to lock in a price today. That is, they both want to eliminate the price risk
associated with gold four months from now. The cash price for gold is currently US$1,652.40
per ounce. The futures price for gold is currently US$1,697.80 per ounce. Each futures
contract is for 100 ounces of gold.
Because the mining company seeks protection against a decline in the price of gold, the
company will place a short hedge. That is, the company will promise to make delivery of
gold at the current futures price. The mining company will sell 10 futures contracts.
The management of the jewellery company seeks protection against an increase in the price
of gold. Consequently, it will place a long hedge. That is, it will agree to accept delivery of
gold at the futures price. Because it is seeking protection against a price increase for 1,000
ounces of gold, it will buy 10 contracts.
The various scenarios for the cash price and futures price of gold four months from
now, when the hedge is lifted, will be examined below.
Perfect hedge
Suppose that at the time the hedge is lifted the cash price has declined to US$1,604.20 and the
futures price has declined to US$1,649.60. Notice what has happened to the basis under this
scenario. At the time the hedge is placed, the basis is US$45.40 (US$1,652.40 US$1,697.80).
When the hedge is lifted, the basis is still US$45.40 (US$1,604.20 US$1,649.60).
At the time of the hedge, the cash market price of gold per ounce was US$1,652.40,
or US$1,652,400 for 1,000 ounces. The value of the futures contracts sold at the time of
the hedge was US$1,697.80. When the hedge is lifted four month later, the value of 1,000
ounces of gold in the cash market is US$1,604,200 (US$1,604.20 1,000). The mining
364

company therefore realises a decline in the cash market in the value of its gold of US$48,200.
However, the futures price has declined to US$1,649.60, or US$1,649,600 for the futures
contracts sold. The mining company thus realises a US$48,200 gain in the futures market.
The net result is that the gain in the futures market matches the loss in the cash market.
Consequently, the mining company does not realise an overall gain or loss. This is an example
of a perfect hedge. The results of this hedge are summarised in Exhibit 24.2.
Exhibit 24.2
A hedge that locks in the current price of gold: cash price decrease
Assumptions
Cash price at time hedge is placed US$1,652.40 per oz
Futures price at time hedge is placed US$1,697.80 per oz
Futures price at time hedge is lifted US$1,649.60 per oz
Number of ounces to be hedged 1,000
Number of ounces per futures contract 100
Number of futures contracts used in hedge 10
Short (sell) hedge by mining company
Cash market Futures market Gold basis
At time hedge is placed
Value of 1,000 oz: Sell 10 contracts:
1,000 US$1,652.40 = US$1,652,400 10 100 US$1,697.80 = US1,697,800 US$45.40 per ounce
At time hedge is lifted
Value of 1,000 oz: Buy 10 contracts:
1,000 US$1,604.20 = US1,604,200 10 100 US$1,649.60 = US$1,649,600 US$45.40 per ounce
Loss in cash market = US$48,200 Gain in futures market = US$48,200
Overall gain or loss = US$0
Long (buy) hedge by jewellery company
1,000 US$1,652.40 = US$1,652,400 10 100 US$1,697.80 = US$1,697,800 US$45.40 per ounce
Gain in cash market = US$48,200 Loss in futures market = US$48,200
365

Project Financing
The outcome for the jewellery company of its long hedge is also summarised in Exhibit
24.2. Because there was a decline in the cash price, the jewellery company would gain in
the cash market by US$48,200 but realise a loss of the same amount in the futures market.
Therefore this hedge is also a perfect hedge.
This scenario illustrates two important points. First, for both participants there was no
overall gain or loss. The reason for this was that the basis did not change when the hedge
was lifted. Consequently, if the basis does not change, the effective purchase or sale price
ends up being the cash price on the day the hedge is set. Second, note that the management
of the jewellery company would have been better off if it had not hedged. The cost of the
gold would have been US$48,200 less. This, however, should not be interpreted as a sign
of a bad decision. Managers are usually not in the business of speculating on the price of
gold and hedging is the standard practice used to protect against an increase in the cost of
doing business in the future. The price of obtaining this protection is the potential windfall
that one gives up.
Suppose that when the hedge is lifted the cash price of gold increased to US$1,692.50
and that the futures price has increased to US$1,737.90. Notice that the basis is unchanged
at US$45.40. Because the basis is unchanged, the effective purchase and sale price will equal
the price of gold at the time the hedge is placed.
In this scenario, the mining company will gain in the cash market because the value
of 1,000 ounces of gold four months later is US$1,692,500 (US$1,692.50 1,000). This
represents a US$40,100 gain compared with the cash value at the time the hedge was placed.
However, the mining company must liquidate its position in the futures market by buying
10 futures contracts for US$1,737,900, which is US$40,100 more than the price when the
contracts were sold. The loss in the futures market offsets the gain in the cash market. The
results of this hedge are summarised in Exhibit 24.3.
The jewellery company realises a US$40,100 gain in the futures market but will have
to pay US$40,100 more four months from now in the cash market to acquire 1,000 ounces
of gold. The results of this hedge are also summarised in Exhibit 24.3.
Notice that in this scenario, the management of the jewellery company saved US$40,100
by employing a hedge. The mining company, on the other hand, would have been better
off if it had not hedged and had simply sold its product on the market four months later.
However, it must be emphasised that the management of the mining company, just like
the management of the jewellery company, employed a hedge to protect against unforeseen
adverse price changes in the cash market, and the price of this protection is that one forgoes
the favourable price changes enjoyed by those who do not hedge.
Basis risk
In the two previous scenarios we assumed that the basis does not change when the hedge
is lifted in four months. There is no reason why this would necessarily be the case. In the
real world, the basis frequently changes between the time a hedge is placed and the time
it is lifted.
366

Exhibit 24.3
A hedge that locks in the current price of gold: cash price increase
Assumptions
1,000 US$1,652.40 = US$1,652,400 10 100 US$1,697.80 = US$397,800 US$45.40 per ounce
1,000 US$1,692.50 = US1,692,500 10 100 US$1,737.90 = US$1,737,900 US$45.40 per ounce
Assume that the cash price of gold decreases to US$1,604.20, just as in the first
scenario; however, assume further that the futures price decreases to US$1,685.80 rather
than US$1,649.60. The basis has now declined from US$45.40 to US$81.60 (US$1,604.20
US$1,685.80).
367

Project Financing
The results are summarised in Exhibit 24.4. For the short hedge, the US$48,200 loss in
the cash market is only partially offset by the US$12,000 gain realised in the futures market.
Consequently, the hedge resulted in an overall loss of US$36,200.
Exhibit 24.4
Hedge: cash price decreases and basis widens
Assumptions
Cash market Futures market Basis
Overall loss = US$36,200

Overall gain = US$36,200
368

There are several points to note here.

First, if the mining company did not hedge, the loss would have been US$48,200,
because the value of its 1,000 ounces of gold is US$304,200 compared with US$352,400
four months earlier. Although the hedge is not perfect, the loss of US$36,200 is less than
the loss of US$48,200 that would have occurred if no hedge had been placed. This is what
we meant earlier by stating that hedging substitutes basis risk for price risk.
Second, the management of the jewellery company faces the same problem from an
opposite perspective. An unexpected gain for one participant results in an unexpected
loss of equal dollar value for the other. That is, the participants face a zero-sum game
since they have identically opposite cash and futures positions. Consequently, the jewel-
lery company would realise an overall gain of US$36,200 from its long (buy) hedge. This
gain represents a gain in the cash market of US$48,200 and a realised loss in the futures
market of US$12,000.
Suppose that the cash price increases to US$1,692.50 per ounce, just as in the second
scenario, but that the basis widens to US$81.60. That is, at the time the hedge is lifted
(four months later) the futures price has increased to US$1,774.10. The results of this hedge
are summarised in Exhibit 24.5. As a result of the long hedge, the jewellery company will
realise a gain of US$76,300 in the futures market but only a US$40,100 loss in the cash
market. Therefore, there is an overall gain of US$36,200 for the jewellery company. For the
mining company, there is an overall loss of US$36,200.
In the two previous scenarios it was assumed that the basis widened. It can be demon-
strated that if the basis narrowed, the outcome will not be a perfect hedge.
Cross hedging
Suppose that a mining company finds a rare metal which metallurgists call donbax and
plans to sell 2,500 ounces of donbax four months from now and that a jewellery company
wants to purchase the same amount of donbax in four months. Both parties want to hedge
against price risk. However, neither donbax futures nor forward contracts are currently
available. Both parties believe that there is a close relationship between the price of donbax
and the price of gold. Specifically, both parties believe that the cash price of donbax will
remain at 40% of the cash price of gold. The cash price of donbax is currently US$660.96
per ounce, and the cash price of gold is currently US$1,652.40 per ounce. The futures price
of gold is currently US$1,697.80 per ounce.
Various scenarios will be examined to demonstrate the effectiveness of cross hedging. In
each scenario, the gold basis is held constant at US$45.40. We make this assumption so
that we can focus on the importance of the relationship between the two cash prices at the
two points in time when the hedge is initiated and when it is lifted.
Before proceeding, we must first determine how many gold futures contracts should be
used in the cross hedge. The value of 2,500 ounces of donbax at the cash price of US$660.96
per ounce is US$1,652,400. To protect the value of the donbax using gold futures, the cash
value of 1,000 ounces of gold (US$1,652.40) must be hedged. Because each gold futures
contract covers 100 ounces, 10 gold futures contracts will be used.
369

Project Financing
Exhibit 24.5
Hedge: cash price increases and basis widens
Assumptions
Cash price at time hedge is lifted US$1,692.50 per oz
Suppose that the cash prices of donbax and gold decrease to US$641.68 and US$1,604.20
per ounce, respectively, and that the futures price of gold decreases to US$1,649.60 per ounce.
Also assume that the relationship between the cash price of donbax and the cash price of
gold when the cross hedge was placed is unchanged when the cross hedge is lifted. That is,
the cash price of donbax is 40% of the cash price of gold. The gold basis stays constant at
US$45.40. The outcome for the short and long cross hedge is summarised in Exhibit 24.6.
370

Exhibit 24.6
A cross hedge that locks in the current price of donbax: cash prices decrease by same
percentage (while the gold basis stays constant)
Assumptions
Price of donbax
Cash price at time hedge is placed US$660.96 per oz
Cash price at time hedge is lifted US$641.68 per oz
Price of gold
Number of ounces of donbax to be hedged 2,500
Number of ounces of gold to be hedged 1,000
assuming ratio of cash price of donbax to gold
is 0.4
Number of ounces per futures contract for 100
gold
Number of gold futures contracts used in 10
hedge
Short (sell) cross hedge by mining company
2,500 US$660.96 = US$1,652,400 10 100 US$1,697.80 = US$1,697,800 US$45.40 per ounce
Long (buy) cross hedge by jewellery company

Project Financing
The short cross hedge produces a gain of US$48,200 in the futures market and an exactly
offsetting loss in the cash market. The opposite occurs for the long cross hedge. There is
neither an overall gain nor a loss from the cross hedge for either hedger in this scenario. The
same would occur if the cash prices of both commodities increase by the same percentage
and the basis does not change.
Suppose that the cash price of both metals decreases but the cash price of donbax falls by
a greater percentage than the cash price of gold. For example, suppose that the cash price of
donbax falls to US$590.63 per ounce, while the cash price of gold falls to US$1,604.20 per
ounce. The futures price of gold falls to US$1,649.60 so that the gold basis is not changed.
The cash price of donbax at the time the cross hedge is lifted is about 37% of the cash
price of gold, rather than the 40% when the cross hedge was constructed. The outcome for
the long and short cross hedge is shown in Exhibit 24.7.
Exhibit 24.7
Cross hedge: cash price of commodity to be hedged falls by a greater percentage than
the futures used for the hedge (while the gold basis stays constant)
Assumptions
Price of donbax
Cash price at time hedge is placed US$660.96 per oz
Cash price at time hedge is lifted US$590.63 per oz
Price of gold
Number of ounces of donbax to be hedged 2,500
Number of ounces of gold to be hedged 1,000
assuming ratio of cash price of donbax to
gold is 0.4
Number of ounces per futures contract for 100
gold
Number of gold futures contracts used in 10
hedge
Short (sell) cross hedge by mining company
Continued
372


Long (buy) cross hedge by jewellery company
What should be clear from these illustrations is just what we stated earlier: hedging
is not as simple as sometimes portrayed in books and popular publications. Although the
outcome may be unknown in a cross hedge because of the risk associated with the basis
for the underlying for the futures contract and the link between the price of the underlying
for the futures and the price of what is being hedged, performing sensitivity analysis (see
Chapter 20) as used in the illustrations above can provide insights as to the risks associated
with the hedge.
1
Municipal industrial revenue bond development financing is covered in Chapter 6.
2
Enerkem secures off-take agreement with Methanex Corporation, the worlds largest supplier of methanol,
press release 14 September 2011: www.prnewswire.com/news-releases/enerkem-secures-off-take-agreement-with-
methanex-corporation-the-worlds-largest-supplier-of-methanol-129801398.html.
3
Swanepoel, E, Paladin signs off-take agreement for Langer Heinrich Output, miningweekly.com, 22 August 2011:
www.miningweekly.com/article/paladin-signs-off-take-agreement-for-langer-heinrich-output-2011-08-22.
4
Fortis and Enel sign 10 year power purchase agreement for Synder Wind Farm, Enel news release, 13 August
2007: www.enel.it/northamerica/boxhp.asp?IdDoc=1513658; and Enel: Wind Farm agreements signed in United
States and Canada, Enel news release, 5 January 2007: www.enel.it/azienda_en/sala_stampa/comunicati/ss_
comunicatiarticolo.asp?IdDoc=1492853.
373

Project Financing
Chapter 25
Controlling risk via risk-sharing derivative

contracts: swaps
A swap is an agreement whereby two parties (called counterparties) agree to exchange peri-
odic payments. The exchange by the two parties is based on a notional principal amount
specified in the contract.
There are four types of swaps:
interest-rate swaps;
currency swaps;
commodity swaps; and
equity swaps.
From what we have observed, all but equity swaps have been used in project financing.1
A swap is not a new derivative instrument. Rather, it can be decomposed into a package
of forward contracts that we described in the previous chapter. While a swap may be nothing
more than a package of forward contracts, it is not a redundant contract for several reasons.
First, in many markets where there are forward and futures contracts, the longest maturity
does not extend out as far as that of a typical swap. Second, a swap is a more transaction-
ally efficient instrument. By this we mean that in one transaction a project company can
effectively establish a pay-off equivalent to a package of forward contracts. The forward
contracts would each have to be negotiated separately. Third, the liquidity of the swap market
has grown since its beginning in 1981; it is now more liquid than many forward contracts,
particularly long-dated (that is, long-term) forward contracts.
The swap markets developed because of the needs of companies, financial institutions,
portfolio managers and governments to manage their exposure to the volatility of interest
rates, exchange rates and commodity prices. Some of the specific needs which led to the
development of the swap market are as follows, although some of the opportunities are far
more difficult to find in the swaps market today.
1 The arbitraging of capital markets by borrowing in one currency in order to generate

another currency by attaching a hedge to the borrowing. This arbitrage process some-
times permits borrowers to generate a desired currency at a cheaper all-in cost than
borrowing the currency directly.
2 The adverse effect of foreign currency translation losses on earnings.
3 The need to eliminate currency and interest-rate exposure by matching of assets and
liabilities both in terms of currency and maturity.
4 The need to cover long-term commitments in foreign currencies.
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Controlling risk via risk-sharing derivative contracts: swaps
5 The access or lack of access to funding in a particular currency.

6 The ability to raise floating-rate funds coupled with lack of ability to raise needed
fixed-rate funds.
7 The lack of coverage available in forward foreign exchange markets.
8 The lack of liquidity for primary borrowing in a particular currency or market.
9 The lack of availability of longer maturities in certain markets.
10 The need to mobilise blocked currencies worldwide.
11 The need to take advantage of any available subsidised government financing from such
sources as export credit agencies, where the primary need is in another currency.
12 The utilisation of excess foreign tax credits by shifting interest cost from unprofitable
to profitable tax-paying entities.
13 The diversification of markets for primary funding so that various capital markets can
be utilised.
14 The avoidance of delays in gaining access to a capital market where the flow of new
issues is limited by government regulation.
1Generic interest-rate swaps

We will begin with the simplest of all swaps contract: the generic or plain vanilla interest-
rate swap. In this type of swap the two counterparties agree to exchange payments based on
a specified interest rate terms and notional principal amount (or simply notional amount).
In fact, the only payments exchanged between the parties are the interest payments, not the
notional amount. In a generic interest-rate swap one party agrees to pay the other party fixed-
interest payments at designated dates for the life of the contract. This party is referred to as
the fixed-rate payer or the floating-rate receiver. The other party agrees to make interest rate
payments based on the reference rate; accordingly, this party is referred to as the floating-
rate payer or fixed-rate receiver. The convention employed in the market is to refer to the
two parties simply in term of whether they are paying a fixed rate or receiving a fixed rate.
In an interest-rate swap the payments to be exchanged can be based upon one of a wide
range of floating interest rates which is referred to in the contract as the reference rate. The
tenor of the reference rate may be any of those commonly used such as daily, monthly,
quarterly, or semi-annually. The most commonly used reference rate is Libor, although
other reference rates have been used (for example, Treasury bill rate, commercial paper
rate, certificate of deposit rate, prime rate and federal funds rate). The fixed rate payment
is called the swap rate. The swap rate is based on a spread over some benchmark, typically
for US dollar interest rate swaps the benchmark is the yield on a US Treasury issue with a
maturity equal to the swaps tenor. The spread is called the swap spread. The convention
that has evolved for quoting interest-rate swaps is that a swap dealer sets the floating rate
equal to the reference rate and then quotes the swap rate that will apply.
As an illustration of a generic interest-rate swap, assume that a project sponsor enters
into the following generic interest-rate swap as the fixed-rate payer:
Notional amount: US$100 million

Reference rate: three-month Libor
375

Project Financing
Swap rate: 4%
Payment frequency: quarterly
Swap tenor: 10 years
For this 10-year swap, the project sponsor would receive every quarter for the next 10 years
three-month Libor. We will simplify this illustration by assuming that the payments are the
same in each quarter. As explained later, the calculations of the payments will depend on
the number of days in the quarter. So if three-month Libor is 3%, the swap payment would
be 3% (the reference rate) multiplied by US$100 million (the notional amount) divided by
four (since payments are quarterly). That is, the floating-rate payment received by the project
sponsor (who is the fixed-rate payer and therefore the floating-rate receiver) is US$750,000.
Since the swap rate is 4%, the payment that will be made by the project sponsor is 4% (the
swap rate) multiplied by $100 million (the notional amount) divided by four or $1 million.
The swap payments are netted so that the project sponsor pays US$250,000. Had three-month
Libor been 5% instead of 3%, then the project sponsor would receive US$1.25 million and
pay US$1 million, resulting in a net receipt of US$250,000.
Application
Here is a basic illustration of how a generic interest-rate swap can be used by a project
sponsor. Suppose that a project sponsor is seeking US$500 million in fixed-rate financing
for 10 years. Assume that the following two funding alternatives are available to the project
sponsor:
Fixed-rate financing: 10-year fixed-rate bond at 4.75%

Floating-rate financing: 10-year floating-rate bond at three-month Libor plus 60 basis points
Assume further that the 10-year generic interest rate swap used in our previous illustration
(4% swap rate) is available. Let us look at the financing cost if the project sponsor issues
the floating-rate bond and simultaneously enters into that swap (with a US$500 million
notional amount) as the fixed-rate payer. Then each quarter the following payments are
made by the project sponsor:
Payment obligation on the floating-rate bond: three-month Libor + 60 bps

Payment obligation on the swap: 4%
The payment received by the project sponsor from the swap is three-month Libor. Letting
L denote three-month Libor, then netting the payments we have:
(L + 0.006) + 0.040 L = 0.046 = 4.6%
Consequently, the 10-year fixed-rate financing by issuing the floating-rate bond and entering
into the swap is 4.6% which is 15 basis points less than if the 10-year fixed-rate bond of
4.75% is issued.
376

Although one can view this financing package results in a cost savings of 15 basis points,
there is credit risk faced by the project sponsor. There is counterparty risk faced by the
project sponsor. Hence, the project sponsor must assess whether or not the potential savings
is sufficient to compensate for counterparty risk. More specifically, if the swap counterparty
fails, the project sponsor must continue to make the floating-rate bond payments. Thus, if
the reference rate increases in the future, resulting in higher floating-rate bond payments,
funding costs will increase.
Calculation of the swap rate

Let us now look at how the swap rate is calculated. At the initiation of an interest-rate swap, the
counterparties are agreeing to exchange future interest-rate payments and no upfront payments
by either party are made. This means that the swap term must be such that the present value
of the cash flows for the payments to be made by the counterparties must be equal. Another
way of saying this is that the present value of the cash flows of the payments made by the
fixed-rate payer must be equal to the present value of the payments received by the fixed-rate
payer. The equivalence of the cash flows is the principle in calculating the swaprate.
For the fixed-rate side, the calculation of the swap payments that must be made by the
fixed-rate payer are known once a swap rate is determined. In contrast, the floating-rate
payments are not known because they depend on the value of the reference rate at the reset
dates. For a Libor-based swap, the Eurodollar futures contract discussed in the previous
chapter can be used to establish the forward (or future) rate for three-month Libor. Given
the cash flow based on the forward rate for three-month Libor, the swap rate is the interest
rate that will make the present value of the payments on the fixed-rate side equal to the
payments on the floating-rate side.
The appropriate rate to discount any cash flow is the theoretical spot rate. Each cash
flow should be discounted at a unique discount rate.2 These rates can be obtained from
forward rates. It is the same three-month Libor forward rates derived from the Eurodollar
futures contract that can be used to obtain the theoretical spot rates.
The procedure can be illustrated with an example.
Swap term: three-year swap

Fixed receiver: Actual/360-day count basis and quarterly payments
Floating receiver: three-month Libor, actual/360-day count basis, quarterly payments
and quarterly reset
In the swap market the actual/360-day count basis is a market convention describing how
to calculate the interest for the period for the floating rate and the fixed rate. In practice,
the day count convention for the fixed-rate leg is 30/360.
The steps and calculations involved in computing the swap rate for our hypothetical
swap are shown in Exhibit 25.1.3 The first column just lists the quarterly periods. It is
assumed that there is a Eurodollar futures contract with a settlement date that corresponds
to each period. The second column shows the number of days in the period for each assumed
377

Project Financing
Eurodollar futures contract. The third column shows the futures price for each contract. As
explained in the previous chapter the future three-month Libor is found by subtracting the
futures price from 100. This is shown in column 4 representing the forward rate.
It is from the forward rates that the discount rates that will be used to discount the cash
flows (payments) will be calculated. The discount factor (that is, the present value of US$1
based on the spot rate) for each period is shown in column 5 using the formula provided
in the note to that column in the exhibit.4 Column 6 shows the floating cash flow which
is found by multiplying the forward rate and the notional principal amount. However, the
forward rate must be adjusted for the number of days in the payment period as shown in
the note to column 6. These values represent the payments by the fixed-rate receiver and
the receipts of the fixed-rate payer. The present value of each of these cash flows is shown
in column 7 using the discount factor shown in column 5. The present value of the floating
cash flow is US$140,531.
In order for no other payments to be exchanged between the counterparties other than
the interest payments, the swap rate must be set such that the present value of the fixed
cash flows is equal to the same value, US$140,531. This can be found by formula. For our
hypothetical swap, the swap rate is 4.988%. The cash flow is as shown in column 8. In
determining the fixed cash flows, each cash flow must be adjusted for the day count as shown
in the note to column 8. Using the discount factors in column 5, the present value of the
fixed cash flows is equal to US$140,531. This confirms that the swap rate is 4.988%, since
it is this rate that equates the present value of the floating and fixed cash flows.
Given the swap rate, the swap spread can be determined. For example, since this is a
three-year swap, the three-year on-the-run Treasury rate would be used as the benchmark. If
the yield on that issue is say, for example, 4.588%, the swap spread is then 40 basispoints.
The calculation of the swap rate for all swaps follows the same principle: equating the
present value of the cash flows.5
Exhibit 25.1
Calculation of the swap rate for a three-year, hypothetical swap
1 2 3 4 5 6 7 8 9
Period Day Futures Forward Discount Floating PV of Fixed PV of fixed
count price rate factor cash flow floating cash flow cash flow
cash flow at 4.988%
1 91 4.05 1.00000
2 90 95.85 4.15 0.98998 10,125 10,024 12,469 12,344
3 91 95.45 4.55 0.97970 10,490 10,277 12,607 12,351
4 91 95.28 4.72 0.96856 11,501 11,140 12,607 12,211
5 91 95.10 4.90 0.95714 11,931 11,420 12,607 12,067
6 94 94.97 5.03 0.94505 12,794 12,091 13,023 12,307
Continued
378

1 2 3 4 5 6 7 8 9
cash flow at 4.988%
7 91 94.85 5.15 0.93318 12,715 11,865 12,607 11,765
8 90 94.75 5.25 0.92132 12,875 11,862 12,469 11,488
9 91 94.60 5.40 0.90925 13,271 12,067 12,607 11,463
10 91 94.50 5.50 0.89701 13,650 12,244 12,607 11,309
11 91 94.35 5.65 0.88471 13,903 12,300 12,607 11,154
12 93 94.24 5.76 0.87198 14,596 12,727 12,885 11,235
13 91 94.10 5.79 0.85947 14,560 12,514 12,607 10,836
Total 140,531 140,531

Fixed receiver:
30/360-day count basis
Quarterly payments
Floating receiver:
three-month Libor
Actual/360-day count basis
Quarterly payments and reset
Explanation of columns
Column 2: the day count refers to the number of days in theperiod.
Column 3: the Eurodollar futuresprice.
Column 4: Fwd rate = Forward rate. The forward rate for Libor found from the futures price of the
Eurodollar futures contract as follows: 100.00 Futures price
Column 5: the discount factor is found as follows:
Discount factor in the previous period/ [1 + (Fwd rate in previous period No. of days in period/360)]
where No. of days in period is found in column2.
Column 6: the floating cash flow is found by multiplying the forward rate and the notional amount,
adjusted for the number of days in the payment period. That is:
(Forward rate previous period No. of days in period/360) Notional amount
Column 7: present value of floating cash flow, found as follows: Column 5 Column 6
Column 8: this column is found by trial and error, based on a guess of the swap rate. In determining the
fixed cash flow, the cash flow must be adjusted for the day count, as follows:
(Assumed swap rate No. of days in period/360) Notional amount
The assume swap rate in the calculation is 4.988% which turns out to be the actual swap rate.
Column 9: present value of fixed cash flow, found as follows: Column 5 Column 7
Fwd rate previous period No. of days in period/360 Notional amount
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Valuing a swap
The value of an interest-rate swap is affected by movements in market interest rates. This is
because changes in market interest rates will change the cash flow of the floating-rate side
of the swap. The value of an interest-rate swap is the difference between the present values
of the cash flows of the two sides of the swap. The three-month Libor forward rates from
the current Eurodollar futures contracts are used to: (i) calculate the floating cash flows; and
(ii) determine the discount factors at which to calculate the present value of the cash flows.
To illustrate this, consider the three-year swap used to demonstrate how to calculate
the swap rate. Suppose that one year later, interest rates change. Column 3 in Exhibit 25.2
Exhibit 25.2
Determining the value of a swap
1 2 3 4 5 6 7 8 9
cash flow
1 91 5.25 1.000000
2 94 94.27 5.73 0.987045 13,708 13,531 13,023 12,854
3 91 94.22 5.78 0.972953 14,484 14,092 12,607 12,266
4 90 94.00 6.00 0.958942 14,450 13,857 12,469 11,957
5 91 93.85 6.15 0.944615 15,167 14,327 12,607 11,909
6 91 93.75 6.25 0.929686 15,546 14,453 12,607 11,721
7 91 93.54 6.46 0.915227 15,799 14,459 12,607 11,539
8 93 93.25 6.75 0.900681 16,688 15,031 12,885 11,605
9 91 93.15 6.85 0.885571 17,063 15,110 12,607 11,165
Total 114,859 95,016
Two-year swap
Fixed receiver:
Swap rate 4.988%
Quarterly payments
Floating receiver:
Three-month Libor
Quarterly payments and reset
PV of floating cash flow: US$114,859
PV of fixed cash flow: US$ 95,016
Value of swap: US$ 19,843
380

shows the assumed prevailing futures price for each assumed Eurodollar futures contract.
Based on these assumed futures prices, the corresponding forward rates and discount factors
are shown in columns 4 and 5, respectively. Column 6 shows the floating cash flow based
on the forward rates in column 4 and column 7 shows the present value of the floating cash
flow using the discount factors in column 5. The present value of the floating cash flow is
US$114,859. This means that the fixed-rate receiver has agreed to make payments with a
value of US$114,859 and the fixed-rate payer will receive a cash flow with this value.
The fixed rate side will be continued because the swap rate is fixed over the swaps
remaining life of two years. The fixed cash flow is given in column 8 and the present value
based on the discount factors in column 5 is shown in column 9. The present value of the
fixed cash flows is US$95,016. This means that the fixed-rate payer has agreed to make
payments with a value of US$95,016 and the fixed-rate receiver will receive a cash flow
with this value.
From the fixed-rate payers perspective, a floating cash flow with a present value of
US$114,859 is going to be received and a fixed cash flow with a present value of US$95,016
is going to be paid out. The difference between these two present values, US$19,843, is the
value of the swap. It is a positive value for the fixed-rate payer because the present value of
the amount to be received exceeds the present value of the amount to be paid out.
From the fixed-rate receivers perspective, a floating cash flow with a present value of
US$114,859 is going to be paid out and a fixed cash flow with a present value of US$95,016 is
going to be received. Once again, the difference between these two present values, US$19,843,
is the value of the swap. It is a negative value for the fixed-rate receiver because the present
value of what is to be received is less than the present value of what is to be paid out.
2 Non-generic interest-rate swaps

Non-generic or individualised swaps have evolved as a result of the needs of borrowers and
lenders and some are described below. One of these variants is an option on a swap, or
more popularly referred to as a swaption. Because it is an option, we postpone its discus-
sion until the next chapter.
Note that regardless of the type of non-generic interest-rate swap, the valuation procedure
described above can be used.
Amortising, accreting and roller coaster swaps

In a generic swap, the notional principal amount does not vary over the life of the swap.
Thus, it is sometimes referred to as a bullet swap. In contrast, for amortising, accreting and
roller coaster swaps, the notional principal amount varies over the life of the swap.
In an amortising swap the notional principal amount decreases in a predetermined way
over the life of the swap. In situations where a liability to be funded increases over time,
an accreting swap can be employed.
An accreting swap is one in which the notional principal amount increases in a prede-
termined way over time. An accreting swap could be used by a lending institution that has
committed to lend increasing amounts to a customer for a project.
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In a roller coaster swap, the notional principal amount can rise or fall from period to
period according to a borrowers cash flow structure.
Zero-coupon swaps
In a zero-coupon swap, the fixed-rate payer does not make any payments until the maturity
date of the swap but receives floating-rate payments at regular payment dates. This type of
swap exposes the floating-rate payer to significant counterparty risk because this party makes
regular payments but does not receive any payments until the maturity date of the swap.
Basis rate swap

In a basis rate swap, both parties exchange floating-rate payments based on a different
money market index.
Forward-rate swaps
A forward swap is simply a forward contract on an interest-rate swap. The terms of the swap
are set today, but the parties agree that the swap will begin at a specified date in thefuture.
3 Currency swaps
In a currency swap, the two parties agree at the time of the trade to exchange a specified
amount (notional amount) of one currency for another and at the end of the swaps life,
to return the original amounts that were swapped at the time of the trade. In contrast to
an interest-rate swap, which does not involve the exchange of the notional amount, in a
currency swap there is an exchange of the notional amount.
Companies engaged in project financing should be interested in currency swaps because
changes in exchange rates can erode or eliminate profit margins. While short-term hedging
techniques can be used for short-term exposure, that strategy does not provide protection
for longer-term currency exposure problems encountered in project financing.
The need for a currency swap in a project financing also arises where loans are avail-
able to the project in different currencies than the project will generate from the sale of its
products or services. This can commonly occur where a project has available subsidised,
attractively-priced export financing in a currency which the project will not generate.
The objective of most currency swap transactions is to reduce foreign exchange risk.
However, swaps can be particularly useful in many project financing situations, including
the following.
Interest costs: under certain circumstances, interest costs may be reduced by using a swap
to raise funds in a foreign currency.
A loan in a foreign currency is not readily available: a swap may be employed to gain
access to a loan in a foreign currency at a reasonable interest rate.
382

Use of blocked currency: when a sponsor company has funds in a currency that is
blocked because of exchange controls, a swap transaction can provide a mechanism to
make use of those funds by lending or selling those funds to another company in need
of such funds. When the purchase of needed foreign currencies may be regulated or
discouraged by investment currency exchange controls thereby making such currencies
expensive or unavailable, a swap transaction may be used in some situations to bypass
such controls.
Whether a multi-currency swap is done on a simple interest differential basis (exchange of

borrowing) or in the form of forward exchange rates at a premium or discount, the under-
lying pricing parameters remain the same:
1 the interest differential between the currencies for a particular maturity;

2 the varying perceptions of different markets and the availability of funding in different
markets; and
3 swaps are tailored to the tax, cash flow and accounting requirements of the company
which provides a degree of flexibility for which market players may be willing to pay a
certain premium over public market rates.
4 Cross-currency interest-rate swaps

Cross-currency interest-rate swaps combine the features of single currency interest-rate swaps
and currency swaps. These swaps may be fixed to floating, whereby one party converts
fixed-rate financing in one currency to floating-rate financing in another currency. Or they
may be fixed to fixed or floating to floating in different currencies.
For example, suppose that a project sponsor domiciled in France wants to build a plant
in the United States and requires funding of US$X million. Assume the following.
The project sponsors funding objective is four-year fixed-rate financing of US$X million.
The project sponsor does not have access to the US capital market (that is, it cannot issue
fixed-rate dollar-denominated bond in the United States).
The US$X million equivalent at the prevailing exchange rate is Y million.
The project sponsor can obtain Y million by issuing fixed-rate bonds in the European
bond market.
In the United States, the project sponsor can obtain from a US bank a four-year floating-
rate loan for US$X million.
Here is how a cross currency interest rate swap can be used by the project sponsor to
accomplish its funding objective of obtaining four-year fixed-rate US dollar financing.
1 It issues four-year fixed-rate bonds in the European bond market to raise Y million.
2 It enters into the swap agreement in which it converts the Y million into US$X million
at the time of the swap.
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Project Financing
3 During the swaps life the project sponsor agrees to an exchange of payments of interest
as follows: (i) pay fixed interest payments in US dollars; and (ii) receive floating-rate
payments linked to Libor.
4 At the end of the swaps life exchange US$X million for Y million.
From 2 and 4 above, the project sponsor has eliminated the currency risk over the four
years (that is, the swaps life). By netting the payments in 3 above, the project sponsor has
achieved its funding objective of obtaining four-year fixed-rate financing in US dollars. Exhibit
25.3 provides a schematic of the payments for this swap. Of course, in this example, the
funding costs will depend on the terms of the swap.
Exhibit 25.3
Illustration of a cross currency interest rate swap
2 Cross currency
interest rate
agreement
3 Floating US loan of US$X

Project sponsor Swap counterparty
million
Fixed euros interest

and principal (Y
1 Issuance 4 Fixed million)
of four- euros
year fixed- interest
rate euro and
bond (Y principal
million)
Fixed-rate lenders in
euros
384

5 Commodity swaps
The commodity swap market can be used to hedge the long-term price risk of the outputs
or inputs for a project. In a commodity swap, the exchange of payments by the counterpar-
ties is based on the value of a particular commodity such as oil. The exchange of payments
is as follows on the payment dates. One party agrees to pay a fixed price for a specified
quantity of the commodity. The counterparty agrees to pay the spot price for the commodity
at that date.
There are several types of commodity swap, the most common used to control risk in
operations being a fixed-floating swap. We have already discussed a generic interest-rate swap
which involves fixed-for-floating interest payments. The reference rate for the floating-rate
side is some reference rate. In a fixed-floating commodity swap, a commodity price is used
to determine the payments for the two parties. There is a fixed price payer and a floating
price payer.
The terms of a fixed-floating commodity swap involve:
a notional amount or reference quantity;

a fixed price;
a floating price;
a reference price;
a pricing period; and
a tenor of the swap.
The reference price is used in determining the floating price for the commodity. A pricing
source or calculation methodology is specified in the swap documentation. The pricing period
is when the payments of the two parties are determined. The payment by the fixed price
payer is determined by multiplying the fixed price by the reference quantity. The payment for
a pricing period that must be made by the floating price payer is determined by multiplying
the floating price (as specified by the reference price) by the reference quantity.
For example, suppose that the sponsor for a project that involves the sale of crude oil
enters into a two-year fixed-floating commodity swap in which it is the floating price payer
with the following terms.
Reference quantity: 100,000 barrels per month of WTI Crude Oil

Fixed price: US$99.00 per barrel
Floating price: computed as the arithmetic average of the reference price during the
pricing period
Reference price: Daily Official Settlement price of the prompt CMEs WTI futures contract
Pricing period: 24 months covered by the swap
Suppose that the reference price for a pricing month is US$96.00 per barrel. This means
that the project sponsor (the floating price payer) must make a payment of US$9,600,000
(US$96.00 100,000). The payment received by the project sponsor from the fixed price
payer (which is the same each month) is US$9,900,000 (US$99.00 100,000). Netting the
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Project Financing
payments, the project sponsor receives US$300,000 for that month. If the reference price
was US$102.00 for a pricing month, then the project sponsor would make a payment of
US$300,000.
1
Another derivative instrument referred to as a swap is a credit default swap where the payoff is contingent upon
the occurrence of a credit event. This type of swap is more appropriately classified as an option-type derivative.
It is not discussed in this book because of its limited use thus far in project financing.
2
For a further discussion, see Fabozzi, FJ, Valuation of Fixed Income Securities and Derivatives, 1998, Frank J.
Fabozzi Associates, ch. 2.
3
Some of the calculations in the exhibit do not agree precisely with the calculations explained because of rounding
during interim calculation by the Excel spreadsheet.
4
The formulas presented below are taken from Dattatreya, RE, Venkatesh, RES, and Venkatesh, VE, Interest Rate
& Currency Swaps, 1994, Probus Publishing, ch. 6.
5
For a more detailed explanation of how this is done with more complicated swaps, see endnote 4, ch. 6.
386

Controlling risk via insurance-type derivative contracts: options, caps and floors
Chapter 26
Controlling risk via insurance-type

derivative contracts: options, caps and
floors
In the previous two chapters, we described various derivative contracts that can be used for
controlling financing risk, exchange rate risk and commodity price risk that are classified
as risk-sharing arrangements. This means that the two parties to the contract are willing to
give up any favourable movement in funding cost, an exchange rate or a commodity price
in order to eliminate the risk associated with adverse outcomes. No party to the risk-sharing
arrangement discussed in the prior two chapters required the payment of a fee or insurance-
type premium in order to induce the other party to provide the protection.
In contrast, an insurance-type derivative contract provides protection for one party who
is willing to make a non-recoverable payment to the other party in order to obtain that
protection. The party seeking insurance-type protection seeks to maintain the potential upside
gain associated with a favourable movement. The party offering the protection receives only
the payment made by the protection-seeking party and nothing else.
Insurance-type derivative contracts can be used by project sponsors to:
impose a ceiling on or a range for future funding costs;

provide a minimum or a range for an exchange rate for a currency in the future;
provide a maximum or a range for an exchange rate for a currency in the future;
provide a minimum or a range for the price of a commodity to be sold in the future; and
provide a maximum price or range for the price of a commodity to be purchased in
the future.
Our focus in this chapter is on insurance-type derivative contracts that can be used by project
sponsors. An important issue associated with the use of these types of derivatives is the cost
of the protection. In the parlance of the literature, this means the pricing or valuation of an
options contract. This topic is beyond the scope of this chapter. There are well-known option
pricing models and the option pricing literature has numerous enhancements and modifications
of the basic model.1 Here we only point out the following. For exchange-traded options,
empirical research suggests that these products are efficiently priced in the market. That is,
exchange-traded option products are fairly priced. In the case of complex over-the-counter
(OTC) options, there can be mispricing due to modelling risk or inappropriate assumptions
and, consequently, project sponsors are well advised in the absence of in-house derivatives
specialists to employ the services of a firm that specialises in valuation.
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Project Financing
1 Options
An option is a contract in which the writer of the option grants the buyer of the option the
right, but not the obligation, to purchase from or sell to the writer something at a specified
price within a specified period of time (or at a specified date). The something specified in
the contract is referred to as simply the underlying as explained in Chapter 24. The writer,
also referred to as the seller, grants this right to the buyer in exchange for a certain sum of
money, which is called the option price or option premium. The price at which the under-
lying may be bought or sold is called the strike or exercise price. The date after which an
option is void is called the expiration date.
When an option writer grants the buyer the right to purchase the underlying from the writer
(seller), it is referred to as a call option or simply a call. When the option buyer has the right
to sell the underlying to the writer, the option is referred to as a put option or simply aput.
An option is categorised according to when the option buyer may exercise the option.
This feature of an option is referred to as its exercise style. Most options permit either
exercise at the expiration date or at any time up to and including the expiration date. An
option that may only be exercised at the expiration date is referred to as a European option;
an option that may be exercised at any time up to and including the expiration date is
referred to as an American option. Because there are situations where options with these
two exercise styles may be insufficient for an end user, customised options can be created
for a bank client. Probably the most common type of non-standard exercise style is the
Bermudian option. This option allows the option buyer to exercise the option at designated
dates over the options life.
The buyer of the option using this instrument for risk control purposes is seeking
protection with respect to an unfavourable movement of the underlying. It could be (as
noted earlier) either an interest rate, an exchange rate or a commodity price. The seller or
writer of an option is basically an insurer. Hence, to induce the option writer to enter into
the transaction, the option buyer must compensate the option writer in the form of a fee.
This compensation is more commonly referred to as the option price or option premium.
The maximum amount that an option buyer can lose is the option price. The maximum
profit that the option writer can realise is the option price. The option buyer has substantial
upside potential, while the option writer has substantial downside risk.
A call option gives the buyer a maximum price (the strike price) at which the underlying
can be purchased. For example, if a project company requires a commodity for current and
future production and the current price is 20 per unit then a call option on that product
(if it exists) with a strike price of say 22 means that if the price exceeds 22 at the expira-
tion date, then the maximum price that must be paid is 22 A put option gives the buyer
a minimum price (the strike price) at which the underlying can be sold. Consequently, for
a project company seeking to control input and output prices, puts and calls can be used.
The cost is equal to the option price. Actually, for both the call and the put, the effective
maximum price for the former is the strike price plus the option price and the minimum
price for the latter is the strike price reduced by the option price.
Although there are well-documented cases in the popular press of the use of options
that result in a financial debacle, information about how options can be used to benefit an
388

end user are scant. Here is an old but nevertheless instructive case. In late 1993, Sonangol,
Angolas national oil company, purchased a put option from a bank (Bankers Trust) to sell
two million barrels of crude oil at a time when the price of oil was US$15 per barrel.2 The
put option was required by the bank to guarantee sufficient cash flow to repay the loan within
one year.3 There was considerable uncertainty about the cash flow because production did
not begin until the following spring. The price of oil subsequently dropped US$3 per barrel.
Sonangol would not have been able to pay back the loan had it not been for the putoption.
The ability of lenders to buy options gives them greater flexibility in structuring loans
for projects. For example, bankers at MeesPierson in Amsterdam structured a deal for the
purchase of equipment by Gecamines, a Zairean mining company. Gecamines would use its
excess production of cobalt for the payment of vital spare parts for its trucks and locomo-
tives. To eliminate the price risk that MeesPierson faced with the payments made in cobalt,
the banker purchased put options on cobalt.4
Moreover, as explained in Chapter 23, puts and calls can be used as a form ofguarantee.
Differences between options and futures contracts

Unlike in a futures contract, one party to an option contract is not obligated to transact.
Specifically, the option buyer has the right but not the obligation to transact. The option
writer does have the obligation to perform. In the case of a futures contract, both buyer and
seller are obligated to perform. Of course, a futures buyer does not pay the seller to accept
the obligation, while an option buyer pays the seller an option price.
Consequently, the risk/reward characteristics of the two contracts are also different. In the
case of a futures contract where the transaction is in US dollars, the buyer of the contract
realises a dollar-for-dollar gain when the price of the futures contract increases and suffers
a dollar-for-dollar loss when the price of the futures contract drops. The opposite occurs for
the seller of a futures contract. Options do not provide this symmetric risk/reward relation-
ship. The most that the buyer of an option can lose is the option price. While the buyer
of an option retains all the potential benefits, the gain is always reduced by the amount of
the option price. The maximum profit that the writer may realise is the option price; this is
offset against any substantial downside risk. This difference is extremely important because
a hedger can use futures to protect against symmetric risk and options to protect against
asymmetric risk.
Exchange-traded versus OTC options

Options, like other financial instruments, may be traded either on an organised exchange
or in the over-the-counter (OTC) market. Exchange-traded options have three advantages.
First, the strike price and expiration date of the contract are standardised. Second, as in the
case of futures contracts, the direct link between buyer and seller is severed after the trade
is executed because of the interchangeability of exchange-traded options. The clearing house
associated with the exchange where the option trades performs the same function in the
options market that it does in the futures market. Finally, the transaction costs are lower
for exchange-traded options than for OTC options.
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Project Financing
The higher cost of an OTC option reflects the cost of customising the option for the
many situations where a customer needs to have a tailor-made option because the stan-
dardised exchange-traded option does not satisfy its investment objectives. Some banks and
dealer firms act as principals as well as brokers in the OTC options market. OTC options
are sometimes referred to as dealer options. The buyer of an OTC option is exposed to
counterparty risk. While an OTC option is less liquid than an exchange-traded option, this
is typically not of concern to a user most project companies who use OTC options as part
of an overall risk management program intend to hold them to expiration.
Exchange-traded futures options

Options can be written on cash instruments or futures contract. Exchange-traded option
contracts whose underlying instrument is a debt instrument, a currency or a commodity are
referred to as options on physicals. The most liquid interest rate, currency and commodity
exchange-traded options are options on futures contracts, called futures options.
An option on a futures contract gives the buyer the right to buy from or sell to the
writer a designated futures contract at a designated price at any time during the life of the
option. If the futures option is a call option, the buyer has the right to purchase one desig-
nated futures contract at the strike price. That is, the buyer has the right to acquire a long
futures position in the designated futures contract. If the buyer exercises the call option, the
writer (seller) acquires a corresponding short position in the futures contract.
A put option on a futures contract grants the buyer the right to sell one designated
futures contract to the writer at the strike price. That is, the option buyer has the right to
acquire a short position in the designated futures contract. If the put option is exercised, the
writer acquires a corresponding long position in the designated futures contract.
Mechanics of trading futures options

As the parties to the futures option will realise a position in a futures contract when the
option is exercised, the question is: what will the futures price be? That is, at what price
will the long be required to pay for the instrument underlying the futures contract, and at
what price will the short be required to sell the instrument underlying the futures contract?
Upon exercise, the futures price for the futures contract will be set equal to the strike
price. The position of the two parties is then immediately marked to market based on
the then-current futures price. Thus, the futures position of the two parties will be at the
prevailing futures price. At the same time, the option buyer will receive from the option
seller the economic benefit from exercising. In the case of a call futures option, the option
writer must pay the difference between the current futures price and the strike price to the
buyer of the option. In the case of a put futures option, the option writer must pay the
holder of the put option the difference between the strike price and the current futuresprice.
For example, suppose an investor buys a call option on some futures contract in which
the strike price is 85. Assume also that the futures price is 95 and that the buyer exercises
the call option. Upon exercise, the call buyer is given a long position in the futures contract
at 85 and the call writer is assigned the corresponding short position in the futures contract
390

at 85. The futures position of the buyer and the writer is immediately marked to market
by the exchange. Since the prevailing futures price is 95 and the strike price is 85, the
long futures position (the position of the call buyer) realises a gain of 10 while the short
futures position (the position of the call writer) realises a loss of 10. The call writer pays
the exchange 10 and the call buyer receives from the exchange 10. The call buyer who now
has a long futures position at 95 can either liquidate the futures position at 95 or maintain
a long futures position. If the former course of action is taken, the call buyer sells a futures
contract at the prevailing futures price of 95. There is no gain or loss from liquidating the
position. Overall, the call buyer realises a gain of 10. If the call buyer elects to hold the
long futures position, then he will face the same risk and reward of holding a long futures
position. But he still has realised a gain of 10 from the exercise of the call option.
Suppose instead that the futures option is a put rather than a call, and the current futures
price is 60 rather than 95. If the buyer of the put option exercises it, the buyer would have
a short position in the futures contract at 85; the option writer would have a long posi-
tion in the futures contract at 85. The exchange then marks the position to market at the
then-current futures price of 60, resulting in a gain to the put buyer of 25 and a loss to the
put writer of the same amount. The put buyer who now has a short futures position at 60
can either liquidate the short futures position by buying a futures contract at the prevailing
futures price of 60 or maintain the short futures position. In either case the put buyer realises
a gain of 25 from exercising the put option.
Variants of standard options

As explained earlier, one type of variant of the standard or vanilla option is the Bermudian
option. This option only differs from the standard option in terms of the exercise style.
There are more complex options with features that make their valuation more difficult. These
options are commonly referred to as exotic options. Some of these options provide specula-
tors with features that allow for greater upside potential. Our concern here is how variants
can be helpful to project sponsors to control risk, not for speculative purposes.
Here are just five examples of exotic options that might be used by a project sponsor
to obtain greater risk-management capabilities: compound options, forward-start options,
barrier options, lookback options and average options.
Compound options
The risk control protection offered by standard put and call options extends over a prede-
termined specified period of time. A standard option over that time period will eventually be
exercised or allowed to expire (at which time the option becomes worthless.) A compound
option also referred to as a split-fee option and an up-and-on option grants the buyer
right to purchase an option at the exercise date; that is, it is basically an option on anoption.
A compound option allows a project sponsor to limit downside losses by permitting a
sponsor time to assess market conditions prior to acquiring additional option coverage. In
its most basic form, a compound option gives a project sponsor the opportunity to buy a
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Project Financing
window on the market for some underlying. The buyer of the option can extend coverage
at expiration of the window period by paying another premium.
The first premium paid for the right to purchase another option is called the upfront
premium. The expiration date for this part of the option (that is, the option covered by the
upfront premium) is called the window date. The buyer may then exercise at the window
date the option by paying another fee known as the back-end fee.
Forward-start options
With a forward-start option the option buyer pays the option price now for an option that
will start at a specified future date. The strike price for the option is typically not specified
in advance but rather at the time the option begins. The determination of the strike price
is set forth in the contract.
Barrier options
In a barrier option, the option buyer pays the option price now for an option that either
goes into effect or terminates once a specified price for the underlying is breached. There
are four types of barrier options: down-and-in, up-and-in, down-and-out and up-and-out.
For the first two, the option goes into effect when the barrier is breached and are therefore
referred to as knock-in options. For the last two, commonly referred to as knock-out options,
the option terminates if the barrier is breached. The barrier price is set above or below the
prevailing price at the time the option is written. The up means that the barrier is above
the prevailing price; the down means that the barrier is below the prevailing price.
Typically, barrier options are written as forward-start options.
Lookback options
A lookback option is an option where the option buyer has the right to obtain the most
favourable value for the underlying (for example, interest rate, exchange rate or commodity
price) that prevailed over the options life.
For example, consider a two-month lookback currency call option to buy yen when the
exchange rate between the US dollar and Japanese yen is US$1 for 78 on Day 0. Suppose
that the next day, Day 1, the exchange rate changes to US$1 for 80. The option buyer has
the right to exchange US$1 for 80. Suppose that on Day 2 the exchange rate changes to
US$1 for 79. The option buyer still has the right to exchange US$1 for 80. Regardless of
what happens to the exchange rate over the 60 days, the option buyer is able to exercise the
option at the exchange rate which prevailed that gave the largest number of yen for US$1
(or, equivalently, at the lowest price per yen).
Average options
An average option, also called an Asian option, has a payoff that is the difference between
the strike price for the underlying and the average price for the underlying over the options
392

life. In the case of a call option, if the average price for the underlying is greater than the
strike price, then the option seller must make a payment to the option buyer. The amount
of the payment is:
Payoff for average call option = (average price strike price) underlying units
In the case of a put option, if the strike price for the underlying exceeds the average price,
then the option seller must make a payment to the option buyer equal to:
Payoff for average put option = (strike price average price) underlying units
2 Caps and floors

A cap is an agreement between two parties whereby one party, for an upfront premium,
agrees to compensate the other at designated times if the underlying (that is, a designated
price or rate) is greater than the strike level. When one party agrees to pay the other when
the underlying is less than the strike level, the agreement is referred to as a floor.
The terms of a cap or floor include:
1 the designation of the underlying;

2 the strike level that sets the cap or floor;
3 the length of the agreement;
4 the frequency of settlement; and
5 the notional principal amount.
In both a cap and floor, the buyer pays an upfront fee, which represents the maximum
amount that the buyer can lose and the maximum amount that the seller of the agreement
can gain. The only party that is required to perform is the seller of the cap or floor. The
buyer of a cap benefits if the underlying rises above the strike level because the seller (writer)
must compensate the buyer. The buyer of a floor benefits if the underlying falls below the
strike level because the seller (writer) must compensate the buyer. In essence, these contracts
are equivalent to a package of options.
Consider, for example, an interest-rate cap. Suppose that a project sponsor buys an
interest-rate cap from a bank with terms as follows:
1 the reference rate is three-month Libor;

2 the strike rate is 3%;
3 the agreement is for five years;
4 settlement is every three months; and
5 the notional amount is US$20 million.
Under this agreement, every quarter for the next five years, the bank will pay the project
company on designated dates whenever three-month Libor for the period exceeds 3%. The
payment will equal the dollar value of the difference between three-month Libor and 3%
393

Project Financing
times the notional amount divided by four. (Actually, the payments are adjusted based on
the day count convention.)
3 Collars
Standard options, caps and floors can be combined to create a collar. This is done by either:
(i) buying a call option and selling a put option; or (ii) buying a cap and selling a floor. A
collar provides a range for which protection is provided.
The motivation for creating a collar is to reduce the cost of obtaining protection by
sacrificing the benefits that would be realised by a favourable movement in the underlyings
value. For example, suppose that a project sponsor is seeking to protect against a rise in
the cost of energy. Of course, the project sponsor can purchase a cap (or call option) that
effectively sets the maximum price (the strike price plus the cap fee or call price) that must
be paid for energy. However, to reduce the maximum price, the project sponsor can write
a floor (or put option) because the proceeds received reduces the cost of buying the protec-
tion. The give-up is that the project sponsor cannot benefit from a price decline below the
strike price for the floor or put option.
4 Swaptions
In the previous chapter, we discussed swaps. An option on a swap more commonly
referred to as a swaption is an agreement that effectively allows the buyer of this option
the right to terminate a swap. For this privilege, the swaption buyer pays a fee as with any
option contract.
Let us look at the motivation for a project sponsor to use swaptions to manage risk.
Suppose that a project company has entered into a four-year commodity swap where it
agrees to swap the product it is producing for a fixed price. Suppose that for some reason,
the project company after two years of operation cannot produce the quantity it agreed to
deliver in the swap agreement. The project company would have to go into the cash market
for that product to acquire the necessary quantity to deliver. Obviously, if the cash market
price at which the project company has agreed to accept in the swap transaction exceeds the
price in the swap agreement, it will realise a loss. A swaption allows the project company
to enter into a transaction that effectively terminates the swap and thereby controls the risk
of failing to produce the necessary quantity required for delivery.
A major part of the swaption market arises from interest rate swaptions for controlling
funding costs. The typical underlying is a generic interest-rate swap that we described in
the previous chapter. A swaption is either a payer swaption or a receiver swaption. With a
payer swaption, the option buyer has the right to enter into an interest-rate swap wherein
the buyer pays a fixed rate and receives a floating rate. The buyer of a receiver swaption
has the right to enter into an interest-rate swap paying a floating rate and receiving a fixed
rate. A swaption can have either an American or European-style exercise provision.
In describing a swaption, the market has developed the following convention. Suppose
that in a swaption the number of years until the option expires is denoted by A and the
394

number of years (term) of the swap if the option is exercised is denoted by B. The swaption
is said to be an AB swaption or alternatively an A into B swaption.
1
The basic option pricing model is the Black-Scholes model. Derivatives textbooks provide a description of other
pricing models.
2
The hidden benefits of derivatives, Project & Trade Finance, February 1994, p. 36.
3
BT puts option into Sonangol, Project & Trade Finance, November 1993, p. 15.
4
Cobalt put options prop up Zairean Mining, Project & Trade Finance, September 1993, p. 15.
395

Project Financing
Chapter 27
Entities for jointly owned or sponsored

projects
Most projects have multiple owners. While many companies prefer absolute ownership
and control of vital supply and distribution projects, a number of factors have dictated the
formation of jointly owned or controlled projects comprised of partners with mutual goals,
talents and resources:
1 the undertaking is beyond a single companys financial and/or management resources;

2 the partners have complementary skills or, in the case of projects in some foreign coun-
tries, political expertise or presence (this would include requirements for local ownership
of a project);
3 economies of a large project lower the cost of the project or service substantially over
the possible cost of a smaller project if the partners proceeded individually;
4 the risks of the project are shared;
5 one or more partners can use tax benefits arising from the project;
6 off-balance sheet financing can be arranged by sponsors, using the project company as
the borrowing entity;
7 requirements of financial covenants and indenture restrictions can be met;
8 greater debt leverage can be obtained;
9 to obtain or maintain control over a resource or market position;
10 one or more of the parties proceeding alone may not have access to funds from lenders
due to political or financial reasons; and
11 a special purpose entity (SPE) or special purpose vehicle (SPV) is required.
There are five basic forms for jointly owned projects:
corporations;
partnerships;
limited partnerships;
limited liability companies;
contractual joint ventures (including undivided interests); and
trusts.
These in turn, can be structured in a variety of ways to meet legal and tax objectives. The
variations, and some of the advantages and disadvantages of each, need to be carefully
considered at the outset.
396

Entities for jointly owned or sponsored projects
Before proceeding to a discussion of the relative advantages and disadvantages of

alternative entities to house a project financing, however, an understanding of accounting
considerations is important.
1 Accounting for joint ventures

Joint ventures are attractive to some sponsors because of the potential off-balance sheet
accounting treatment of the debt of the project company, where not more than 50% of the
project company is owned. However, this is under scrutiny post Enron and other financial
accounting scandals.
Where a parent owns more than 50% of a corporation, contractual joint venture or
partnership, general tradition or practice in many countries require line-by line consolidation
of assets and liabilities for financial accounting purposes.
This is based on the premise that more than 50% ownership results in control over the
venture,1 and that control requires consolidation. Such consolidation on a line-by-line basis
can adversely affect the financial statements and ratios of the parent.
On the other hand, ownership of 50% or less of a joint venture company is generally
insufficient to achieve control, and in such case the parent can use the equity method of
accounting which requires only a one-line entry on the balance sheet disclosing the amount
of investment in the joint venture company. Likewise, only a one-line entry is required on the
profit and loss statement. Less than around 20% ownership generally requires nodisclosure.
The two key tests for accounting purposes are about ownership and control, recognising
one may not automatically lead to the other. International Financial Reporting Standards 10,
11 and 28 are the relevant standards and they are expected to come in to force in 2013.
For the US, US GAAP ASC 810 applies and consultation on this with FASB is ongoing at
the time of this writing.
2 Corporations
A corporation may not be a satisfactory way in which to structure a joint project financing
because a sponsor cannot file a consolidated federal income tax return for the project.
Although it may be possible for tax benefits from investment tax credit, energy tax credit,
depreciation, and interest expense to be claimed by the project corporation, these tax benefits
will be delayed for a considerable period or lost forever if the project corporation has limited
taxable income.
An example of this, illustrating the additional dangers of tax-driven deals and over
optimistic projections, occurred when the North Sea became a mature oil province and
many large companies that were leading groups developing or producing oil fields realised
that they were starting to pay significant tax, making the UK a comparatively less attrac-
tive investment area. British Petroleum (BP) and Occidental (Oxy) decided to reduce their
shares of two of the first oil producing fields Forties and Claymore by running tender
offers to sell small participations in units of 0.25% interest in the fields to other oil and
gas companies in the North Sea.
397

Project Financing
The attraction for the two larger companies was that the well-established production was
generating income on which a high marginal rate of tax was being paid and BP and Oxy
had limited offset in terms of anticipated exploration costs. They also saw the production
about to enter a steep fall as the field entered its final phase of productivity (the decline
phase), so that the recapturing of tax losses across years would be difficult.
In contrast, smaller companies involved in exploration and development activities, had
tax absorptive capacity as a result of the tax losses from their other existing exploration
commitments, but no income against which they could offset the losses. Many were optimistic
that they could match tax losses against shares in the Forties or Claymore oilfield income
and follow the field decline curves closely, since to miss a year or loss/income matching
would have a significant impact on the project net present value.
The UK government also saw this as a way to boost smaller companies and grow the
domestic oil and gas corporate sector. Thus far, this sounds like a win win situation.
However, in order to borrow money to fund the tenders for the Forties units or Claymore
units, the smaller companies needed to persuade banks to lend as much as possible, and
preferably on a non-recourse basis. Non-recourse financing was needed because the smaller
companies typically had few other producing assets to generate cash flow and the Forties
and Claymore fields had a production history that was mature and stable. So some banks
provided loans based on high loan-to-asset ratios assuming that the debt would be repaid
from assigned cash flows that would be enhanced by an offset of all of the tax payable as
a result of the current and future exploration activity of the smaller companies.
However, the smaller companies had small stakes in their other investments and as such
had limited influence on decisions about the timing of when wells were drilled. All of the
larger companies were pulling back their investment in the North Sea, and thus were reluc-
tant to agree to commit to exploration expenditure just to help out the smaller companies,
when the larger companies paid most of the drilling costs. The tax offset was confined to
North Sea income and costs only, so not offsettable against any other oil and gas activity in
other areas. Thus, some of the more bullish smaller companies that had been successful in
the tender offer began to see that they would be unable to optimise their income from the
tax offsets and thus the cash flow to repay the loan was unlikely to be sufficient. The result
was consolidation, resale and exit among the smaller companies and some pain to bankers.
So, while the income of the project corporation can be controlled to some extent by the
sponsors, unrealistic assumptions can cause problems as illustrated above or tax adjustments
may be subject to attack by the authorities if not evidentially at arms length and may give
rise to loss of deductions.
True lease from third-party leasing company to a corporation

Corporations can be used as entities for jointly owned projects without wasting tax benefits
if the project equipment is financed through a true lease from a third-party leasing company
able to claim the tax benefits and pass through most of those tax benefits to the lessee in
the form of low cost lease payments.
398

True lease from sponsors

If the project sponsors can use tax benefits, a corporation can be used as an entity for a
project without wasting tax benefits through the use of a tax-oriented lease from the spon-
sors to the entity in which the sponsors claim the tax benefits of ownership under the lease
(see Chapters 18 and 19 for coverage of leasing).
Example of a corporation jointly owned by sponsors which borrows to

finance a project
A jointly owned corporation borrows on the basis of its own credit to finance a project.
Typical projects include electricity generating, refining or processing plants. Investment and
operating expenses are segregated for purposes of the project company. Rates necessary to
meet costs and to provide a return on equity can be easily identified.
Income tax: the project company files its own income tax return and may not be consolidated
on any sponsor tax return, dependent on sponsor ownership and local regulations.
Debt rate: the debt rate will usually be higher than the debt rate of the individual
participants or sponsors.
Sponsors balance sheet and loan covenants: the investment in the project company may
be shown as a one-line equity investment entry for a sponsor that owns less than 50% of
the controlling stock, and the debt of the project company may be off-balance sheet for
the sponsor. If the sponsor owns more than 50% of the controlling stock, a line-by-line
consolidation is required. If less than 50% owned, project company liabilities will probably
not constitute debt for debt-equity ratios, or a loan for loan or mortgage restrictions.
Variances:
same as above, with credit backed by long-term take-or-pay contracts in proportion to
ownership (take-or-pay contracts are discussed separately);

same as above, with credit backed by obligations of the owners to make up deficits; and
same as above, with true lease from one or more sponsoring parties able to claim
tax benefits.
debt of the project company may be off-balance sheet for the sponsor if less than 50%
owned and not controlled (but take care with new regulations!);
outside loan covenants restricting debt of leases;
capital preserved for other uses;
economies of a large-scale project achieved by combining and concentrating financial

an essential facility built without the sponsor-participant being required to pay the

cost segregated for rate-making purposes;
risks of the project are shared;
loan is non-recourse to sponsor; and
insulated from tort and contractual liabilities of the project company, subject to piercing
the corporate veil or proof of an agency relationship.
399

Project Financing
Disadvantages for the sponsor:

higher borrowing cost;
lack of absolute control over the facility; and
possible loss or delay in claiming tax benefits by the jointly held company.
This structure can be problematic to negotiate if the different sponsors are of quite different
size and creditworthiness, as the larger company may perceive that it is supporting the smaller
ones and sacrificing lower borrowing costs to do so.
Example of a joint venture corporation with tax benefits claimed by one party
One advantage of a corporate joint venture may be the opportunity which exists for one
party to claim the entire tax shelter attributable to the project company. (Again this is an
area for care!) This is shown in Exhibit 27.1.

debt of the project company is off-balance sheet for the sponsor if less than 50%-owned;
outside loan covenants restricting debt or leases;
capital preserved for other uses;
economies of a large-scale project achieved by combining and concentrating financial


cost segregated for rate-making purposes;
risks of the project are shared;
loan is non-recourse to sponsor; and
insulated from tort and contractual liabilities of the project company, subject to piercing
the corporate veil or proof of an agency relationship.

Disadvantages
higher borrowing cost;
possible loss or delay in claiming tax benefits by the jointly-held company.
3 Partnerships
A partnership can operate a project, hold property, hold property in its own name and
enter into a financing arrangement in its own name. Partnerships, as entities for joint legal
ownership of a project, have numerous advantages from an income tax standpoint. Often,
a partnership is not a separate taxable entity, does not pay income tax and files a partner-
ship income tax return which reports the revenues, deductions and credits attributable to the
partnership. The partners report their distributive shares of these items plus their distributive
shares of partnership income and loss, thus permitting immediate benefit by the partners for
tax purposes of available depreciation deductions, operating expenses, investment tax credit
and interest deductions.
400

Exhibit 27.1
Joint venture with tax benefits claimed by one party
Corporation A
2 Loan or
4 Tolling
non-voting preferred
contract reflecting
convertible to 100 shares
tax benefits to
of common after
Corporation B
10 years
Project
corporation
1 100 shares
3 Operating
of common stock
contract to operate
(100% of original
the mine
issue)
Corporation B
5 Consolidated 5 Tax benefits,

income tax depreciation,
return and so on
Internal
Revenue
Service
Continued

Project Financing

Summary
Corporation A needs coal but has no operating experience. Corporation B is an operator. Corporation B can
use tax benefits from modified accelerated cost recovery system (MACRS) depreciation, but Corporation A
cannot use tax benefits. They decide to enter into a corporate joint venture on the following basis:
1 The project company is formed. Corporation B provides capital and loans to the project company and is
issued 100 shares of its common stock, which is 100% of the originalissue.
2 Corporation A loans or purchases non-voting preferred stock of the project company which is convertible
into 100 shares of its common stock after 10 years, with anti-dilution protection. This loan (or purchase)
provides the bulk of the capital for theproject.
3 The project company enters into a 10-year operating agreement with Corporation B whereby Corporation
B will operate themine.
4 Corporation A enters into a 10-year tolling agreement for the purchase of coal from the project company.
The tolling agreement reflects most of the tax benefits which can be claimed by CorporationB.
5 Corporation B files a consolidated income tax return with the project corporation and claims the tax
benefits of depreciation on qualified equipment of the projectcompany.
6 (not shown) Corporation A converts its debt (or stock) to 100 shares of common stock of the project
company after 10 years. Corporation A and Corporation B are then equal owners of the projectcompany.
A corporation, on the other hand, pays tax as a taxable entity and claims available tax
deductions for depreciation and operating expenses, on its own returns. In start-ups, these
deductions must be carried forward for many years until the corporation is taxable. When
dividends are paid, stockholders must pay tax on such distributions of profits.
General partnerships present problems from a legal standpoint inasmuch as general
partners generally are jointly and severally responsible for all partnership liabilities which
cannot be satisfied from partnership assets. These include liabilities for contracts, debt and
tort liabilities. In the case of a corporation, stockholders are not generally responsible for
such liabilities. Limited partnerships avoid this problem.
However, partners can protect themselves to some extent by forming subsidiaries to
enter into a partnership agreement to operate a joint venture. If the subsidiary is nominally
capitalised and has limited operations, the parents may possibly still be held to be the true
partners by piercing the corporate veil. (Special purpose subsidiaries to act as partners may
be preferable in any event, to avoid the parent unnecessarily having to qualify to do busi-
ness in a state, or unnecessarily subjecting itself to a regulatory agency.) This is shown in
Exhibit 27.2.
Further steps can be taken to protect joint venturers who wish to operate as a partner-
ship. One such step is to require lenders to limit their recourse for loans against the assets
of the partnership and waive rights against the assets of the partners. Lenders will go along
with such limitation if the assets of the joint venture are strong enough to support the
transaction. In such circumstances, these assets may include an unconditional take-or-pay
or through-put contract from a responsible creditworthy stakeholder.
Another step is an agreement among the partners not to enter into loan agreements or
material contracts without the consent of all or some specified percentage of the partners.
402

Exhibit 27.2
General partnership with nominally capitalised subsidiaries
Sponsor Sponsor Sponsor

corporation corporation corporation
Stock, 80% or Stock, 80% or Stock, 80% or

more control more control more control
Nominally Nominally Nominally

capitalised capitalised capitalised
subsidiary subsidiary subsidiary
General
partnership
agreement
This type of agreement is typically buttressed by cross indemnities of the partners or

their parents.
Potential tort liabilities, in excess of partnership assets, can usually be covered byinsurance.
Care must be taken that, in limiting the functions of the partnership, the resulting entity
for tax purposes does not constitute an association which will be taxable as a corporation.
Normally, it is possible to form a partnership which will not be deemed to be an associa-
tion even though protective steps are taken to limit the exposure of the partners to debt and
contractual liability by agreements with creditors and among themselves.
403

Exhibit 27.3
Corporate financing vehicle
Partnership
1 Debt 3 Borrowed 4 Debt

certificates funds service
Corporate
financing
vehicle
2 Debt certificate
with identical terms to
3 Borrowed 4 Debt
partnership certificates, secured
funds service
by pledge of partnership
certificates
Insurance
company
investors
Summary
1 A partnership issues notes to a nomineecorporation.
2 The nominee corporation issues notes or bonds to lenders which are identical in interest rate and
maturities to the partnership securities. The partnership notes are pledged assecurity.
Continued

3 The lenders pay the bond or note proceeds to the nominee corporation, and the corporation pays the
funds to thepartnership.
4 Debt service is paid by the partnership through the nominee corporation or through a securitytrustee.
Financial accounting for partners in reporting liabilities of partnerships usually follows

the same rules as for corporations. More than 50% control generally requires line-by-line
consolidation. Less than 50% control but more than 20% control generally requires only
a one-line entry of the partners investment. However, when the lenders to the partnership
agree that they will seek recourse against only the partnership assets and not the assets of
the partners, the partnership debt is not included in the balance sheets of the partners, but in
the footnotes. To qualify for such treatment, the partnership must have entity status to own
property and borrow funds in its own name (not a contractual joint venture, discussed later).
Exhibit 27.4
General partnership to operate a project
Partnership Leasing
Lenders
facilities companies
2 Loan
3 Title 2 Leases
agreements
Partnership
business
1 Partnership
agreement
capital
Partner Partner Partner
Continued
405

Project Financing
Summary
1 Three partners enter into a partnership agreement and contribute capital to a partnership to conduct and
operate a certainbusiness.
2 The partnership in its own name enters into loan agreements and enters into leaseagreements.
3 The partnership holds title to property in its ownname.
A disadvantage of a partnership as compared with a corporation is the inability of the

partnership to issue securities which qualify as legal investments for insurance companies.
However, this problem can be solved by establishing a corporation known as a corporate
financing vehicle. The partnership issues debt certificates to the corporate financing vehicle,
which in turn issues debt securities with identical terms which are secured by a pledge of
the partnership securities and partnership obligations. The debt certificates issued by the
corporate financing vehicle then can qualify as a legal investment for insurance companies.
This is shown in Exhibit 27.3.
General partnership to operate a project

Two or more parties decide to jointly own and/or operate a business through a general
partnership. This is shown in Exhibit 27.4.
Rate base: costs are segregated.

Income tax: a partnership income tax return is filed. Subject to certain limits, a partners
distributive share of partnership income, loss or other items is determined by the partnership
agreement. Partners can claim deductions for depreciation, interest and operating expenses
in excess of income. The entity is not taxed as a corporation.
Credit: borrowings by the partnership reflect the joint and several liability of the general
partnership and the partners. The debt base reflects the credit strength of the strongestpartners.
Sponsors balance sheet: each partners balance sheet generally reflects its partnership
interest, using the equity method of reporting where a single partner lacks control.
Sponsors loan covenants: joint and several liabilities of the partnership may not be
restricted by the loan covenants of individual partners.
Variation: the parties desiring a partnership substitute subsidiaries to act as partners. (If
the subsidiary acting as a partner has no other significant business purpose, the subsidiary
will not constitute a reliable shield for the parent against partnership liability.)
Advantages:
off-balance sheet and outside loan covenants as to the portion of capital contributed
by other partners in the partnership;

the economies of a large-scale operation may be achieved by combining and concentrating
the financial resources and technical skills of several partners;
406

the borrowing cost may be lower as a result of combining the project with other
partners; and
partners immediately claim tax deductions.
Disadvantages:
the loss of absolute control over the project;
joint and several liability of the partners for contractual and tort obligations; and
the partnership cannot issue securities which constitute legal investments except through
a corporate financing vehicle.
A general partnership with limited recourse secured debt supported by a

take-or-pay from the sponsor partners
Two or more companies desire to enter into a partnership for the purpose of owning or
operating a joint project or business and wish to limit their partnership contractualliability.
The partnership enters into loan agreements for financing major assets which are secured
by those assets, other partnership assets and the assignment of a take-or-pay contract from
the partners for product produced by the partnership. However, the loan agreement limits
the lenders recourse to the partnership assets and to the proceeds from the take-or-pay
contract. It can be used for almost any processing or productionproject. (See Exhibit 27.5.)
Rate base: cost is segregated.

Income tax: partnership return is filed. Partners can immediately claim deductions for
depreciation, interest and operating expense in excess of income.
Credit: the value of the take-or-pay contracts, the security value of the project properties
and other partnership assets.
Sponsors balance sheet: a take-or-pay contract constitutes an indirect obligation and is
disclosed in the commitments and contingent liability section of the footnotes to the balance
sheet. The limited recourse debt of the partnership need not be shown by a partner that
does not control the partnership.
Sponsors loan covenants: senior debt restrictions and lease restrictions of the individual
partners may be avoided by the fact that the loan agreement is with limited recourse to
the partners. A take-or-pay contract constitutes a long-term contract generally outside the
scope of covenants limiting debt or leases.
Variations: the parties desiring a partnership substitute subsidiaries to act as partners. If
the subsidiary acting as a partner has no other significant business purpose, the subsidiary
might not constitute an adequate shield for the protection against liability; the corporate
veil may be pierced. Therefore, a subsidiary active for some business purposes should be
used as a partner.
Advantages:
the advantages of a partnership are obtained for tax and accounting purposes without
having to assume joint and several partnership contractual liability for the major debt
of the partnership;
407

Exhibit 27.5
Partnership with limited recourse debt
3 Loan
proceeds
Manufacturer 3 Purchase Indenture
Lenders
or contractor price trustee
5 Debt
service
2 Mortgage,
6 Funds not security agreement
4 Debt
needed to and assignment of
payments
service debt take-or-pay
contracts
Partnership 3 Loan agreement

3 Title with limited recourse
project
to partners
4 Payments
1 General parnership
under take-or-
agreement and
pay contracts
take-or-pay contracts
Partner Partner Partner
Continued

Summary
1 Three partners enter into a general partnership agreement to operate a project as a partnership. Each
partner also enters into a take-or-pay contract with theproject.
2 The partnership enters into a security agreement with an indenture trustee, which includes a mortgage
on certain property to be acquired by the partnership and an assignment of proceeds from the take-or-
paycontracts.
3 The partnership enters into a loan agreement with a group of lenders under an arrangement whereby the
lenders agree to limit their recourse against the partners to the partnership assets only. Loan proceeds
are paid to the indenture trustee, which in turn pays the manufacturer the purchase price of the property
to be acquired by the project. The manufacturer than conveys title to the partnership in the partnership
name, subject to themortgage.
4 The partners make payments under the take-or-pay contract directly to the indenture trustee. The
partnership makes any additional payments to the indenture trustee required to meet current
debtpayments.
5 The indenture trustee pays the debtservice.
6 Funds not needed to service the debt are paid to thepartnership.
by other credits in the partnership;
limited recourse debt of the partnership is generally off-balance sheet and outside loan
covenants of partners;
the financial resources and technical skills of several partners;

entire cost of the project; and

the borrowing cost may be lower as a result of combining the project with otherpartners.
Disadvantages:
joint and several liability of the partners for contractual obligations (other than limited
recourse debt) and tort obligations.
4 Limited partnerships
Limited partnerships are entities which expressly limit the liability of limited partners to the
amount of their capital investment. Since limited partners can, nevertheless, claim a propor-
tionate share (and, according to some tax experts, a disproportionate share) of tax benefits
from the operation of the partnership, the limited partnership entity has great appeal to
investors seeking to shelter their tax liabilities with little risk to capital.
Limited partnerships have been used extensively to finance development of oil and gas
properties and these types of limited partnerships are separately discussed in Chapter 28.
Limited partnerships have also been used extensively in financing real estate and such limited
partnerships are discussed later in this chapter. More recently, limited partnerships have
409

Project Financing
been used to finance research and development and such R&D limited partnerships are also
discussed later in this chapter. Leveraged lease arrangements also use structures similar to
limited partnerships.
The diversity of limited partnership structures supports the use of such structures for
other financing contexts.
Limited partnerships must always have one general partner. This may be the sponsor,
or some person or corporation associated with the sponsor. For tax purposes, the general
partner must have financial substance.
Care must be used to structure the limited partnership so that it will qualify as a part-
nership for tax purposes. Among the differences are (and these vary by country):
mode of creation (intent may not be enough) and separate legal identity and written
agreement;
independent existence from its owners;
continuity of life;
centralised management;
limited liability; and
free transferability of interest.
The most important thing to remember is that unless limited partners stay passive (or there
is specific legislation that permits them to take an active interest) they may lose their advan-
tageous tax status and incur liability for the partnerships obligations. A limited partnership
scheme is shown in Exhibit 27.6.
Income tax: limited partnerships file a partnership tax return but may not be subject to
tax as a legal entity such as a corporation. Limited partners are taxable on their share of
partnership income, may claim their share of any investment tax credit (ITC) and may
deduct operating expenses, tax depreciation and interest. From the standpoint of the
company using the limited partnership to finance a project, if such a company were unable
to use tax benefits currently, it could indirectly gain the benefit of tax depreciation and
ITC from reduced rents or fees charged by the limited partnership. It could also claim
deductions for such rents or fees.
Rate base: the rents or fees charged by the limited partnership would be segregated
expenses recognised for rate base purposes.
Loan covenants: restrictions in loan covenants might be avoided by use of limited
partnerships for financing facilities or services.
Advantages:
low cost financing as a result of limited partners claiming tax benefits and passing them
through in the form of reduced rents or fees. Tax benefits are not wasted;
off-balance sheet financing;
ratios not affected;
loan covenants not affected;
risk of failure shifted to limited partners; and
access to a new source of funds (wealthy individuals).
410

Exhibit 27.6
Limited partnership
Promoter 7 Partnership
manager return
2 Agreement
6 Fees
for services
5 Reports 1 General
Limited General
on partnership partner
partnership partner
operations agreement
4 Funds
loaned
3 Subscription 4 Loan
3 Units agreements and agreement liens on Lenders
funds assets purchased
Limited Internal
7 Individual
partners Revenue
returns
Service
Continued

Project Financing
Summary
1 A limited partnership is formed upon the general partner agreeing to act as general partner and the
completion of a sale of a unit to the generalpartner.
2 The partnership enters into an agreement for management services with a designated manager (usually
a separate entity). These services might include sales of units, organisation of the partnership, the
investment of partnership funds and management of partnershipassets.
3 Subscriptions for limited partnership interests are sold, funds advanced and unitsissued.
4 A loan agreement is negotiated, funds are advanced and liens are recorded on purchased assets. These
funds are invested in the assets or activities of thepartnership.
5 The activities of the partnership begin. Reports on partnership activities are distributed by themanager.
6 Fees are paid to the manager for promotional and managementservices.
7 The partnership files a partnership income tax return for information purposes, reporting the distributive
shares of partners in income and expense; limited partners file individual returns, reporting their share of
revenues and their distributive shares of operating expense, interest expense and depreciationexpense.
Disadvantages:
somewhat complex structure;
loss of some control over facilities or service functions; and
time and legal expense in arranging the financing.
Compliance with local regulations, especially if the limited partners are expected to be
passive, is vital.
Leveraged limited partnerships

In a leveraged limited partnership, the limited partners achieve high rates of return by reducing
their initial after-tax investments by borrowing on a non-recourse basis.
One form of leveraged partnership provides that a portion of the original investment
of a limited partner is in the form of a recourse note. This type of investment is called
staged equity, meaning that the equity is paid in stages. In some circumstances, the limited
partners may be permitted, under this arrangement, to take tax deductions equal to, or in
excess of, their initial cash investments. The limited partner pays the note over a period of
time as the partnership needs the funds. If the partnership is generating payments due to
the limited partners, the note may be paid by offsetting such payments against the obliga-
tions under the note.
R&D limited partnerships

R&D limited partnerships have been used successfully in a number of countries to accomplish
off-balance sheet project financing of research and development expense. Many of these R&D
412

limited partnerships have been formed in the United States, and most have been privately
placed, but large public placements of units have also been made. Unfortunately in the past,
some very large and visible publicly placed R&D partnerships have been spectacular failures,
notably DeLorean Motor Company and Trilogy Ltd that planned to develop a new computer
chip. Following these events many partnerships moved towards pooled investments in the asset
base in order to spread risk. Nevertheless, the structures may be worth considering in the
right circumstances, subject to meeting the regulatory requirements for optimal taxtreatment.
The structure of an R&D partnership

A corporation (the sponsor) which requires capital for research and development of prod-
ucts sets up a wholly owned subsidiary to engage in research and development. This R&D
subsidiary in turn organises a limited partnership, with itself as general partner. The R&D
subsidiary as a general partner sells a 99% interest in the partnership to limited partners.
The limited partnership interests are sold in units which are typically priced at US$5,000
to US$10,000 each. This is usually accomplished by a private placement. The limited partners
have no voice in the management of the limited partnership and no liability for partnership
debts beyond their original investment.
The limited partnership enters into a contract with the R&D subsidiary of the sponsor
(or with some other subsidiary of the sponsor) whereby the subsidiary contracts to develop
a product. An R&D limited partnership structure is shown in Exhibit 27.7.
Rewards for investors

If the project is successful, the partnership (and limited partners) may be compensated in a
variety of ways, which are set forth in the terms of the contracts between it and the corpo-
ration. Some of the methods used are:
the sponsor may have an option to purchase the exclusive rights to the products developed.
Purchase price may be paid in stock or cash;
the sponsor and the limited partnership may enter into a joint venture to manufacture
and/or market the products developed; and
the sponsor may have an option to obtain an exclusive licence to manufacture and/or
sell the new products in return for payments to the partnership in the form of royalties.
The royalties may be based on:
sales (either a fixed amount per unit sold or a percentage of the selling price);
profits from sales of the new products; or
a certain percentage of sales until the limited partners have received a specified return
on their investment, after which the percentage will decrease.
The sponsor can protect itself by making royalty payments subject to a ceiling and payable only
if the corporation has a positive cash flow from manufacturing and selling the newproducts.
413

Exhibit 27.7
R&D limited partnership
100% Sponsor
ownership corporation
Subsidiary of 1 100%
sponsor ownership
Sponsors R&D 6 Sale of

subsidiary product
4 Contract 4 Contract 2 General 6 Proceeds or

to develop a to develop a partnership royalties from
product product agreement sale of product
Limited R&D
partnership
7 Distribution
3 Funds for
3 Units of profits from
units
sale of product
Limited
partners
5 Tax benefits
for R&D
deductions
Internal
Revenue
Service
Continued

Summary
1 The sponsor corporation, which requires capital for research and development of some promising
products, sets up a wholly owned R&Dsubsidiary.
2 The R&D subsidiary forms a limited partnership, in which it acts as general partner and which itmanages.
3 Units are sold to limited partners and funds are paid to thepartnership.
4 The partnership enters into a contract with the R&D subsidiary (or some other subsidiary of the sponsor)
to develop aproduct.
5 Limited partners claim tax benefits for R&D deductions, if any, as they areincurred.
6 The R&D subsidiary develops a product which is sold by the partnership to the sponsor or marketed by
the sponsor. Proceeds or royalties are paid by the sponsor to thepartnership.
7 Profits or royalties from the sale of the product are distributed to the limited partners by thepartnership.
The sponsor may also have the right to purchase the exclusive rights to the basic tech-
nology and to the products developed after it has begun to pay royalties to the partnership
and it may have the right to offset some or all of the royalties against the purchase price.
However, the rights and compensation paid to the limited partnerships obviously have
a significant effect on the attractiveness of the investment to investors.
US income tax considerations: the attractiveness of this transaction to the limited partners
can arises from special tax provisions in a number of jurisdictions that have been designed
to encourage R&D expenditures and from the way in which partnerships are taxed.
One example is the R&D credit in the US described in IRC41, though it is also worth
noting this is subject to regular renewal by Congress. Under normal accounting rules,
expenditures for research and development are usually capital costs, which must, in line
with the general principle of matching income and related expenses, be amortised over
some reasonable period of time. It may be allowable for investors to elect to deduct as
they are incurred.
Every few years Congress threatens to do away with R&D partnership tax benefits, but
continues to preserve them. Tax counsel should be consulted regarding the current status
of the tax credit. Other countries offer different incentives for innovation.
Credit: the sponsors credit is not affected by the transaction. The sponsor has only a
contract to produce a product, which may or may not be successful.
Sponsors loan covenants: the sponsors loan covenants should not be affected, unless they
are specifically drafted to prevent such a transaction.
Securities laws: limited partnership interests are usually considered to be securities that
must be issued and distributed in accordance with the provisions of the Securities Act
1933. Securities law compliance is expensive and can result in substantial liability if
improperly done.
Private placements, the method by which most R&D partnerships have been sold, are
often less expensive and simpler than public offerings but still require extensive disclosure
415

Project Financing
documents to be prepared. Mis-statements in these documents, including omission of facts

that later turn out to be significant, may give rise to liability under the securities laws.
Each state has its own system of securities regulation. Depending on the standards of
local law and the state regulators whim, it may be inordinately expensive or impossible
to sell limited partnership interests in some states.
Accounting: accounting is treated differently in different jurisdictions and local expertise
should be sought. Not all jurisdictions recognise limited partnership structures for R&D
development but may offer incentives to joint venture partnerships involved ininnovation.
Advantages for a sponsor:
large amounts of capital for R&D can be obtained with a good track record;
expense of R&D may be moved off the income statement;
better financing costs can be obtained because investors may be able to claim all or
part of their investment as a tax loss until the project becomes profitable;
no adverse effect upon the financial statements of the sponsor;
risk of failure of research and development activities shifted to limited partners;
tax benefits are used currently for a good purpose and not wasted;
the sponsor can retain control over the R&D project as well as control over other
operations;
issuing equity to raise funds for R&D would result in expanding the ownership of the
enterprise, impact the earnings per share and might result in loss of control;
avoids debt service requirements for future cash flow, avoids impact on debt to equity
ratios and strengthens financial ratios for rating services;

the sponsor retains greater flexibility in dealing with the limited partnership than in a
group of stockholders;
access to a new source of funds;
lower initial costs using debt to finance R&D; and
qualified research and development personnel can be hired who otherwise might be
concerned about the funding and dedication of resources to research anddevelopment.

Disadvantages for a sponsor:
although limited partners have no legal management rights, it is not realistic to expect
that investors in a limited partnership project will always agree with the general partners
actions. If the limited partners sense that development is being poorly handled, or that
better opportunities are available for exploiting a developed product, they may attempt
to impose their views through lawsuits, effectively throwing management into the hands
of the courts. This is where issues may potentially arise about limited partners, their
roles and the tax regulations;
the sponsor may be particularly vulnerable to attack at the point where a commercially
profitable product has at last been developed. Although the corporation that formed
the partnership will have an option to acquire exclusive rights to the development,
the limited partners may object that the option was not negotiated at arms length, or
should for other reasons be revised. Since contracts between corporations and affiliated
limited partnerships are rarely negotiated at arms length, such arguments may receive
a sympathetic judicial hearing;
416

the eventual costs of a successful R&D development will probably be higher than if
the R&D had been developed with conventional financing. This is because the potential
rewards offered investors must usually be substantial to attract risk capital; and
a lot of time and expense is required to establish an R&D limited partnership.
Advantages for an investor:

a good speculative investment with substantial upside potential in the carefully researched
deal; and
protection of the securities laws.
Disadvantages for an investor:

investor must rely heavily on the good faith of the corporation in whose R&D program
they have invested. They have few means of determining on their own whether R&D
funds are being used effectively;
there is little independent bargaining between the limited partnership and the contractor
performing the research and development. Consequently, the contract may be distinctly
unfavourable to the limited partners. Provisions frequently included are guaranteed
profits for the contractor and limitations on the potential return of the limited partners;
the tax authorities may challenge some of the anticipated tax benefits; and
risk of loss is shifted to the limited partners.
5 Contractual joint ventures

The term joint venture is used in connection with project financing to describe all kinds of
contractual relationships between investors in projects. Jointly owned corporations or limited
liability companies are referred to as joint ventures, and general partnerships and limited
partnerships may also be termed joint ventures.
Although, use of the term to describe corporation and partnership structures is not incorrect,
there are contractual relationships called joint ventures which are neither partnerships nor corpo-
rations. Such joint venture-type agreements are used in project financing where the participants
desire to minimise the duties and obligations among themselves and for each others actions.
A joint venture closely resembles a partnership. However, the parties contract among
themselves, rather than enter into a partnership agreement. One of the joint venture parties,
with extensive experience in the type of project to be constructed and operated, is typically
designated the manager, with delegated authority to act for the joint venture. In the alter-
native, the participants may, by agreement, appoint a corporation to act as an agent for
purposes of operating the project. The best way to describe a joint venture is to note the
difference between a joint venture and a partnership.
1 Partners have general agency for one another. Joint venturers do not.
2 Partners may be jointly and severally liable beyond their investment. Joint ventures are
liable only to the extent of their investments and advances to the project.
3 Property of a partnership may be held in partnership name. In certain cases, the property
of a joint venture may be held as tenants in common, where each party holds an undivided
interest. Joint ventures may also incorporate and own shares according to their ownership in
the activity in order to have a distinct legal entity for governance and managementpurposes.
417

Project Financing
4 Generally partners may sue each other about matters relevant to the partnership agree-
ment only by bringing suit for an accounting (equity) action. Joint venturers may sue each
other for breach of contract.
5 The joint venture often has a fairly limited purpose and life, which may be determined
by the nature of the project.
The Alaskan pipeline project was one of the most famous joint venture arrangements.
There, the participants organised a new corporation to serve as operating agent, the Alyeska
Pipeline Company. The facilities are held in proportion to expected use and each of the
joint venturers is responsible for financing costs of the project in proportion to its interest
in the project facility.
A joint contractual venture resembles a limited partnership more than a general partner-
ship. But there are differences in that a limited partnership must have at least one general
partner. Although the party designated as the operator of a joint venture has some charac-
teristics of a general partner, the operator does not have the broad management control or
the general liability characteristics of a general partner.
A major motivation for creation of a joint venture which is neither a partnership nor
corporation is its status for income tax purposes, including such things as taking advantage
of the method of depreciation or interest capitalisation. It is very important that each party
to the joint venture is permitted to make independent elections with respect to income and
expense items in its own tax return.
A ruling on the tax status of a contractual joint venture is advisable, since a joint venture
resembles an association taxable as a corporation as well as taxable as a partnership. Where
members retain the right to take a share of the project produced in kind, or where any
agency to sell the product is revocable, the tax authority (for example, the Internal Revenue
Service) may take the position that the association is not taxable as a corporation because
of lack of joint purpose and centralised management.
Contractual joint ventures by their nature do not constitute legal entities which can
easily borrow for their own account (except in the case of some production payment loans).
Leases offer a financing vehicle well suited for joint ventures, since each joint venturer can
be a co-lessee of an undivided interest in the leased asset, if this is the model in use. Joint
venturers can arrange separate financing of their undivided interests in the joint venture
and the joint agreement can be drawn with this type of financing in mind so as to provide
collateral to lenders to the joint venture members.
Financial accounting for ownership of joint ventures usually follows the same rules as for
ownership of corporations. More than 50% control generally requires line-by-line consolida-
tion. Fifty per cent or less than 50% control but more than 20% control generally requires
only a one-line entry of the investment in the project.
Joint ventures have been used in recent years by electric and gas utilities seeking energy
sources. They have also been used extensively in developing and operating mines. Joint ventures
are used in development of oil and gas production, but other forms of ownership are more
favoured in that industry, primarily for tax reasons. As noted earlier, the term joint venture
is used to describe partnership and jointly owned corporations. There are joint ventures and
joint ventures. It is important to keep the distinction in mind when discussing projectfinancing.
418

Joint venture supplier financed by advances of each joint venturer

A contractual joint venture (not a formal partnership or a corporation) constructs and oper-
ates a facility to provide a product or service to members of the joint venture. The project
is financed by capital advances and operating advances from each joint venturer. The project
is owned as tenants in common. Capital expenditures and operating expenses are shared in
proportion to ownership. Liability of each joint venturer is limited to investment.
The obligations of the parties to the joint venture are set forth in an operating agree-
ment. If one does not pay its share of expenses, its share is forfeited to other parties or
may be sold to a new venturer. Other venturers are often required to assume obligations
of a defaulted venturer in proportion to their investment. Voting may be done on the basis
of majority in interest and majority in number. Changes in the operating agreement may
require more than a majority vote. Typical projects include liquified natural gas (LNG) plants
and facilities, coal gasification plants, pipelines, mines and electrical generating plants. An
example is shown in Exhibit 27.8.
Rate base: where a sponsor is a public utility and the project is to assure a source of
supply, its direct investment may usually be included in the sponsors rate base.
Income tax: expense and income flow back to sponsors.
Credit support: credit of each joint venturer and their undertakings in the operatingagreement.
Individual venturers may borrow using their interests in the joint venture as a pledged
security for the loan. In the event of default by the borrower, the lender may step into
the shoes of the borrower.
Debt rate: funds are advanced by each joint venturer as needed. Debt cost for such funds is the
debt rate for joint venturer. This results in the lowest possible cost of funds for each of the joint
venturers. However, the joint venture itself might borrow on a secured basis or lease. In such
instances, the lender or leasing company will lend or lease on the basis of the collateral, the
joint obligations of the joint venturers and the importance of the project to the jointventurers.
Balance sheet: investment, debt and liability are on the balance sheet of each sponsor to
extent of exposure.
Loan covenants: the liability of each sponsor is counted as debt for purposes of the
sponsors debt equity ratios, as loan restrictions and so on.
Advantages:
each joint venturer enjoys the benefits and economies of a large facility, and an assured
source of supply which would not be feasible for the utility to finance alone;
may be off-balance sheet and outside loan covenants as to the portion of a loan or
lease to weaker credits in the joint venture;

economies of a large-scale project may be achieved by combining and concentrating
financial resources and technical skills of several venturers;


the borrowing cost may be lower.
Disadvantage:
lack of absolute control over the facility.
419

Exhibit 27.8
Joint venture electric generator
1 Joint venture
agreement
Utility Utility Utility
2 Investment 2 Investment 2 Investment

and advances and advances and advances
Joint supply 4 Construction Contractor

facility contract
3 Mortgage 3 Lease
loan
Leasing
Term lender
company
Continued

Summary
1 Three utilities agree to form a joint venture to build and operate an electricity generating facility, whereby
each party will hold title to an undivided interest in thefacility.
2 Each of the utilities purchases stock and makes subordinated loans to the joint supply facility in
accordance with theiragreement.
3 On the basis of the capital contributions, a lien on certain assets of the joint venture and prospects for the
jointly formed company, construction loans and long-term debt to take out the construction loans or a
lease to take out the construction loans arearranged.
4 The operating manager of the joint supply facility arranges for the construction of the facility; thereafter,
the joint venture operates as an independent company arranging its own financing asneeded.
Exploration, development and/or operation of a mine under a joint venture

operating agreement
Several parties who can use the production of a mine enter into a joint venture to develop
and operate a mining property. They construct and operate the mine under a joint operating
agreement which typically contains the following provisions.
1 The operating agreement defines a particular scope of activity to be carried out by the
joint venturers and limits the activity to a particular area.
2 Title to the property is generally held by the parties as tenants in common. Each of the
parties has an undivided interest in the project and in all mineral interests subject to
the joint operating agreement (JOA). Each party makes capital advances and operating
advances to the project as needed to carry on the activity of the project in proportion to
its respective interest.
3 One party is designated the operator of the project. The operator has day-to-day manage-
ment responsibility for the project and work plans approved by the parties. Major policy
decisions are made by a joint operating committee (JOC) composed of representatives of
all the parties. The committee approves work plans for proposed new undertakings of
the joint venture. The committee approves all major expenditures. The approval of a new
work plan or major expenditure may require a majority in number as well as majority in
interest of members of the committee.
4 Each party to the agreement shares in the production of the project in kind in propor-
tion to its interest in the project. Generally, each party uses the production. However,
arrangements may be made for other disposition.
5 In the event a party fails to provide its allocable contribution, the agreement may provide
various remedies, including complete forfeiture, forfeiture of project until sufficient produce
is sold to cover the deficiency and sale or assignment of the interest of the defaulting
party to a third party.
421

Project Financing
Typical projects include exploration, development and operation of a mine, or oil and
gas activity covered further in Chapter 28. An example is shown in Exhibit 27.9.
Income tax: parties need to ensure they can make an election not to report income from
the joint venture as a partnership. This permits each joint venturer to make independent
income tax elections with respect to its respective share of income and expense items in
its own tax return. A ruling on the tax status of the joint venture is advisable since a
joint venture resembles an association taxable as a corporation as well as a partnership.
Credit support: the credit support comes from the creditworthiness of each joint venturer
and its undertakings under the operating agreement. A party to the joint venture may
borrow using its interest in the joint venture as pledged security for the loan and so, in
the event of default by that specific joint venture partner, the lender may assume the
borrowers interest. There can be problems, however, with natural resource investments
where the host government may not want bankers, as opposed to resource development
professionals, in the partnership, and so the host government may reserve the right to give
prior approval. It may also affect the dynamics of the partnership if the bank has limited
expertise in this area. Finally the bank is likely to want to seek an exit to its involvement
and thus that may also impact on the plans of other members of the joint venture.
Debt rate: funds are advanced by each joint venturer as needed. Debt cost for such funds
is the debt rate for each joint venturer. This results in the lowest possible cost of funds for
each of the joint venturers. However, the joint venture itself might borrow on a secured
basis or a lease. In such instances, the lender or leasing company will lend or lease on
the basis of the collateral, the obligations of the joint venturers and the importance of
the project to the joint venturers.
Balance sheet: investment, debt and liability are on the balance sheet of each sponsor
to the extent of exposure. If a party owns and controls over 50% of a joint venture, a
line-by-line consolidation may be appropriate. If voting is on the basis of both a majority
of parties and a majority of investment, mere ownership of more than 50% may not
require consolidation.
Loan covenants: the liability of each venturer is counted as debt for debt-equity ratios
and as loans for loan restrictions. Borrowings of a joint venture less than 50% owned
by a party are probably not included.
Advantages:
availability of the right either to file a partnership return or to elect not to file a
partnership return, thus preserving for each joint venturer the right to make income
tax elections;
may be off-balance sheet and outside loan covenants as to the portion of the loan or
lease to other credits in the joint venture;

resources and technical skills; and

an essential facility is built without the sponsor-participant being required to pay the
entire cost of the project.

Disadvantage:
422

Exhibit 27.9
Joint venture mine
Steel 1 Operating Steel

company agreement company
Steel Steel
company company
3 Advances and 3 Advances and

contributions Operator contributions
to capital to capital
2
Management
3 Advances and 3 Advances and

Iron ore mine
contributions contributions
joint venture
to capital to capital
4 Mortgage 4 Lease
loan
Term lender Leasing

or bank company
Continued

Project Financing
Summary
1 Four steel companies enter into an operating agreement to operate a mine as a joint venture in which
each steel company owns an undivided interest in the mineproperties.
2 One of the steel companies is designated the operator in charge of day to day management of themine.
3 Advances and contributions to capital are made to the joint venture operation by the steel companies as
needed and in accordance with the terms of the operating agreement. Each steel company arranges the
financing of itscontribution.
4 A secured mortgage loan or a lease may be possible by the joint venture based on the security of the
assets involved, the obligations of the joint venturers to support the project and the importance of the
project to the jointventurers.
Lease by a utility of an undivided interest in a co-generation facility to be

operated as a joint venture
A utility, a tyre company and a chemical company join together in a joint venture to finance
and operate a co-generation facility (see Exhibit 27.10). The utility company needs electricity.
The tyre company and the chemical company primarily need steam. The tyre company and
the chemical company both enjoy a higher debt rating than the utility. Therefore, the tyre
company and the chemical company are reluctant to have the project finance itself with
debt or with a lease. Under the agreement between the parties, each party agrees to provide
one-third of the cost of the facility. Each party is to have an undivided one-third interest
in the facility.
The chemical company provides its US$100 million from internally-generated funds and
proceeds from past debt issues. The tyre company finances its US$100 million investment
by providing US$30 million internally generated funds and borrowing US$70 million from
lenders on the basis of the security of its undivided one-third interest in the project. The
tyre company can make use of the tax benefits. The debt market will accept a one-third
undivided interest in the project as acceptable collateral for its US$70 million debtplacement.
The utility cannot currently use the tax benefits. Therefore, the utility uses a third party
leasing company to provide the financing of its US$100 million interest in the joint venture.
The lease runs from the third party leasing company to the utility.
Credit support: the value of the one-third undivided interest of the project together with
the general credit of the utility provides the credit support of the lease transaction. The
credit support for the loan to the tyre company consists of the collateral value of the
one-third undivided interest in the project facility, plus the lenders appraisal of the support
the tyre company will provide the project.
Lease and debt rate: the lease rate will reflect the value of the one-third undivided interest
in the project facility, plus the general credit standing of the utility lessee. In the case of
the tyre company, the debt rate will be determined by the value of the one-third undivided
424

interest in the project facility plus the value the lenders place upon the likelihood the tyre
company will support the debt.
Balance sheet: the lease will probably show as a capital lease on the balance sheet of
the utility. The debt will probably show as a liability on the balance sheet of the tyre
company, even though secured.
Loan covenants: since the lease will probably be classified as a capital lease, the lease may
also be counted as debt for purposes of loan covenants of the utility. Since the debt is
secured, the debt might not be counted as debt under the loan covenants of the tyrecompany.
Income tax: the lessor can claim interest and depreciation deductions. The agreements
between the joint venture parties must be structured to permit the lease to qualify as a
true lease; particularly on residual value, a tax authority may challenge the lease of an
undivided interest. The tyre company and the chemical company can claim tax benefits
from depreciation and interest deductions. In the year of inception, each of the holders
of an undivided interest has a full tax year. (This would not be true in a partnership and
might result in loss of tax benefits from a partial tax year.)
Variations: the same structure can be used for many joint ventures such as mines, processing
plants or transportation facilities.
Advantages:
two of the three sponsors end up with control of the key asset of the project at the
end of the true lease with the third sponsor;

by other sponsors to the project;

the financial resources and technical skills of several sponsors;

an essential facility is built without any one sponsor being required to pay the entire
cost of the project or assume the entire risks of the project; and
each borrower goes to the debt market separately and gains the advantage of his
respective credit standing and debt rate.

Disadvantage:
lack of absolute control over facility.
Sponsor-owned joint venture supplier financed by sponsors severable lease

A joint venture project is financed with a lease to the joint venturers in which they are each
only liable to the extent of their interest in the project. However, a default by one party
in its share of the rent would place the entire lease in default. Typical projects include a
pipeline, refinery, reforming facility, or mine. An example is shown in Exhibit 27.11.
Rate base: if the lease is a capital lease, the related asset might be included in the rate
base of a public utility sponsor.
Income tax: depreciation deductions are claimed by the lessor.
Debt rate: the lease rate is determined in relation to the debt for each lessee and the
likelihood other venturers will assume obligations of a venturer which becomes insolvent.
Weak co-venturers adversely affect the lease rate and viability of the transaction. Where
425

Exhibit 27.10
Co-generation facility
7 Rent
6 Term debt
US$70 million
6 Equity funds Indenture 7 Debt

US$30 million trustee service Lenders
5 Mortgage 7 Revenue
4 Owner trust assignment of not needed for 6 Notes
agreement lease and debt service
rents
Equity
4 Trust Owner trustee Utility
participants 4 Lease
certificate (lessor) (lessee)
of lease
7 Revenue
not needed for 6 Title 2 US$100
debt service
million
Co-generation
6 US$100 project Chemical
2 Title
million company company
facility
3 US$100
3 Title
million
1 Joint venture
agreement
Tyre
company
3 Security 3 Loan
agreement 3 Loan 3 Notes
3 Debt service agreement
proceeds
Security 3 Debt
Lenders
trustee service
Continued

Summary
1 A chemical company, a tyre company and a utility enter into a joint venture agreement whereby each will
hold an undivided one-third interest in a co-generationfacility.
2 The chemical company contributes its capital to the co-generation facility from general corporatefunds.
3 The tyre company finances its contribution to the co-generation facility by arranging a secured loan in
which its undivided interest in the co-generation facility is pledged assecurity.
4 The utility finances its contribution to the co-generation facility through a leveraged lease, owner or equity
participants establish an owner trustee which, in turn, enters into a lease with the utility for the one-third
undivided interest in the co-generationfacility.
5 A mortgage on the undivided interest, and the lease and rentals under the lease, are assigned as security
to an indenture trustee for the benefit of lenders under the leveragedlease.
6 The owner trustee issues notes to the lenders who pay the loan proceeds to the indenture trustee, in the
meantime, the equity participants have provided equity funds to the indenture trustee. The indenture
trustee purchases the undivided one-third interest in the co-generation facility, with title passing to the
ownertrustee.
7 Rental payments are made by the utility to the indenture trustee which services the debt and pays
revenue not needed for debt service to the owner trustee, which in turn passes through unneeded
revenue to the equityparticipants.
subsidiaries of strong credits are the joint venturers, the debt rate can be improved by
arranging the lease directly with the parent companies which, in turn, sub-lease to their
respective subsidiaries.
Sponsors balance sheet and loan covenants: each joint venturer reports its severable lease
obligation the same as a net lease in the amount of the severable obligation. Leases of
construction equipment can often be structured as operating leases. The sponsors loan
covenants are treated as a lease to the extent of the severable obligations of eachsponsor.
Variation: a leveraged lease using commercial paper as debt has been proposed for a
relatively short-term lease of construction equipment for building a pipeline.
Advantages:
may be off-balance sheet if structured as an operating lease;
may be off-balance sheet and outside loan covenants on the portion of the loan or
lease to weak credits in the joint venture;


an essential facility is built without any one sponsor-participant being required to pay
the entire cost of the project; and

costs are segregated for rate-making purposes.
Disadvantages:
somewhat higher borrowing cost and lack of absolute control; and
possibility that necessity may force credit support of weaker parties to the jointventure.
427

Project Financing
Exhibit 27.11
Joint venture with severable lease
Leasing
company
1 Severable lease
of construction
equipment
Oil Oil Oil

company company company
2 Sublease 2 Sublease 2 Sublease
Pipeline
construction
company
Summary
1 Three oil companies enter into a severable lease of construction equipment, with each oil company
leasing an undivided one-third interest in each piece ofequipment.
2 Each of the oil companies, in turn, sub-leases its undivided one-third interest in the equipment to a
pipeline construction company which is building a pipeline the oil companies will need anduse.
Sponsor-owned joint venture supplier with one or more weak sponsors

financed by loan or lease
Where one or more companies with excellent credit are parties to a joint venture with other
parties whose credit is weak, lenders or lessors may be convinced that the nature of the
project and its importance to the strong venturers is such that the strong venturers cannot
afford to abandon the project, but will be compelled to support the obligations of the parties
whose credit is weak if any such parties are unable to meet their obligations. Methods that
may be used are discussed in Chapter 28 where we cover oil and gas drilling.
428

This type of contingent liability is not reflected on the balance sheet of the strong credit
supporting the transaction. An example might be a project to build a pipeline or facility by a
joint venture whose members are several strong oil or gas companies and a construction company
with limited capital. Although lenders would probably be satisfied to lend to such a joint venture
company on the basis that the oil and gas companies were indirectly liable regardless of the terms
of the joint ventureagreement there are risks implied in guarantees as discussed in Chapter 23.
Another example might be a mine operated by a joint venture made up of several parties
who are strong credits and one or two parties who are weak credits. If the strong credits
required the production of the mine and if the ore was attractively priced as compared with
alternative sources for the strong credits, a lender would probably feel comfortable lending
to the joint venture.
Advantages to strong sponsor:

may be off-balance sheet as to the portion of the loan or lease to weak credits;
outside loan covenants as to the portion of the loan or lease to weak credits;

costs segregated for rate-making purposes.
Disadvantages:
higher borrowing cost; and
Sale of appreciated equipment to a joint venture which finances the

purchase with non-recourse debt
The owner of an offshore oil rig which has appreciated in value desires to form a joint
venture with a foreign investor located in the host country near which the rig is working.
The owner forms a joint venture with the host country investor to own and operate the
rig. The offshore rig company then enters into a long-term agreement with the joint venture
whereby the rig company agrees to operate the rig under a management contract for the joint
venture. If possible, the rig is placed under charter to an oil company for a term of years.
The joint venture arranges a loan to purchase the rig which is secured by a first mortgage on
the rig, together with an assignment of the charter revenues, net of operating costs. Proceeds
from the loan, together with contributions to capital by the joint venturers, are then used to
purchase the rig from the offshore rig company for its fair market value. Typical projects
include an oil rig or any appreciated asset to be acquired by a joint venture to which the
owner of the equipment is a party. This is shown in Exhibit 27.12.
Income tax: the owner will realise a capital gain on the proceeds from the sale of one-half
of the value of the rig less basis. The debt rate on the loan used to finance the purchase
of the rig is a function of the credit of the joint venture, the value of the asset and the
value of the charter.
Balance sheet: from the standpoint of the offshore rig company, cash will be realised
from the sale price and any existing indebtedness on the rig will be paid off and removed
429

Exhibit 27.12
Sale of appreciated equipment to a joint venture
Shipping
company
2 Joint venture Offshore rig

agreement company
3 Agreement to
operate rig
3 Sale of rig;
Joint venture title; assignment 1 Charter of rig
of charter
4 Loan to
purchase rig, mortgage, 5 Loan 5 Purchase Oil
assignment of proceeds price company
charter payments
Bank
Continued

Summary
1 An offshore rig company owns a rig which is on charter for a significant period of time to an oil company.
The value of the rig is substantially in excess of the rig companys bookvalue.
2 The rig company enters into a 5050 joint venture agreement with a shipping company to own and
operate therig.
3 The rig company enters into an agreement with the joint venture for the sale of the rig, subject to the
charter and an assignment of the charter. The joint venture entity and the rig company enter into an
agreement whereby the rig company will operate the rig for fees for a number of years at least equal to
the term of thecharter.
4 The joint venture arranges a loan to purchase the rig and secures the loan by a first mortgage on the rig
and an assignment of the charterpayments.
5 The loan proceeds are paid to the joint venture. The loan proceeds and capital contributions by the two
joint venturers are used to pay the purchase price to the rigcompany.
from the balance sheet. Whether or not the debt of the joint venture will be shown on
the balance sheet of the rig company will depend upon an interpretation of whether the
rig company controls the joint venture for financial accounting purposes.
Variation: the loan by the bank is on a non-recourse basis to the joint venture or, in the
further alternative, to the joint venturers.
Advantages:
the rig company cashes out a portion of the appreciated value of the rig, thus raising
capital for other needs;

the rig company retains the profits from the operating agreement; and
political pressure from the host company for local participation in the development of
its natural resources is solved.

Disadvantage:
loss of complete ownership and control of the rig.
1
Note this is not necessarily the case because it is possible to have some shares that have multiple votes, some
shares that may carry no votes and some shares that can outvote any other decisions.
431

Project Financing
Chapter 28
Reserves-oriented financing and drilling

funds
Reserves-oriented financing is based on the collateral value of oil reserves, gas reserves and
mineral reserves, itself determined by the potential for cash flow. Some types of reserves-
oriented financing are with recourse to the borrower and resemble a loan secured by a
mortgage on real estate. In other types of reserves-oriented financing, the lender looks solely
to the value of the reserves based on a conservative market price for production and the
ability and undertakings of an operator as the source of funds for repayment of debt.
Many of the structures used in reserves-oriented financing were developed in part as
tax avoidance schemes in the 1950s and 1960s. As the tax laws were changed to do away
with perceived unjustified tax advantages, the structures nevertheless survived because of
their usefulness in financing and particularly in achieving project financing objectives. In this
chapter we will trace the early history of some of these structures to provide some perspective
in their development. We include a number of structures that are not widely used today in
order to provoke creative approaches to problem solving by drawing on lessons from thepast.
It is important to keep in mind when reading this chapter that the ownership of oil and
gas and indeed other minerals varies by country. Although in the US, for example, mineral
rights can be owned by individuals often the landowner may also own the mineral rights
below ground, this is not true in other countries. In many other jurisdictions, some or all
of the rights are owned by the government, or in the case of the UK, by the Crown (and
managed by the government). In the case of national ownership, the government (usually via
the appropriate ministry or department) grants exploration and development or production
licenses for fixed terms with payments to the host government and often a revenue sharing
agreement. This means that US tax-driven project finance structures may not be applicable
in all jurisdictions.
1 Production loans
Production loans are widely used to finance the development of reserves. In a production
loan, an operator simply borrows money under a loan agreement, evidenced by a promis-
sory note and secured by mortgage on the reserve and a security interest in the production.
Production loans are sometimes arranged as a line of credit against which the operator may
borrow and repay so long as the total amount outstanding at any one time does not exceed a
borrowing base. Usually the borrowing base is determined by a pre-agreed percentage of reserve
values as verified from time to time by petroleum engineers and is subject to overalllimits.
These types of loans are sometimes called borrowing base loans. The liability of the
borrower may be evidenced by a single note in the maximum amount which may be borrowed,
432

Reserves-oriented financing and drilling funds
or it may be evidenced by notes in the amounts actually outstanding. In some cases, the
credit facility revolves as long as the borrowing base remains at or above the level agreed
with the lenders and reviewed by the petroleum engineers.
2 Non-recourse production loans

A non-recourse production loan resembles a production loan, except that the lender agrees to
make a loan based solely on the security of the oil or gas or mineral reserves, the ability or
undertaking of the operator to produce the reserves, and a security interest in the production
and proceeds of production which can be sold at an adequate price to service the debt. More
specifically, the lender relies on the following security and undertakings for repayment of itsloan.
1 A take-or-pay contract, unless the lender is satisfied that expected market prices and
customers for the production will exist.
2 Placement of the project in a special project entity which will be restricted in liabilities
other than to the lender.
3 An undertaking by the special project entity and the sponsor or reputable operator to
construct, complete and operate the project to certain standards of efficiency. In other
words, a completion guarantee.
4 First mortgage and security interest in all reserves and assets involved in the project.
5 Assignment of all contractual rights of the borrower which relate to the project.
Clearly, the lender needs to have a strong sense of the dynamics of the geology of the area
where the oil and gas is located the first well to be drilled in a particular location that taps
in to a particular level of rock thought to be petroliferous is as risky as any venture capital
investment. One of the challenges is that rock strata are not necessarily uniform in distribution
and, of course, are invisible because they are located deep underground. Although seismic
analysis has progressed enormously over the last 30 years costs of computing have come
down and imaging has become more sophisticated, aiding in the assessment of the reservoirs
unexpected events can still happen and anticipated production levels fail to materialise.
3 Production payments as collateral to obtain financing

A mineral production payment is a right to either a specified share of the production from a
certain mineral property or a sum of money in place of the share of production. Stated another
way, a production payment is a conveyance by a mineral owner of certain undivided inter-
ests in minerals to be produced and sold in the future. Production payments can be precisely
calculated, albeit from forecasted data. This makes the use of production payments attractive
as security in financial transactions. The production payment frequently bears interest payable
out of future production. In other words, the value of a production payment is the present
value of the expected future stream of production payments discounted at some interestrate.
Loans based on production payments are one of the earliest forms of project financings.
Like many financing structures first used for oil and gas production financing, the structures
were originally devised to achieve certain tax objectives. Although tax laws were changed to
433

Project Financing
Exhibit 28.1
Loan secured by a reserved production payment
Seller
1 Sale for
US$350,000
3 Production
subject to 2 Cash
payment
US$650,000 US$350,000
US$650,000
production
payment
Purchaser
Summary
1 The seller sells a mineral property for US$350,000, subject to a production payment in the primary
sum of US$650,000, plus an amount equal to an interest factor on the unliquidated balance of the
productionpayment.
2 At the time of the sale, the purchaser pays US$350,000 incash.
3 As production is produced, the purchaser makes production payments of US$650,000, plus the agreed
upon interest factor on the unliquidatedbalance.
eliminate the real or imagined benefits of such arrangements, the structures survived because
they were useful in arranging project financing.
A production payment is secured by an interest in the minerals in place. Payment is
dischargeable only out of runs of oil or deliveries of gas or minerals accruing to certain
property charged with production payments. It cannot be satisfied out of other production.
The right to the production is for a shorter period than the expected life of the property. The
owner of a production payment looks exclusively to proceeds from production forpayment.
For a production payment to be valuable enough to use as collateral for a loan, the
production payment must be generated from a proven mineral reserve.1 An appraisal of
the reserves must be obtained from one or more reputable appraisers, who analyse the
nature and extent of the reserves. The feasibility of the production must be confirmed by
434

an engineering study which analyses the economies of obtaining the production, expected
quality of production, probable cost of production, probable markets, cash flows expected
to be generated and cash needs. Expected market prices for production are obviously very
important in structuring a production payment loan.
A loan secured by a production payment is self-amortising. Income from the sale of the
oil, gas or other minerals is dedicated and used to pay back the loan.
Undertakings by an operator of good reputation and integrity are also needed if the
production payment is to be used as collateral. Undertakings by the operator may include a
completion guarantee to complete the well or mine within certain time limits, to provide the
necessary equipment and make the necessary expenditures to achieve completion and to pay
any cost overruns. Completion means the well or mine will be constructed in a manner to
permit certain specified production rates and production of a specified quality. The operator
also undertakes to protect the property and keep it free from liens.
Since the undertakings of the operator are considerable, the operator is usually the major
stakeholder in generating the cash flow to repay the proceeds of the loan secured by the
production payment. Thus, the operator has the motivation and responsibility to perform.
Although the potential of production of oil, gas or minerals in the ground has some
value, the confirmed existence of known quantities and qualities of such production, coupled
with undertakings by an operator of good reputation to take the steps necessary to produce
the product in a definite time frame, gives a production payment value as collateral.
Example of a reserved production payment to finance a purchase of an oil

or mineral property
A seller sells an oil and gas property it owns which is valued at US$1 million to a purchaser
for US$350,000 in cash and reserves a production payment in the amount of US$650,000
plus interest. A typical project would be the sale of an operating interest in an oil or gas
well or mineral property, as shown in Exhibit 28.1.
Income tax: the production payment is treated as a purchase money mortgage loan for
tax purposes. The seller reports receipt of payments as consideration for a sale. Interest
will be imputed if not stated. The seller cannot take depletion on the oil used to satisfy
the payment. The purchaser has a basis of US$1 million, will be taxed on the income
from the well used to pay the production payments and is entitled to claim depletion.
Debt rate and balance sheet: the debt rate is negotiated between purchaser and seller. The
obligation of the purchaser to pay the seller does not show as debt on the purchasers
balance sheet. It may show as a deferred liability. Covenants against debt are notaffected.
Advantages:
the loan is non-recourse except against production of the purchased property;
the production payment is outside loan covenants restricting debt or leases; and
the purchasers capital is preserved for other uses.
Disadvantages:
the reserved production payment may result in a somewhat higher borrowing cost; and
in certainty regarding future market prices may result in over collateralisation.
435

Project Financing
Reserved production payment in a lease transaction

The owner-lessor leases an oil and gas property to an operator as lessee. Under the lease
agreement, the lessee pays the lessor a front-end bonus of US$100,000, the lessor retains
a one-eighth royalty and the lessor also retains a production payment of US$500,000. A
typical project might be the lease of an oil or mineral property as shown in Exhibit 28.2.
Tax consequences: the bonus and production payments are taxed as income to the owner-
lessor. Production is taxed as it is sold. The owner-lessor is entitled to claim depletion.
The operator-lessee treats the production payment as a bonus paid the owner-lessor
in instalments. The operator-lessee includes production payments in gross income and
capitalises the payments as part of his depletable investment base in the lease. Any interest
element in the production payment is excluded from taxable income of either the lessor
or lessee and is treated as part of the production payment.
Debt rate, balance sheet and covenants: the debt rate is negotiated as part of production
payment. A reserved production payment is probably not included under the lessees
loan covenants.
Advantages to lessee:
the loan is non-recourse except against production of leased property;
the production payments is outside loan covenants restricting debt or leases; and
capital of the operator-lessee is preserved for other uses.
Disadvantage to lessor:
the disadvantage to the lessor is a somewhat higher borrowing cost.
Carved-out production payment (non-development) to raise capital

Suppose that A, the owner of a producing property believed to be worth US$1 million,
desires to raise US$650,000. A creates (carves out) a production payment with a principal
amount of US$650,000 plus interest, taxes and certain expenses out of the producing prop-
erty, which A then sells to C for US$650,000. A retains the residual.
C is a nominally capitalised independent company. C borrows US$650,000 from a bank
which secures its loan by a deed of trust, mortgage and assignment of proceeds of produc-
tion accruing to the production payment. (Banks are not generally permitted to own real
property which includes mineral interests and, therefore, cannot invest directly in production
payments.) It is a method of borrowing against an oil, gas or mineral property on a non-
recourse basis and not an acquisition of assets. (See Exhibit 28.3.)
Income tax: carve-outs are a complex area where expert advice should be sought. Under
some conditions, carve-outs can be treated as debt. The proceeds of production accruing to
the production payment (runs) constitute income to A who may be able to claim depletion
and intangible expense, although depending on the form of the carve out (oil and gas as
produced or asset) this may cause a mismatch over expenses. Any interest element in the
production payment is treated as interest expense and income to A and C, respectively.
Debt rate: the debt rate depends on the value of the secured property plus whatever C is
paid as a spread. With the change in tax laws, tax reasons no longer exist for avoiding
436

Exhibit 28.2
Lease secured by a reserved production payment
Lessor
1 Lease subject
to royalty and
reserved production
payment
2 Front-end
bonus
3 Production
3 Royalty
payment
Lessee
operator
Summary
1 Lessor enters into a lease of an oil or mineral property which is subject to a royalty and a reserved
productionpayment.
2 The lessee pays a front-end bonus to thelessor.
3 As production is produced, lessee makes production payments and royalty payments to thelessor.
guarantees and undertakings by the operator in order to induce the bank to make a loan
to C or give a better interest rate. However, the operator wants to avoid such guarantees
to avoid debt on its balance sheet.
Balance sheet: the sold production payment does not appear on As balance sheet as debt.
The sold production payment may be shown as a deferred liability on As balance sheet.
The debt of the purchaser C does not appear on As balance sheet as debt.
Loan covenants: the sale of an existing asset might violate a loan covenant. The transaction
is similar to placing a nonrecourse mortgage on an unencumbered asset.
437

Project Financing
Exhibit 28.3
Carved-out production payment
4 Production
payments
US$650,000 A Owner and
operator
3 Cash 1 Production
US$650,000 payment contract
US$650,000
C Nominee
corporation
2 Deed
and mortgage
3 Cash production 2 Loan
US$650,000 payment and agreement
assignment of
production
Bank
Summary
1 An owner-operator sells a production payment contract to a nominee corporation for the primary
sum of US$650,000, plus an amount equal to an interest factor on the unliquidated balance of the
productionpayment.
2 The nominee corporation enters into a loan agreement with a bank, and secures its loan by a deed of
trust and mortgage on the production payments and an assignment of the production accruingthereto.
3 The proceeds of the loan in the amount of US$650,000 are paid by the bank to the nominee corporation
which, in turn, pays that amount to the owner-operator.
4 The owner-operator makes production payments directly to the bank that are sufficient to service
principal and interest on the loan. (The interest factor on the production payment equals or slightly
exceeds the loan interest.)
Advantages to owner:
the borrowing is non-recourse except against production of property carved out;
the production payment is outside loan covenants restricting borrowing, but may
constitute a disposition of an asset; and
438


Disadvantages to owner:
a somewhat higher borrowing cost; and
not really a financing, but rather a sale of an asset, the present value of certain assured
future production.
Development carve-outs: pledged production payments dedicated to

development of a property
A development carve-out is a method whereby an owner raises capital to develop an oil, gas
or mining property in exchange for a stated amount payable out of production.
In one type of development carve-out, A, the owner of the mineral interest, estimates
development costs and determines if such amount can be borrowed from a bank on the basis
of an assignment of a production payment on a non-recourse basis. When this amount is
determined, the production payment is sold to C, an independent and nominally capitalised
company. C borrows the same amount from a bank and assigns to the bank a trust deed,
mortgage and assignment of proceeds of production accruing to the production payment. The
production payment must be sufficient to pay the principal amount of the loan, plus interest,
local tax and a spread to C. C uses and dedicates the proceeds of the production payment to
develop the property from which production is carved out. C reserves an interest spread for
itself. Drawdown of the loan may be over a period of time as development expense isincurred.
Another method is for the owner of the property to deal directly with a drilling company
or mining company which agrees to drill the well or develop the mine on a basis whereby
payment for materials and services will be from a production payment in the amount of the
cost of the materials and services to be used in the development of the property from which
the production payment is carved. If the risk is high or circumstances warrant, the drilling
company (or mining company) may receive several dollars in production payments for each
dollar expended. Ten-for-one arrangements were not uncommon in the early uncertain days
of oil well development in the United States.
Development carve-outs may be used for developing an oil well or a mine, intangible
drilling expenses or equipment used solely or principally for development of specific prop-
erty charged with the production payment; mining equipment such as draglines, shovels and
underground face equipment which can be used for production apparently do not qualify.
Income tax: the proceeds of the development production payment may be treated as
income to A, the property owner. A has no basis for and nothing to depreciate with
regard to equipment financed by a development production payment. C, the company
acquiring the production payment, has as a basis to allow depreciation of the amount
received (or expended) for equipment and services, treats production payments as income
and is entitled to claim depletion. C is not entitled to deduct intangible drilling costs or
development expense in the year when such expense is incurred. Excess of proceeds over
development costs are taxed as ordinary income to C, the developing company and as a
loan repayment to A. The owners ability to claim depletion is improved by elimination
of depreciation deductions.
439

Project Financing
Debt rate: the debt rate is a function of the risk in the transaction plus what C is paid as a
spread. At some point the risks in a transaction may become equity rather than credit and
several dollars of production payments may be paid for each dollar of development cost.
Balance sheet: the property owner has no direct liability for the production payment loan
of C or obligations of the developing company. The obligation to make the payment does
not show as debt. The value of the assets of the property owner are adversely affected by
the sale of the production payment which is a charge against the property. The obligation
to make the production payment may be shown as a deferred liability.
Loan covenants: the sale of a production payment from an existing asset might violate
a loan covenant. The non-recourse debt of C, or obligations of the developing company,
would not be counted as debt for loan covenant restrictions.
Advantages to owner:
development costs are paid out of pre-tax income;
borrowing is non-recourse except against production of property carved out;
the production payment is off-balance sheet as debt;

Disadvantage to owner
the higher borrowing cost (but paid out of pre-tax income).
Wrap-around carve-out
A property owner desires to maximise the tax effects of a development carve-out by financing
all development costs, but requires other capital for operating expense. A long-term carve-out
wrapped around the development carve-out can be used to provide the additional capital
needed. The loan secured by the wrap-around carve-out is drawn down as required. Payback
of the wrap-around commences after repayment of the development carve-out. Typical proj-
ects include oil, gas or mining developments.
Income tax, debt rate, balance sheet and loan covenants: the characteristics of the
development carve-out are the same as previously discussed. The characteristics of the
wrap-around carve-out are the same as traditional carved-out production payments.
Advantage to owner:
it combines the tax advantages of development carve-outs to the extent possible with
a traditional carve-out, while preserving the off-balance sheet financing characteristics

of each method.
Use of income from stable country production to finance development of

unstable country production
A corporation is formed, which is not consolidated for tax purposes, to hold properties located
in three countries, of which one is politically stable and two are politically unstable. An entity
lends against the portfolio of properties on a non-recourse basis for development purposes
440

using, for example, a development carve-out arrangement. The income from the more stable
country is used to underpin the finance development in the stable country and bring the cost
of borrowing down. Typical projects include development of oil, gas and mineral deposits.
Income tax, debt rate, balance sheet and loan covenant: interest rates will be higher for
development loans in the unstable countries because of expropriation and political risk,
but will be lower for the stable country. By combining and diversifying the collateral,
the overall borrowing rate for the high risk countries can be definitely lowered. It may
be possible to structure as off-balance sheet development loans and non-recourse loans.
The ABC deal: purchase of mineral-producing property by off-balance

sheet financing
Suppose that B desires to purchase an existing oil-producing property from A. A, the owner,
is willing to sell the producing oil well for US$1 million. The value of the property is such
that a bank is willing to lend US$650,000 on the basis of the value of the property alone
and on a non-recourse basis. A sells the property to B, subject to a reserved production
payment in the principal amount of US$650,000 plus an amount equal to interest expense
on the outstanding balance of the production payment, taxes and certain agreed expenses.
The sale price to B is US$350,000, which B pays A in cash. A sells the reserved production
payment to C, an independent and nominally capitalised corporation, for US$650,000 cash,
which C raises by borrowing US$650,000 from the bank which was willing to loan on a
non-recourse basis. C is compensated by a spread between the interest on the production
payment and interest on the loan. The bank secures its loan by deed of trust and mort-
gage on the production payment and an assignment of proceeds of production accruing to
the production payment. A typical project would include purchase of an oil, gas or other
mineral-producing property and is shown in Exhibit 28.4.
Income tax: tax changes have rather diminished the attractiveness of ABC production
payment schemes.
Debt rate: the debt rate depends on the value of the secured property, plus whatever C
is paid as a spread.
Balance sheet: originally the production payment used to pay for the property did not
show on Bs balance sheet as debt. It may have been shown as a deferred liability.
Loan covenants: the production payment used to pay for the property does not affect
Bs loan covenants.
Advantages to purchaser:

Disadvantage to purchaser:
a somewhat higher borrowing cost.
441

Exhibit 28.4
ABC production payment
A Seller
4 Cash 1 Cash
US$650,000 US$350,000
2 Sale of 1 Purchase for

US$650,000 US$350,000 subject to
production production payment of
payment US$650,000 plus an
interest factor
3 Loan of US$650,000
C Nominee secured by a deed of trust B Purchaser
corporation and mortage on US$650,000 (operator)
production payment and
assignment of payments
4 Loan 5 Production
proceeds of payments of
US$650,000 US$650,000
Bank
Continued

Summary
1 A, the owner of an oil-producing property, sells the property to an operator for US$350,000, subject to a
production payment to be paid the seller by the purchaser of US$650,000, plus an interest factor on the
unliquidated balance of the productionpayment.
2 A, the seller, sells the production payment to C, a nominee corporation, for US$650,000 to be paid
incash.
3 C arranges a bank loan for US$650,000 at a rate of interest below the interest factor or equivalent carried
on the reserve payment, and secures the loan by an assignment of a deed of trust and mortgage on the
production payment and an assignment of the proceeds of production accruingthereto.
4 The loan proceeds are paid by the bank to the nominee corporation and the nominee corporation pays
the same amount to theseller.
5 The operator, B, makes the production payments of US$650,000 plus the interest factor directly to the
bank, which are sufficient to service the principal and interest payments due on theloan.
The ACB deal: purchase of mineral-producing property by off-balance

sheet financing
B desires to purchase oil-producing properties from several owners, A1, A2 and A3. They
are willing to sell for US$1 million. A bank is willing to lend US$650,000 on the property
on a non-recourse basis. At the closing, the sellers A1, A2 and A3 sell their properties to
C for US$1 million cash. C is a nominally capitalised independent company. C reserves a
production payment worth US$650,000 and raises US$650,000 by borrowing that amount
from a bank, securing the loan by a deed of trust and mortgage on the production payment
and an assignment of the proceeds of production accruing to the production payment. C
sells the properties to B for US$350,000 subject to the reserved production payment and C
applies the US$350,000 to the purchase price.
C might sell the production payment to D for US$650,000 as a variation, which D would
use to borrow from a bank. This is called an ACBD deal and is shown in Exhibit 28.5.
Typical project would be the purchase of an oil, gas or other mineral-producing property
from a number of owners.
Income tax: ABC and ACB transactions originated in the 1950s and 1960s to take
advantage of tax laws favouring such arrangements. Before the Tax Reform Act 1969, C
rather than B was taxed on production accruing to the production payment. B purchased
the property with pre-tax dollars. After the Tax Reform Act 1969 production payments
were taxed to B and the production payment was treated as a purchase moneymortgage.
Debt rate: the debt rate depends on the value of the secured property plus whatever C
is paid as a spread.
Balance sheet and loan covenants: the production payment used to pay for the property
may not appear on Bs balance sheet as debt. The production payment used to pay for
the property probably does not affect Bs loan covenants.
443

Exhibit 28.5
ACB production payment
1 A Owner 2 A Owner 3 A Owner
1 and 4 Sale for 1 and 4 Sale for 1 and 4 Sale for

US$200,000 US$300,000 US$500,000
4 Loan
C Nominee 2 Cash
proceeds of
company US$350,000
US$650,000
3 Loan of US$650,000 2 Purchase for

secured by a deed of trust US$350,000 subject to
and mortgage on US$650,000 production payment of
production payment and US$650,000 plus an
assignment of payments interest factor
B Purchaser
(operator)
5 Production
payments of
US$650,000
Bank
Continued

Summary
1 The owners of three oil-producing properties sell those properties to a nomineecorporation.
2 The nominee corporation purchases the combined properties for US$350,000 cash, subject to a
production payment in the primary amount of US$650,000, plus an amount equal to an interest factor on
the unliquidated balance of the productionpayment.
3 The nominee corporation enters into a loan agreement with a bank at a rate of interest slightly below the
interest factor or equivalent carried on the reserve payment, and secures the loan by a deed of trust and
mortgage on the production payment and an assignment of the production accruingthereto.
4 The loan proceeds are paid by the bank to the nominee corporation and, in turn, paid to the
respectiveowners.
5 The operator pays production payments plus the interest factor directly to the bank; such payments are
sufficient to service principal and interest payments on theloan.
Advantages to purchaser:

Disadvantage to purchaser:
somewhat higher borrowing costs.
4 Advance payments for oil, gas or coal payments

Advance payments transactions involve the sale and the purchase of a mineral prior to its
production. Typically the sale is to an independent entity which borrows funds necessary to
make the advance purchase. The purchaser agrees to purchase the mineral as it is produced.
The purchase contract, the minerals and proceeds of the sale are assigned to the lender as
security for the loans. As the mineral is produced and sold, the loan is repaid.
Example of an advance payment for gas and oil

The sponsor, a public gas utility or pipeline, seeks a source of gas. A drilling company owns
certain properties for development. The sponsor makes an advance of US$10 million to
the drilling company to be used exclusively for exploration and development of a specified
number of wells on certain of the drilling companys properties. The sponsor is to receive
back US$15 million payable out of oil and gas production attributable to the wells and
properties specified. The sponsor also acquires the right to purchase all gas from the prop-
erties, since its prime motive is to secure a source of gas for itself. The same arrangement
might be made for oil or coal.
445

Project Financing
The drilling company can insulate itself from liability by placing the property to be
developed in a subsidiary formed for purposes of the transaction. The property is developed
using the advances which are repayable only out of production. Thus, the drilling company
enjoys the benefits of a project financing repayable only out of production and non-recourse
to the drilling company. While property is transferred to the project by the drilling company,
the value of the property is greatly enhanced by development. Furthermore, in some cases
advances might be used to acquire the property to be developed.
A typical project would be exploration and development of a source of gas, oil or coal.
An example is shown in Exhibit 28.6.
Rate base, income tax, credit and debt rate: a utility sponsor may be permitted to include
such an advance in its rate base. The drilling company may be entitled to various tax
benefits such as depreciation, intangible drilling and development costs. For the credit
and debt rate, the sponsor relies upon the ability of the drilling company. The cost of
premium varies with the risk of developing the new source of supply.
Balance sheets and loan covenants: the obligation of the drilling company to repay the
advance from production is debt under FAS 19. The advance to the supplier shows as
an asset. The borrowing to finance the advance shows as a liability. This arrangement
avoids restrictions on increasing senior debt and leases. However, the disposition of an
asset occurs and that may be restricted by loan covenants.
Advantage to sponsor:
achieves a source of supply by joining forces with a company with the requisite technical
skills and properties, thus avoiding the need to acquire such talent and properties.
Disadvantages to sponsor:
expensive because it is a direct impact on cash, balance sheet, debt ratings, earnings
and rates;
in the case of natural gas, the federal government might re-allocate the sponsors gas
to areas of the country which are short of gas; and

market price of gas may change.
Advantages to supplier:
development costs are paid out of pre-tax income;
borrowing is non-recourse except against production of property carved out;
the production payment may be outside loan covenants restricting borrowing, but may

capital preserved for other uses.
Disadvantage to owner:
the higher borrowing cost (albeit paid out of pre-tax income).
Oil and gas development funding outside the US

Whilst the earlier examples are based in the US, since the early 1970s, lenders have been
financing companies taking part in oil and gas development elsewhere, of which the most
established area is the North Sea. Consortia or syndicates of lenders have made loans to
individual members of joint ventures formed to develop North Sea production projects (see
446

Exhibit 28.6
Advance payment for production
Sponsor
(public utility)
1 Contract
2 Production
giving sponsor 1 Advance
payment
right to purchase US$10 million
US$15 million
product
Drilling
company
Summary
1 A public utility sponsor makes an advance of US$10 million to a drilling company in return for the drilling
company giving the utility the right to purchase the production from the property to bedeveloped.
2 Production payments are made from proceeds of production in an amount equal to the advance, plus
additional amounts to compensate the utility for the risk in making theadvance.
also Chapter 27). These loans are secured by assignments of the rights of each individual
borrower in the project, which include the borrowers rights under operating agreements
between the joint venturers and the borrowers rights under the sales contracts. However,
such loans can present unusual risks and are usually only available where the reputation of
the borrower or its parent is established and the success of the project seems assured. The
classic example is the BP financing of its Forties Field interest shown in Exhibit 28.7, an
oil field in which it currently no longer has a direct interest, though it retains an interest in
the associated pipeline.
We might ask, as borrowers often do, why the field development group is not financed
with a single loan, and why a series of loans to different members of the development
447

Exhibit 28.7
Forties Field in the North Sea
British
Petroleum
1 100% 2 100% 1 100%

ownership control ownership
British
3 Production British
Petroleum 6 Payments
licence Petroleum
Trading for oil
assignment Development
Company
5 Oil
4 Advance
5 Oil payments
Norex
against
production
3 Production
3 Loan
licence 4 Funds 6 Debt service
agreement
assignment
Banks
Continued

Summary
1 British Petroleum forms two entities, British Petroleum Trading Company and British
PetroleumDevelopment.
2 Norex is formed by British Petroleum as a special purpose company to arrangefinancing.
3 British Petroleum Development assigns its production licence to Norex, and Norex borrows from banks
on the basis of an assignment of the production licence. (The production licence can be assigned only
with consent, which is revocable. No mortgage could be assigned since the British government owns the
oil and gas.)
4 Funds are advanced by banks under the loan to Norex which, in turn, advances such funds to British
Petroleum Development againstproduction.
5 Oil is produced by British Petroleum Development and is marketed by British Petroleum
TradingCompany.
6 British Petroleum Trading pays Norex for the oil and Norex services thedebt.
group are required. In a relatively new oil province with a mix of large experienced
international companies and smaller, newer companies (often representing part of the host
country share of the development although privately owned) there is a significant range of
creditworthiness and experience. For the smaller company, with a smaller share of the field,
this might be an attractive possibility because it would potentially gain from the umbrella
effect of the creditworthiness of the larger companies. However, for a larger company: (i)
the field financing rate would be affected by the inclusion of smaller, often newer compa-
nies and thus indirectly point to an increase in loan spread paid by this borrower (albeit
as part of a field); and (ii) there is an implicit expectation that the large members will
take care of the weakest members of the field in order to ensure the financing proceeds
smoothly. Finally, the number of parties to such an agreement, especially, for example in
the early days of the North Sea, could be considerable because at some point, govern-
ment policy favoured the award of exploration and production licences to consortia with
significant UK content.
Hence at the beginning, participation was financed individually and in the case of BP via
a bank loan, with other early entrants offering equity based incentives or royalty payments
to lenders to enable finance to be raised.
The original financing of the Forties Field in the North Sea was one of the largest
production loan or advance payment schemes. Nine hundred million dollars was advanced
against the risk that the oil was there and that BP could produce the oil at reasonable costs.
The usual security supports were not available to lenders. No mortgage or first lien on the
oil in the ground (or sea) was available because the British government owned the oil. The
production licence could be assigned only with the consent of the government and such
consent was revocable.
How many lenders understood the risks is open to conjecture. Fortunately, oil prices
rose and the project has been successful, so much so that Apache, the company that bought
BPs remaining interest has upgraded the recoverable reserve estimates.
449

Project Financing
Comparison of advance gas payment contract with carved-out

development production payments
Advances for development of sources of gas, oil or coal closely resemble, or may be the
same as, a traditional carve-out financing. In some cases such advances might be structured
as development carve-outs to achieve more tax benefits (see Exhibit 28.8).
Exhibit 28.8
Comparison of advance gas payment contract with carved-out development produc-
tion payments
Advanced gas payment resembling Carved-out development production

a traditional carve-out payment
Sponsor a gas utility Yes Yes
Typical project: development of a Yes Yes
supply of gas
Advances by sponsor to finance well Yes Yes
developments
Use of advances Unrestricted to timing, properties, Solely for development of property
use out of which production is carved
Number of properties Can be several Limited to one
Income tax treatment to the sponsor Advance is treated as a mortgage Sponsor uses amount expended for
loan to drilling company. Interest development and services as a tax
portion of production is interest basis, treats production payments
income as income and is entitled to claim
depletion, ifany.
Income tax treatment to drilling Entitled to deduct depreciation and Not entitled to deduct depreciation
company intangibles to extent paid. Taxed on or intangible expense. Not taxed on
income attributable to runs going income attributable to runs going to
to satisfy production payment; satisfy production payments
interest expense portion is treated
as interest expense
Supplier project facility financing supported by user-sponsors advances

An independent supplier of gas, crude oil, feedstocks or LNG, with limited credit and
limited access to capital, finances a project facility by obtaining advances from a sponsor
seeking a source of supply. A typical project might be storage facilities, refineries, reforming
facilities, pipelines.
450

Rate base, income tax and credit: the sponsor may be permitted to include an advance in
its rate base. The supplier gets tax benefits of depreciation. Credit is that of the supplier.
The sponsor is relying on the ability of the supplier to produce the supply and the integrity
of the supplier to invest the funds prudently.
Suppliers debt rate, balance sheet and loan covenants: the suppliers debt rate is negotiated.
The interest rate usually does not reflect risk. On the other hand, the sponsor may get a
price concession on the product or be compensated in some other way.
The advance will show on the suppliers balance sheet as debt. However, the advance may
be structured as subordinated debt (subordinated to senior creditors and trade creditors).
The advance avoids restrictions on increasing senior debt or leases. The advance may be
to an unrestricted subsidiary.
Terms of borrowing: the loan is repaid out of production. Accrued interest may also be
paid out of production. The sponsor may get a discounted price. The sponsor receives
the right to purchase production.
Sponsors balance sheet: the advance to the supplier shows as an asset. Any borrowing
to finance the advance shows as a liability.
Advantage to sponsor:
achieves a source of supply by joining forces with a company with the requisite technical
skills and properties, thus avoiding the need to acquire such talent and properties.
Disadvantage to sponsor:
an advance is expensive and has a direct impact on cash, balance sheet, earnings and
rates of the sponsor.

Advantages to supplier:
the borrowing is non-recourse except against production; and
an advance is outside loan covenants restricting borrowing, but may constitute a
disposition of an asset.
Disadvantage to supplier:
the advance may be at a somewhat higher borrowing cost than a loan.
Using financial support from other group members in a consortium

to assist in financing through carried interests and farm-in/farm-out
approaches
Traditionally, before banks began to get involved, oil and gas wells were financed within
the development group. The stronger partner offered to provide financing for the weaker
partner in a number of ways. Whilst these ideas have origins in petroleum finance, they have
been taken and adapted in a number of other contexts to offer financing of projects based
on well developed legal structures and case law.
There are three main concepts briefly discussed below:
a carried interest;
a farm in/farm out; and
net profits interest.
451

Project Financing
A carried interest
In a carried interest structure, a financially stronger partner (or indeed it may be shared
across a group of partners) agrees to pick up (carry) all of the costs for that development
associated with a weaker partner, which become a financial obligation secured by the weaker
partners interest in the project. The contract specifies the interest rate or other recompense
for this and the obligation is repaid out of the weaker partners share of the project revenues
once production begins. Once the costs are paid off, the full amount of the weaker partners
participation is restored to them.
The advantage of this structure is that it is fast because there is no need to wait for
a weaker partner to find a bank or raise equity, which may cause significant delays. The
disadvantages are that the provider of financial support may end up with a larger exposure
to the project should the company being carried subsequently default. The smaller company
may threaten a hold out strategy to get a better deal, thus causing potential delays and
bad feeling before the project starts.
A farm in/farm out

With the farm in/farm out structure, the interests change inside a consortium, possibly for
a number of different reasons. A new partner may wish to enter the group and farm in
by paying for drilling a well; a group member may not have tax absorptive capacity in one
year when wells are being drilled and so may farm out to another party.
For example, suppose A has a 100% share of the project Alpha. A would like to drill
a new well but it is not a priority investment. B likes the economics of the Alpha invest-
ment and approaches A. A farms out 50% of its share to B in exchange for a well that is
drilled on Alpha funded by B. Following completion of this work, A now has a 50% share
and B has farmed in for a 50% share in Alpha. No money has changed hands, but value
is delivered into the project as a result of the drilling of the well as a higher priority for B
and the new information it yields.
The advantage of this structure is that it can often happen quickly without a need for
public disclosure as opposed to a sale of an interest, which would require possibly revealing
sensitive information in a data room to prospective buyers who may actually be data window-
shoppers. This can be changed and reversed farm ins/outs can be temporary.
The disadvantage of this structure is that although the group normally has to agree, this
can cause difficult dynamics in a development group if all members are not happy with the
choice of new entrants.
As for the tax treatment, clarification is need. There have been debates in the UK about
capital allowances and companies farming in.
Net profits interest

The net profits interest structure is more commonly seen in the US oil and gas, where it arose
because landowners might not be interested in oil and gas development but still want to
retain ownership. There are a few examples of this structure in early UK North Sea financing
452

by smaller UK companies. However, this is the structure that has been widely adapted for
use in other contexts. The owner of an asset essentially leases it to another party so that
the asset can be exploited, in return for an interest in the profits after pre-agreed costs have
been recovered. Variant forms of this structure appear in concession agreements and also in
some host government mineral exploration and development contracts. It can also appear
as a carve out of a working interest.
For example, A owns a farm under which is believed to be significant oil reserves. As
family has owned the land for generations and A does not wish to sell it. Instead, A leases
the mineral rights for 10 years to B in exchange for a net profits interest of 10%. Each year,
for 10 years, A receives a 10% participation in the net profits of the oil and gas activity.
Note A does not share the losses.
The advantages of this structure are that:
A is able to benefit from the mineral exploitation without any investment;

the asset reverts to A at the end of the lease period; and
provided the lessee is knowledgeable and experienced, this is an attractive investment.
The disadvantages are:
B gains most of the tax allowances and A is limited to those allowances associated with
the net profits interest A holds but this may vary from country to country, especially
where there may be specific tax treatment for oil and gas related revenues;
B might enhance the expenses, often a potential cause of bickering in deals of this type.
if B is bankrupt, A may find they have another neighbour, depending on how the contract
is drafted; and
if B is bankrupt or fails to observe best practice, A may face significant clean up costs
to reuse the land.
5 Limited partnership drilling funds

Limited partnerships have long been an important source of funds for exploration and devel-
opment of mineral properties. A great variety of limited partnership structures are used in
the US and use of this approach has been attempted elsewhere in different industries. Some
of these structures are discussed in this chapter.
It should be noted, however, that limited partnership drilling funds became popular as
tax shelter investments for individuals. This unfortunately resulted in some poorly structured
funds which were aggressively sold by securities dealers and promoters throughout the
United States. The collapse in oil and gas prices as well as incompetence resulted in many
individuals realising nothing but tax losses on these schemes. Legitimate limited partnership
drilling funds continue to be a potential source of capital, despite this bad experience of a
few bad apples.
453

Project Financing
Example of a limited partnership drilling fund

A sponsor seeks capital for exploration and development by forming a limited partnership within
which the sponsor acts as general partner and individual investors are sought as limitedpartners.
Under this arrangement, limited partners pay all non-capital costs which can be deducted
for tax purposes immediately. The general partner pays all capital costs. Since the non-capital
costs (intangibles) are incurred in exploration and drilling the well, much of the risk of the
success of the venture is on the limited partners. The general partner is liable only for capital
expenses and these will not be incurred until the drilling is completed and tests indicate the
likelihood of production.
The general partner is entitled to a stated share of revenues from the well even though
amounts which the general partner contributes for capital expenditures constitute a lesser
percentage of total expenditures; examples may include up to 40% for the general partner
Exhibit 28.9
Limited partnerships to finance exploration and development
Partnership
agreement
Limited General Limited

partners partner partners
Funds for Funds for Funds for

non-capital capital non-capital
intangible expenses intangible
expenses expenses
Operating
funds
drilling
partnership
454

and therefore 60% for the limited partners. This may include additional remuneration for
the general partner for success fees and so on. An example is shown in Exhibit 28.9.
A typical project would be exploration and development of oil and gas wells, especially
in the US and Canada, though forms of this structure also exist in other countries such as
Norway and in other industries such as shipping. This was also discussed in Chapter 27.
Income tax: income tax benefits may be allocated in a partnership. In a typical limited
partnership the limited partners pay and claim deductions for non-capital expenses
(intangible) which are immediately deductible. The general partner pays the capitalised
costs and claims ITC and depreciation.
There may be limits such as a requirement for a general partner to have at least 1% of
every item of partnership income, credit, gain, loss or deduction, and that the aggregate
tax deduction in the first two years of a limited partnership should not exceed the equity
capital invested.
Debt rate and balance sheet: each partner raises its own capital. The liability of each
limited partner is limited to its investment or subscription if it does not participate in the
management of the partnership.
A general partner does not incur liability until wells are drilled and prospects look
good. This concept enables a drilling company to develop properties with most of the
risk of opening new wells on the limited partners.
The following are four variations of the limited partnership structure.
Two-tier partnerships: the two-tier partnership consists of a general partnership which invests
in a limited partnership as a limited partner. In a limited partnership, the names of individual
investors often have to be disclosed under recording statutes. This is not required for general
partnerships. Hence, the general partnership is used to keep the names of investorsconfidential.
Leveraged investment by limited partner: in this type of arrangement, a limited partner
pays only a portion of the subscription price in cash, and finances the rest by borrowing
from a bank under a loan arranged by the partnership. This bank loan is generally backed
by a letter of credit issued by the investors bank for the benefit for the lending bank.
Leveraged production payment loans: a loan may be arranged by the limited partnership
against the properties owned or operated by the limited partnership for the development
stage of a property. The loan is a production loan, secured by reserves and proceeds
from sales of production. The loan is non-recourse to protect the general partner. (The
general partner probably cannot directly or indirectly guarantee or provide the debt.) Such
non-recourse leverage provides more capital and permits more drilling. On the other hand,
the investor has the risk of dry holes, the additional burden of debt service, and the risk
that foreclosure will result in taxable income from forgiveness of indebtedness.
General partnership: a general partnership may be used in place of a limited partnership.
Corporate general partners can limit their liability by using subsidiaries with limited capital
as partners. Names of general partners do not have to be disclosed as is sometimes the
case under limited partnerships. Limited liability companies with partnership characteristics
can also be used.
455

Project Financing
The advantages to the general partner are:
1 the general partner raises capital needed for exploration and drilling without recourse to
themselves and with no impact on their balance sheet or loan agreements. Only when
it appears the project will be successful does the general partner make their investment,
and then they receive a share in production disproportionately large to their contribution
(which is compensation for their contribution of technical skill);
2 without such financing, the general partner might be unable to raise needed capital;
3 a new source of funds in the form of investments by individuals; and
4 financing costs are lower than a direct loan because individual partners can claim
tax benefits.
This is an area for specialist legal and tax advice.
Discussion of special tax problems in oil and gas limited partnership

drilling funds
In a typical limited partnership formed for the purpose of developing oil and gas wells, the
limited partners pay and claim deductions for most non-capital expenses which are imme-
diately deductible and which include intangible drilling costs. A general partner pays the
capitalised costs and claims tax depreciation.
Under tax laws where these structures flourish, partnerships are generally permitted to
allocate shares of partnership income and loss to different partners. However, the tax authori-
ties may disallow special partnership allocations if the principal purpose of such allocations
is the avoidance of tax.
The limited partnership drilling fund constitutes an important method of raising capital
for oil and gas exploration. The structures developed may have application for developing
other extractive resources. Although the drilling limited partnership structure has been used
for many years as a method of raising capital for development of oil and gas wells, recent
changes in tax regulations in the US have resulted in some changes.
Care must be used to structure the limited partnership so that it will qualify as a part-
nership for tax purposes. Among the differences are (and these vary in different countries):
mode of creation (intent may not be enough) and separate legal identity and written agreement;
independent existence from its owners;
continuity of life;
centralised management;
limited liability; and
free transferability of interest.
The most important thing to remember is that unless limited partners stay passive (or there
is specific legislation that permits them to take an active interest) they may lose their advan-
tageous tax status and incur liability for the partnerships obligations.
456

In addition to characteristics which distinguish a partnership from a corporation, a

limited partnership must have certain operating characteristics for the tax authority to rule
that an organisation is a partnership for tax purposes.
6 POGO2 type plans: financing offshore exploration through a newly

formed controlled subsidiary
The sponsor desires to raise funds for financing offshore exploration. The sponsor forms
a subsidiary corporation with two classes of stock, and purchases all the class A voting
common stock. The subsidiary then sells units consisting of class B non-voting stock and
subordinated debentures convertible into the class B stock. The sponsor retains over 80%
voting control through class A stock. If there is a default by the subsidiary on payment of
principal or interest on the debentures, they are convertible into the sponsors stock based
on the then current market value.
The sponsor files consolidated tax returns during the early years to get the benefit of
operating losses generated by the subsidiary. Later, the distinction between class A stock
and class B stock ends and voting control is reduced to 40% at the time the subsidiary is
expected to generate profits.
A typical project would be gas, oil, or mining exploration, where prospects are favour-
able enough to permit the sale of securities an example is shown in Exhibit 28.10.
Income tax and debt rate: the sponsor gets deduction of early expenses through 80%
ownership control. The debt rate is a function of the markets acceptance of thesecurity.
Balance sheet: it appears on the balance sheet as a consolidated subsidiary during the
start-up period. Debt of the subsidiary will then show on the parents balance sheet. A
one-line reporting of investment after reduction in ownership is shown. The conversion
feature will dilute per-share earnings of parent.
Loan covenants: must have freedom to form and contribute substantial capital to a
new corporation.
Advantages to sponsor:
obtains tax deductions in early years;
financing is off-balance sheet, after control is reduced to less than 50%;
financing is non-recourse except for possible conversion;

the project as carried on by the controlled subsidiary might be too large for the sponsor
to undertake using its own resources.

Disadvantages to sponsor:
possible conversion dilutes earnings per share of sponsor;
debt of the subsidiary is consolidated for financial accounting purposes during the time
that 50% control is retained; and

obligations of the sponsor must be disclosed in a footnote to the balance sheet.
457

Exhibit 28.10
POGO plan
Sponsor
1 Class A stock 1 Nominal

80% voting capital
control
3 In the
event of default, a Controlled subsidiary
conversion right into US$130 million capital
sponsors stock
2 Purchase price
2 Convertible of stock and
2 Class B stock
debentures debentures
US$130 million
Public
Continued

Summary
1 The sponsor forms a subsidiary and provides nominal capital to obtain 80% of the class A votingstock.
2 The controlled subsidiary sells units consisting of class B non-voting stock and convertible subordinated
debentures (convertible into class B stock) to raise US$130million.
3 If there is a default by the subsidiary on payment of principal and interest on the debentures, they are
convertible into the sponsors stock based on the then current marketvalue.
7 Combination of POGO-controlled subsidiary and limited partnership

A sponsor may try and raise funds for offshore exploration using the POGO approach,
but in a manner whereby the subordinated debt will not show up on its balance sheet. The
sponsor forms a corporation which sells units to the public consisting of stock and subor-
dinated debentures. The sponsor does not retain ownership of any stock or debentures. The
subsidiary then becomes a limited partner in a partnership in which the sponsor is the general
partner. Under the partnership, the sponsor provides funds for exploration and development
and is entitled to the tax deductions for such expenses.3
The debentures have a bail-out feature which permits the debenture holders to receive cash
or sponsors stock in the event of a default on the debentures. The sponsor also guarantees
the interest on the debentures. A typical transaction would be an oil or mining exploration
where the prospects are favourable enough to permit sales of securities (see Exhibit 28.11).
Income tax, debt state and balance sheet: sponsor deducts exploration and development
expenses. The debt rate is a function of the markets acceptance of the security. Debentures
of the subsidiary are not on the sponsors balance sheet. The interest guarantee is a
contingent liability to the sponsor. The conversion feature dilutes the stock of thesponsor.
Advantages:
the sponsor obtains tax deduction in the early years;
the financing is off-balance sheet except for possible conversion or guarantee in the
event of default which must be disclosed in a footnote;


the project as carried on by the controlled subsidiary might be too large for the sponsor
to undertake using its own resources.

Disadvantages:
possible conversion dilutes earnings per share of the sponsor; and
obligations of the sponsor must be disclosed in a footnote to the balance sheet.
459

Exhibit 28.11
POGO-type subsidiary and limited partnership
1 General
partnership
Sponsor contribution for
deductible
expenses
Partnership for
offshore
exploration
1 Limited
3 Bail-out for
partner
cash or stock if Controlled subsidiary
contribution of
debentures US$130 million capital
US$100 million
default
capital expenses
2 Purchase price
2 Convertible of stock and
2 Stock
debentures debentures
US$100 million
Public
Continued

Summary
1 Sponsor enters into a partnership agreement with a controlled subsidiary; the sponsor is a general
partner claiming deductible expenses and the controlled subsidiary is a limited partner claiming
capitalexpenses.
2 The controlled subsidiary raises capital of US$100 million by issuing stock and convertible debentures to
the public. The capital contribution by the limited partner is used for offshoreexploration.
3 The sponsor agrees to bail out the debentures for cash or its stock in the event that the
debenturesdefault.
1
A comparative study of different international approaches defines proven mineral reserves: proved mineral reserves
are the economically mineable part of a measured mineral resource. A probable mineral reserve has a lower level
of confidence than a proved mineral reserve. See, Vaughan, WS, and Felderhof, S, International mineral resource
and mineral reserve classification and reporting systems, paper prepared for and presented at the 48th Annual
Rocky Mountain Mineral Law Institute, Lake Tahoe, Nevada, 2426 July 2002, p.10.
2
POGO is an acronym for Pennzoil Offshore Gas Operators, Inc, which originated the POGO plan financing
offshore exploration. The POGO structure served as a model for several similarly structured companies.
3
This was essentially a Tenneco Offshore Company financing.
461

Project Financing
Chapter 29
Restructuring
The same techniques that apply to a project financing of a new road, factory, or gas devel-
opment can also be used when contemplating corporate restructuring. Once again there
should be a distinct cash flow, a bundle of assets and a risk environment and a network of
contracts. In this chapter, we will consider how techniques from project financing are used
in corporate restructuring. Different regulations about the use of assets to support corpo-
rate restructuring debt apply in different jurisdictions so whilst some systems may allow the
acquirer to use the assets of the proposed acquisition to support the financial package to
make the acquisition, this is not always permitted.
1 Asset sales, acquisitions and mergers

As part of their stewardship obligation towards shareholders or stockholders, the manage-
ment of companies should always be alert to opportunities to restructure activities to enhance
shareholder value including disposing of properties or operations that do not have the growth
and profit potential offered by alternative new project opportunities, and acquiring and inte-
grating new sources of revenue into their businesses. The present value of the potential cash
flow from properties under consideration for disposal should be compared with the present
sale value of such properties in a continuous dynamic review process. The effect upon the
balance sheet, debt service, interest coverage and ratios should be considered. Apart from
improving the working capital and financial statement by such disposals, management time
may be freed to work on more productive ventures and significant reductions in the selling
companys overheads may add to the gain. Getting rid of marginal operations is not an easy
task, but few successful companies tolerate marginal operations where the same capital can
be better employed elsewhere.
A merger or an acquisition of companies or properties for stock or cash can sometimes
be used as a method of improving the overall financial strength of the acquiring company
through economies of scale or scope. A merger results in a single legal entity being created;
an acquisition retains the discrete nature of one company as it enters the corporate struc-
ture of another. Both may use forms of project financing: depending on local regulations,
properties of the acquired company may be used as collateral for additional borrowings.
The balance sheet of the acquiring company may be substantially improved and the overall
borrowing capacity of the combined companies or properties greatly increased as a result
of economies of scope and scale.
Acquisitions of the interests of other parties in joint venture projects of the acquiring
company may sometimes be accomplished by stock securities with warrants rather than cash.
The borrowing capacity of the project may then be improved as a result of greater concen-
tration of control in one party. Bookkeeping, management and overhead expenses may be
462

Restructuring
saved as a result of elimination of partners or investors in projects by the primary owner or

sponsor. The management of a project with a large number of partners with relatively small
shareholdings can incur significant co-ordination costs, especially if the partners disagree. As
mentioned in Chapter 28, in some oil and gas projects where there were larger numbers of
smaller local participants, once the project matured, the numbers of partners fell in order
to speed up decision-making processes and lower co-ordination costs.
The subject of sales of properties or mergers and acquisitions is a broad one, mentioned
briefly in this chapter because it merits consideration along with other alternatives.
2 Leveraged buyouts of companies

Leveraged buyouts (LBOs) and management buyouts (MBOs) of companies and divisions
of large companies are often accomplished as fairly pure project financings in which lenders
are willing to advance funds for the purchase of a company or division on the basis of the
projected earnings before interest, taxes, depreciation and amortisation (EBITDA) cash
flows available to service debt, the security of the underlying assets and personal guarantees
from the key individuals concerned.
In many LBOs or MBOs the equity funds provided by the managers or promoters are
fairly modest as compared with the funds required for the acquisition.
In some MBO cases this modest capital contribution is justified by the unique expertise
of the management team and the sweat equity they will contribute to making the company
successful. These are typically buyouts of large company divisions that no longer fit in the
parents strategic plans, but other MBOs may be buyouts by employees of closely held
companies owned and controlled by individuals who, because of old age or other reasons,
are retiring from the business. (The term LBO is used hereafter to refer to both LBOs and
MBOs.) The modest equity requirement is also a form of recognition of the astuteness of
the sponsor purchasers in locating an acquisition with characteristics which permit an LBO
with advantages for all parties to be structured so that lenders provide most of the cash
required for the acquisition. The willingness of the seller to provide financing subordinate to
other lenders will have a material effect on structuring especially if seller or vendor financing
takes the form of subordinated equity (as opposed to subordinated debt).
Essential to a LBO is an excellent incoming management team who will be mainly
concerned with reducing debt to more easily manageable levels. Lenders to LBOs do not
want an empire builder in charge, or to be dependent on a single individual for the proj-
ects success. In practice, many LBOs are structured with insider management and external
investors combining talents and expertise to structure a successful LBO, when they are also
known as buy-in management buyouts (BIMBOs).
Leveraged buyout structures are used by companies, private investors and managers of
spun-off companies to finance acquisitions. Typically, those purchasers have limited financial
resources and need to maximise the leverage of their capital through projected free cash
flows (EBITDA) and/or using asset-based financing techniques, using the acquired assets as
security, where this is possible.
The usual ingredients for a leveraged buyout are:
463

Project Financing
1 the unit to be acquired must have a consistent history of positive cash flow;
2 the assets of the borrower (including value as a going concern) must have a liquid value
which exceeds the amount of the senior debt;
3 the lender must be able to monitor the cash flow and the changing value of pledged
assets during the loans;
4 the incoming management must have substantial experience in the business areas of the
LBO target; and
5 the incoming management needs to be sufficiently incentivised whilst allowing the major
financiers the ability to take control should things go wrong.
Cash is king
Cash is king in structuring LBOs, since they are often fairly typical project financings in
which the acquisition debt is to be serviced and retired from the cash flows generated by
the business.
Cash projections (EBITDA) and financial projections are discussed in Chapters 2, 4, 5
and 8. These projections and their robustness to change and their validity under close scru-
tiny, comprise the most important information in analysing, entering into or lending to a
LBO. Special attention must be paid to contingencies as well as known future requirements
(capital expenditures and debt service) and their impact on the expected future cash flows.
An equity investor with a deep pocket and a reputation for supporting investments in
the case of difficulty is comforting to lenders. An equity investor with little in the transac-
tion (except its own fees perhaps) is less comforting because of the lack of an equity stake
and the inability or reluctance such an investor may have to inject new capital should the
need arise. Lenders are not being paid for the equity risk and do not want to be forced to
assume that risk.
Debt structures
Simply stated, the capital and debt structures in LBOs and MBOs usually fall into the
following pattern:
equity (common stock);

subordinated debt (mezzanine debt);
senior secured debt; and
working capital loan.
These were discussed in Chapter 10. In some cases there may be a bridging loan for the
acquisition or buyout that would be the subject of a refinancing package once control of
the assets had been gained. There are risks associated with bridging loans, especially when
there may be expectations of partial repayment from asset sales. There have been examples
of such loans being adversely affected because the market for the proposed asset sales has
declined as a result of events in the external environment, leaving the undercollateralised
lenders in an unhappy position.
464

Restructuring
The capital debt structure of a typical LBO or MBO typically may involve several tiers
of debt or equity, such as the following:
common stock;
preferred stock;
subordinated debt (with warrants for common stock);
subordinated debt;
senior secured bank debt;
asset-based finance (inventory and accounts receivable);
equipment leases;
working capital debt; and
trade credit.
These financial instruments were discussed in earlier chapters. Needless to say, debt structures
in LBOs and MBOs are limited only by the imagination of the sponsor and the appetite of
the market for such financial instruments.
Senior debt
The senior debt for a LBO (like most project financings) is usually subdivided further into:
secured debt;
unsecured debt (with a negative pledge) or a subordinated loan; and
revolving loan for current needs including working capital.
The providers of senior debt for LBOs are usually banks or insurance companies or finance
companies. Such senior debt often has the following characteristics:
historically for a term of four to eight years, sometimes split into tranches some of which
may have a balloon payment. More recent deals have been for shorter periods reflecting
a significant refinancing debt overhang in the US markets;
interest may be fixed or floating;
the senior debt comprises around 70% of the capitalisation;
the lenders do not get an equity kicker;
the risk is palatable to cash flow lenders not balance sheet lenders; and
the senior debt has financial covenants which ensure cash flow will be used to retiredebt.
Revolving loans are for working capital and current needs rather than for the acquisition
of assets. A revolving loan is often secured by current assets of the acquired unit, such as
accounts receivable and inventory.1 The amount of the loan is based on a percentage of the
face value of current assets which represents their quick liquidation value. Since the amount
of the inventory and accounts receivables varies with seasonal and other factors, the amount
of the revolver varies. The loan can increase as well as decrease. There is no amortisation
465

Project Financing
schedule and the borrower pays down the loan as business conditions permit, unless the
collateral base value falls.
A revolver which automatically renews each year is called an evergreen revolver. If
a revolver is not renewed, the balance is typically then paid over a period of time like a
short-term loan.
Junior and subordinated debt

The junior debt (mezzanine financing) for LBOs is usually a smaller layer of capitalisation
consisting of up to 20% of total capitalisation (though this has not always been the case).
Such debt is provided by finance companies, risk capital companies, asset-based finance divi-
sions of banks or insurance companies. It may also be provided by the selling company and
perhaps be payable out of future earnings.
Junior debt is subordinated, and may hold a residual claim on any security as the senior
debt is paid down. This debt generally has the following characteristics in a LBO.
The debt is subordinated to senior debt but not necessarily other debt.
For a term of six years but has historically been longer.
Now likely to include warrants, payments in kind or to be convertible to common at an
attractive price.
Carries a higher interest rate than senior debt.
May be zero coupon or stripped interest instruments.
Interest may be fixed or floating.
In large LBOs, publicly issued so-called junk bonds have been used to finance such acquisi-
tions. These bonds are more preferable to the promoters of the LBO because:
they do not contain restrictive covenants such as would be required in private placements;
the interest rate requirement is low in relation to the risk; and
often, equity kickers such as stock warrants or convertible features are not required.
US savings and loan associations have been big buyers of these bonds with mixed success,
and anecdotal reliance upon the presence of senior lenders to monitor the borrowers current
and future viability.
Equity
The equity in a LBO is common stock purchased by the promoters the key executives
and managers or the ultimate owner if it is a company acquiring the target company. In
a LBO the equity may be only 10% or less of real capitalisation. There can be different
classes of equity designed to meet different investor requirements, but simple structures
minimise co-ordination costs.
In recent years, there has been a proliferation of large investment funds formed for the
purpose of investing equity in LBOs.
466

Restructuring
Collateralised loan obligations

The repackaging and bundling of leveraged buyout debt into collateralised loan obligations
(CLOs) to generate liquidity for banks has raised some concerns about the underlying asset
values and the difficulty in ascertaining them. CLOs were discussed in Chapter 22.
Project finance structures used in LBOs

There are two basic structures which might be used for leveraged buyouts. In the first
structure, the purchaser arranges for the acquired entity to be housed in a subsidiary. In the
second structure, the acquired entity is merged into the acquiring company. In either case,
an asset-based financing can be used but the focus must be on cash flow to repay debt.
Leveraged buyout housed in a subsidiary

This structure is shown in Exhibit 29.1.
1 Purchaser and seller agree to a purchase of a division of seller.

2 At a simultaneous closing, the following events take place:
the bank and subsidiary sign an asset based loan and security agreement which covers
the acquired assets;

loan proceeds are advanced to the subsidiary by the bank;
the subsidiary pays a dividend (or makes a capital distribution) to the purchaser; and
the purchaser:
makes an equity investment in the subsidiary; and
pays the purchase price to the seller.
The seller transfers the assets of the division being sold to the subsidiary. (If a subsidiary
of the seller had been sold, the stock of the subsidiary would have been transferred to
the purchaser.)
Leveraged buyout in which the acquired subsidiary or division is merged into

the acquiring corporation
1 The seller and purchaser enter into a contract whereby the purchaser is to acquire sellers
subsidiary or division for a price.
2 At a simultaneous closing, the following events take place:
the bank and subsidiary sign an asset based loan and security agreement, which covers
the acquired assets as well as other assets of the purchaser;

the loan proceeds are advanced to the purchaser by the bank;
the purchaser pays the purchase price to the seller; and
the seller transfers title to the stock and/or assets to the purchaser.
467

Exhibit 29.1
Leveraged buyout housed in a subsidiary
Seller of
division
6 Purchase 1 Transfer
price for of assets of
acquisition division
4 Asset-
2 Transfer based loan and
of ownership security agreement
of stock
Subsidiary
corporation of Bank
purchaser
1 Agreement
to purchase 4 Loan
division proceeds
5 Dividend 3 Equity
or capital investment
distribution
Purchaser
Continued

Restructuring
Summary
1 The seller agrees to the sale of a division to purchaser. The assets of the division are transferred to a
subsidiary ofseller.
2 The stock ownership in subsidiary is transferred by seller to owner, subject to receipt of purchase price (a
simultaneous closing).
3 Purchaser makes an equity investment in thesubsidiary.
4 The subsidiary borrows funds from a bank sufficient to cover the purchaseprice.
5 The subsidiary pays a dividend or makes a capital distribution sufficient to pay the purchase price to
thepurchaser.
6 Purchaser pays the seller the purchase price (all this occurs at a simultaneous closing).
Retention of key personnel

The purchasers in any leveraged buyout should be concerned to retain the key management
of an acquired company. Typically this problem is addressed by making the key members
of management become committed stakeholders with a piece of the action either through
founders stock, options for stock and/or incentive plans based upon a share of the profits.
Valuation of an acquisition
Appraisals can be very complex and involve everything from the value of underlying fixed
assets, intangible assets, stock multiples of similar companies to discounted cash flows. Such
appraisals are all very instructive and valuable in reaching an investment or lending decision.
However, arriving at a value for a company or a division being acquired in a LBO or MBO
is usually directly related to EBITDA. The initial question an investor or lender usually asks
is: What is the price multiple of free cash flow (EBITDA)?
Different industries or lines of business support different multiples of cash flow. A compar-
ison of multiples for similar companies is obviously very important in determining the value of
a company targeted for acquisition. Also, such factors as prevailing interest rates at the time
of an acquisition as well as general economic conditions will affect the free cash flowmultiple.
The liquidation value of the fixed assets in a forced sale is very important if such assets
have significant value.
Due diligence in the analysis of a proposed acquisition

Investors or lenders to a LBO or MBO acquisition that is being financed largely as a project
financing dependent upon future cash flows to service interest and repay debt, must conduct
a thorough due diligence investigation of the company. This investigation supplements, and
must support and be consistent with, the financial projections for the entity proposed to
be acquired.
If the entity proposed to be acquired or financed has had a previous history as an
independent entity, the due diligence and credit examination falls into a familiar pattern.
469

Project Financing
If, however, the acquisition has been operating as a division or subsidiary with overlapping
accounting and accountabilities, the task is more difficult.
The following is a sample due diligence checklist for the analysis of a prospective acqui-
sition. Not all items on the list will be available or appropriate in many cases. However,
where an item is not available that fact should be noted along with the reason it is not
available. It obviously is not possible to construct a checklist applicable to all circumstances,
so additional items to the example checklist are certainly appropriate in each case. The list
is only intended as a starting place for construction of a due diligence questionnaire which
must be tailored to a particular acquisition situation.
Industry reports and analyses

1 Industry reports, normally provided by external experts, describing prospects for the
relevant industry and markets.
2 Recent analyses of the company or any subsidiaries and their business prospects, prepared
by investment bankers, engineers, management consultants, accountants or others, including
market studies, credit reports and other types of reports, financial or otherwise.
3 Detailed list of all competitors and strategic and financial analyses as well as estimated
market share for each.
Corporate documents
1 Charter documents for all group companies.
Certificate of incorporation, as amended to date.
Bylaws.
Long form good standing and tax certificates in state of incorporation.
List of jurisdictions in which each company is qualified to do business or is
otherwise operating.
Form of stock certificates.
2 Corporate minutes and related materials for the last five years.
Minutes of board of directors meetings.
Minutes of shareholders meetings.
Minutes of committees of the board of directors.
Materials (including financial projections) distributed to members of board of directors
and committees thereof in connection with meetings.

3 Loan and other financing documents.
All documents and agreements evidencing borrowings, whether secured or unsecured,
including loan and credit agreements, promissory notes and other evidence of
indebtedness and all guarantees.
Bank letters or agreements confirming lines of credit, including covenants thereto.
Loans and guarantees of third party obligations.
Credit agreements and indentures.
Correspondence with lenders or providers of funds, including all compliance reports
submitted by the company or its independent public accountants.
470

Restructuring
Trade financing agreements including letters of credit or other instruments.

Islamic financing arrangements made by the group or individual company members.

Any off-balance sheet or project financing arrangements entered into by any group
members or related or associated companies.

4 Lease agreements.
Financing leases and sales, and lease-back agreements.
Conditional sale agreements.
Equipment leases.
Correspondence with landlords.
5 Capital stock.
Securities authorised and outstanding.
Covenants of preferred stock, if any.
Agreements relating to the purchase, sale or issuance of securities, includingwarrants.
Agreements relating to voting of securities and restrictive share transfers.
Agreements relating to pre-emptive rights.
Shareholder list indicating ownership by class of stock of all shares of the company.
Agreements relating to registration rights, if any.
6 All patents, trademarks, copyrights, licenses and other intellectual property rights and
applications therefore and assignment and ownership documents relating thereto held
by the company or its employees.
7 Personnel.
Employment contracts.
Consulting contracts.
Contracts with unions, including collective bargaining agreements.
Loans and guarantees to directors, officers or employees.
Employee benefits, including vacation pay and severance policies.
Employee stock option plans.
Employee size, turnover, absentee history and distribution reports.
Personnel manuals.
8 Pension fund related data (for example, ERISA if applicable).

Pension and profit-sharing plans.
Multi-employer plans.
Deferred compensation plans.
Other employee benefit plans.
Actuarial valuation reports for the last three years for each pension plan including
multi employer plans, to which the company currently contributes.

Any estimates of withdrawal liability that have been performed for the company that
relate to multi-employer plans.

Current listing of benefit changes adopted or intended to be adopted by each of the
pension plans since the last actuarial valuation.

Audited financial report for the last two years for each pension plan.
List of any non-qualified pension plans or employee compensation agreements showing
the individuals covered, a description of the benefits provided, and the actuarial
methodology and assumptions used for expense purposes.
471

Project Financing
Census of all employees showing date of birth, date of hire, sex, job classifications

and current salary.

Defined contribution plans including audited financial report (for two years) and results
of any tests performed for top-heavy status determination.

9 Management salaries, bonuses and incentive pay.
10 Organisation chart.
Management structure.
Officers and directors.
A complete map of the current group structure showing all subsidiaries, affiliates and
associated companies and detailing the relationships between the different entities.
11 Status of legal proceedings.
Schedule of all material pending litigation.
Litigation, claims and other proceedings settled or concluded.
Litigation, claims and proceedings threatened or pending.
Consent decrees and injunctions.
Regulatory compliance.
Questionable payments.
Attorneys letters to auditors.
Environmental proceedings not covered elsewhere.
12 Compliance with laws.

Citations and notices received from government agencies.
Pending investigations and governmental proceedings.
Government permits and consents including Environmental Protection Agency, United
States Department of Agriculture, state, local or foreign government regulatory

approvals or applications for such approvals.
Reports to and correspondence with government agencies.
13 Real property.
Deeds.
Leases or subleases of real property.
Zoning variances.
Easements, restrictions and other encumbrances.
Recent property surveys.
Title insurance policies.
Legal description of all real property owned.
14 Sales and marketing and contracts.

Sales commission plan, if any.
Sales allowance and return policies
Warranty or consignment policies.
Other agreements, as applicable.
Marketing agreements, including sales agent, dealer and distributor agreements,
original equipment manufacturer (OEM) agreements and pricing agreements.

Government contracts and subcontracts.
Supply agreements.
Purchase and requirements contracts.
472

Restructuring
Joint venture and partnership agreements.

License agreements.
Franchise agreements.
Management, service and tax sharing agreements.
Construction agreements and performing guarantees.
Advertising agreements.
Agreements associated with acquisition and disposition of companies, significant
assets or operations.
Secrecy, confidentiality and non-disclosure agreements.
Commission, brokerage and agency agreements.
Contracts outside the ordinary course of business.
Samples of forms of purchase orders and invoices.
Indemnification contracts and similar arrangements for officers and directors.
Intercompany documents relating to the relationship and conduct of business among
the company, its corporate parent or significant shareholders and any subsidiary or
affiliated companies, and any of their divisions, departments or affiliated entities.
Agreements with insiders including interested director transactions and stock options
granted to officers and directors.

Form of product warranties of the company.
All other agreements material to the business of the company.
Schedule of major suppliers and customers, setting forth annual dollar amounts
purchased or sold.
Structure of purchasing organisation, purchasing practices and accountability.
Insurance
1 Personal property.
2 Real property, including hazardous waste and flood, if required.
3 General liability.
4 Business interruption.
5 Workers compensation.
6 Product liability.
7 Key man insurance.
8 Automobile insurance.
9 Loss experience for the last three to five years for property, general liability, business
interruption, workers compensation, product liability, automobile fleet and any other
insurance coverage.
Group insurance and welfare benefits

1 Comprehensive listing of all welfare/insurance programs including post-retirement life and
health insurance, if applicable.
2 Summary plan description for all programs.
3 Descriptions of insurance financing arrangements for all programs.
473

Project Financing
4 Claim experience and premium history for the last three years for all programs.
5 Current listing of any medical claims in excess of, or anticipated to be in excess of a
limit such as US$50,000.
6 A separate listing of any non-qualified or executive medical reimbursement programs
showing the individuals covered and a description of benefits offered.
Environmental/OSHA compliance
1 A list of all waste treatment, storage or disposal sites relating to the operations of
the company.
2 Copies of any permits received under the Resource Conservation and Recovery Act (RCRA)
or financial compliance filings made there under.
3 Copies of any notices of violations or warnings received from any authoritative body.
4 Information as to generation of hazardous wastes as defined in Section 3002 of RCRA.
What kinds and where have these wastes been stored or disposed? What is the annual
volume of waste generated?
5 Written estimates, if available, of future expenditures for environmental programs and
their effect on the companys business (prepared for the internal purposes or filed with
governmental agencies).
6 Information about any accidents that have taken place in the last five years.
7 Information about policies and procedures adopted and testing schedules and reports for
compliance with industry and other health and safety codes of conduct and/or standards.
Product development
1 R&D cost by project for the last three years and projections for the next three years.
2 Sources of outside R&D funds including any joint venture agreements.
3 Complete list of any patents or trademarks held and registration details.
4 Information on expected intellectual property resulting from these activities.
Manufacturing inputs and costs

1 Five-year historical analysis of per-hour direct wage rate and fringe benefit cost.
2 Five-year historical analysis of manufacturing productivity by equivalent unit ofmeasurement.
3 Three-year historical analysis of components of fixed overhead and fixed burden rate.
4 Three-year historical analysis of components of variable overhead and variable burdenrate.
Financial information
1 Balance sheets and income statements for the last five years as included in the consoli-
dated financial statements of the company.
2 Quarterly balance sheets and income statements for the last two years as included in the
consolidated financial statements of the company.
474

Restructuring
3 Balance sheet and income statement for the most recent fiscal quarter as included in the
consolidated financial statements of the company.
4 Budget for current fiscal year.
5 The most recent available general ledger(s).
6 A chart of accounts.
7 Inventory valuation and pricing policies.
8 Accounts receivable analysis and aging as of the most recent practicable date.
9 Accounts payable analysis and aging, including trial balance as of the most recent
practicable data.
10 Most recent business plan of the company (that is, five-year plan) including projected
financial statements.
11 Copies of the calendarised business plans for the last three years.
12 Firm sales order backlog data for the last three years through the most recent
practicable date.
13 A copy of the accounting policy and procedures manual.
14 A summary of changes in accounting principles or estimates made in the last five years
that had the effect of increasing or decreasing earnings.
15 Copies of accountants management letter comments for the last three years.
16 Correspondence with independent accountants.
17 Reports and studies prepared by outside consultants on the companys business or
financial condition.
18 Reports and materials prepared for the board of directors or committees thereof.
19 A summary of all extraordinary and non-recurring expenses for the last five years.
20 A summary of bad debt experience for the last five years and most recent fiscal quarter
and managements explanation.
21 The most recent available aged inventory summary (preferably by location).
22 A summary of obsolete inventories written off during the last five years and
managements explanation.
23 A summary of book to physical adjustments for the last three years including
management explanations.
24 A fixed asset listing by location including date of acquisition, cost, useful life and
accumulated depreciation.
25 A summary by location of significant acquisitions and disposals of property, plant and
equipment for the last three years.
26 Appraisals of fixed assets or tax assessment valuations.
27 List of all material contracts in progress, including total contract price, costs incurred
to date, estimated cost to complete and estimated profit margin.
28 A list of all open sales and purchases commitments, including terms.
29 List of accounting costs of all land and buildings.
30 Three-years historical analysis of scrap factor or reject rate.
31 As of the most recent practicable date, an analysis listing the components of:
other income (expense);
prepaid expenses;
deferred charters;
475

Project Financing
other assets;
accrued liabilities; and
other liabilities.
32 An analysis of the following expenses for the past three fiscal years and the most recent
fiscal quarter:
warranties outstanding and claims history;
research and development;
advertising and promotion;
bonus and profit sharing;
pension and retirement benefit plans;
repairs and maintenance;
workers compensation; and
post-retirement benefit obligations.
Tax matters
1 Federal, state and local tax returns for the last three years for all corporate entities.
2 Audit adjustments proposed by the Internal Revenue Service or equivalent national taxa-
tion authorities and state and local tax authorities since 1986.
Projections
1 Assumptions underlying sales projections, including unit volumes and prices, product
line extensions or cutbacks, new product introductions, industry demand and projected
economic cycles.
2 Assumptions underlying cost of sales and gross profit projections, including raw material
costs, direct and indirect labour, and variable and fixed manufacturing overheads.
3 Assumptions underlying operating expense projections.
4 Assumptions underlying balance sheet projections.
Miscellaneous
1 Press clippings and releases relating to the company or its subsidiaries, if any, for the
past five years.
2 Copies of company newsletters, if any for a similar period.
3 List of all miscellaneous benefit programs including educational assistance, jury duty,
employee service awards, health care, housing, travel concessions, company discounts and
so on, including the approximate annual cost of each program.
4 Any salary administration studies that have been performed.
5 List of key employees who have left the company during the last five years.
6 Work safety reports that have been performed.
7 Any other documents or information which, in your judgement, are significant with
respect to the business of the company, or which should be considered and reviewed
in making disclosures regarding the business and financial condition of the company to
prospective investors.
476

Restructuring
3 Employee stock ownership plans

Employee stock ownership plans (ESOPs) are included in this chapter on restructuring because
they offer a way for employees to participate in and even fund projects. ESOPs are similar
to corporate pension and profit-sharing plans and trusts. In the US, ESOPs are controlled
by the Employee Retirement Income Security Act (ERISA) and in the UK by the Companies
Acts. The use of employee share ownership approaches has been slow outside the US, other
than in the UK, and the EU has launched several initiatives including four PEPPER (promo-
tion of employee participation in profits and enterprise results) reports spanning a 20-year
period. The latest report, PEPPER IV, published in 2009 suggests that whilst there is appears
to be reported increase in employee participation across the 27 EU member states, further
examination suggests this is limited to a small number of countries and also concentrated
in multinational companies. Increasing the adoption of employee ownership schemes will
require changing or developing new legislation and/or fiscal rules across the EU states and
in the education of employees.
An ESOP should be established by a company for the exclusive benefit of its employees.
The structure has a number of characteristics which make it an attractive mechanism for
accomplishing project financing objectives for a tax-paying sponsor. Specifically, ESOPs may
be used as the means of transferring ownership of closely held firms that for one reason or
another do not wish to go public, or cannot go public, or merge. The ESOP structure has
been used to achieve or assist in financing leveraged buyouts. An ESOP can also be used
to cash out individual shareholders, their estates and corporate shareholders in succession
planning, and may be used to fund acquisitions and to finance new projects.
There were 11,300 employee stock ownership plans in early 2010, according to the
National Centre for Employee Ownership website. Some are forms of stock plans, in which
the employers contribute stock into a trust for employees every year. The companies get tax
deductions for the value of the stock contributed. The employees do not make acontribution.
The others are leveraged ESOPs; the company sets up an ESOP that borrows money
to buy stock either from the company or on the market. The company contributes money
every year to the ESOP that uses the money to retire the debt. Both principal and interest
on ESOP loans are tax deductible. However, principal payments may be legally limited to
a percentage of the annual payroll, determined each year.
So, although ESOPs do not in themselves constitute pure project financing structures,
they can be used in some circumstances to accomplish objectives associated with project
financing (for example, obtaining the optimum use of a tax shelter and optimising leverage).
ESOPs differ from profit-sharing plans and trusts in a number of ways:
An ESOP may invest most of its assets in stock or property of its corporate sponsor,
whereas most pension and profit-sharing trusts are limited in the amount they may
invest in their sponsor company stock in order to offer employees diversification in the
underlying portfolio.
ESOPs may be permitted to leverage (borrow funds for) investments in the sponsor
company stock or other investments, something many pension and profit-sharing trusts
are not permitted to do.
477

Project Financing
Sponsors of ESOPs are permitted to contribute stock of the sponsor to the ESOP and
take a tax deduction equal to the fair market value of the stock contributed. Only cash
can be contributed to a profit-sharing trust.
Distributions by an ESOP to the employee participants must be in stock of the sponsor
company, whereas profit-sharing plans usually distribute cash.
An ESOP cannot create debt capacity which does not already exist. However, an ESOP for
a company paying tax may increase debt capacity or permit a much more rapid repayment
of debt out of pre-tax revenue.
Securitised ESOP loans

For example, a company using a conventional ESOP loan has decided to sell, say, 20%
of its stock to an ESOP with the purchase price payable over seven years. It borrows the
current value of that 20% stake and gives the borrowed funds to the ESOP to buy the
stock. The company then pays the loan over seven years (or a shorter term if the company
prefers). The shares of stock are allocated to employees as the loan is paid off. (An ESOP
loan can be either to the company setting up the plan or to the plan with a guarantee from
the company.)
A disadvantage is that the ESOP loan adds a significant loading of debt to the company.
While this may not be a problem for a privately held company, it may be a serious draw-
back for a public company due to the accounting treatment of ESOP debt. This requires the
ESOP debt to be shown on the companys balance sheet even though the ESOPs equity is
not shown until it is allocated.
Use of an ESOP to cash out a shareholder sponsor from a project company

A project company is owned either by an individual shareholder or a corporate shareholder.
The shareholder wishes to cash out their investment. The project company is profitable and
has a substantial payroll. In our example, the project company establishes an ESOP and
makes annual contributions to the ESOP equal to 25% of its payroll. The ESOP, in turn,
purchases the project company stock from the stockholder sponsor for its fair market value
and uses the proceeds from the cash contributions to pay for the stock.
The stockholder sponsor, thus, receives cash for their stock and pays capital gain tax
on such sale. Depending upon the amount of stock sold, the stockholder sponsor may retain
control over the project company after the sale is completed. The project company uses pre-tax
cash to contribute to the ESOP, whereas dividends paid directly to the sponsoring stockholder
would be after-tax and subject to ordinary income tax for an individual shareholder, or an
effective tax of about 8% when received by the corporate stockholder.
Had the stockholder sold stock directly to the project company, the transaction might
be treated as a dividend. If the sale was made to an outsider, anything less than majority
control might be difficult if not impossible to sell at a reasonable price. (See Exhibit 29.2.)
478

Restructuring
Exhibit 29.2
Use of an ESOP to cash out a shareholder
Project
company
1 Annual tax
deductible cash
contribution
ESOP
2 Purchase 2 Sale and

price for stock delivery of stock in
in project project company
company
Stockholder
in project
company
Summary
1 The project company makes an annual tax deductible contribution to its ESOP which is equal to 25%
ofpayroll.
2 The ESOP uses its cash to purchase stock of the project company from stockholders of the
projectcompany.
Use of an ESOP to divest a profitable division

The sponsor transfers the assets and operations of a profitable division to a newly established
project corporation in exchange for all of the stock of a project corporation.
The project corporation establishes an ESOP and makes annual tax deductible contribu-
tions in cash to the ESOP equal to 25% of payroll. The ESOP then uses the cash to purchase
project company stock from the sponsor. Further purchases of the stock held by the sponsor
can be financed through a bank loan by the ESOP and the pledge of the project company
stock as security. An example of this is shown in Exhibit 29.3.
479

Exhibit 29.3
Use of an ESOP to divest a profitable division
Sponsor
3 and 5 Sale of
project company stock
by sponsor to ESOP
for cash
4 Loan and
pledge of stock for
project company
1 Transfer of
assets and operations
from sponsor to project
corporation in exchange
for stock of project
corporation ESOP of
project 4 Loan
Bank
company proceeds
6 Loan
service
2 Annual tax
deductible
Project
contribution in
company
cash equal to
25% of payroll
Continued

Restructuring
Summary
1 The sponsor company establishes a project company by transferring assets and operations of one of its
profitable operating divisions to the project company in exchange for itsstock.
2 The project company establishes an ESOP and makes annual tax deductible contributions in cash to the
ESOP equal to 25% ofpayroll.
3 The ESOP uses cash to purchase stock in the project company from thesponsor.
4 The ESOP borrows from a bank using stock of the project company as security for theloan.
5 The loan proceeds are used to purchase additional stock of the project company from the sponsor
forcash.
6 The ESOP pays the loan fromearnings.
Use of an ESOP to acquire a project company or to increase stockholdings

in a project company with pre-tax dollars
The sponsor company desires to acquire or increase its stockholdings in a project company.
Once more the sponsor company makes a tax contribution to its ESOP, equal in this example
to 25% of its eligible payroll. The ESOP then uses such cash to purchase stock either from
the project company or from stockholders of the project company willing to sell their shares.
The ESOP then exchanges the acquired stock of the project company with the sponsor
company for sponsor company stock equal in fair market value to the project companystock.
Use of an ESOP to permit repayment of a bank loan by the ESOPs sponsor

company using pre-tax dollars
The project corporation needs US$1 million for plant expansion, and arranges a bank loan
for that amount. The project company makes annual tax deductible cash contributions to
its ESOP equal to 15% of its payroll. The project company then sells shares of its own
stock for fair market value to its ESOP for cash. The number of shares sold is such that the
entire annual cash contribution to the ESOP is used to pay for the shares in cash. The cash
received by the project company is then used to service the principal and interest payments
on the bank debt. An example of this is shown in Exhibits 29.4 and 29.5.
Disadvantages:
the project company repays bank debts with pre-tax dollars;
the project company claims interest deductions on the outstanding bank debt;
the project company is able to sell stock at fair market value for cash, whereas a sale
to a third party might be difficult to arrange;

the parent of the project company retains control;
over a period of time, the parent of the project company would lose control if this
practice continued; and

will the banks offer 100% finance on a back to back basis in todays climate?
481

Exhibit 29.4
Use of an ESOP to raise capital through a loan
Sponsor
parent
Stock
ownership
Project
corporation
2 Sale of stock in 2 Payment of 1 Annual deductible

project corporation US$1 million contributions equal
for US$1 million for stock to 25% of payroll
ESOP
(project
corporation)
3 Pledge 3 Loan to 5 Redelivery

4 Loan service
of stock in project ESOP for of stock when
on bank loan
corporation US$1 million loan repaid
Bank
Continued

Restructuring
Summary
1 The project company makes annual deductible contributions to its ESOP in cash equal to 25% ofpayroll.
2 The project company sells stock in the project corporation to its ESOP for US$1 million; the ESOP uses
the cash contributions it previously received to pay the project company the US$1 million purchaseprice.
3 The ESOP borrows US$1 million from a bank and pledges stock from the project corporation as security
for the loan. These loan proceeds are used to purchase additional stock in the projectcompany.
4 As future contributions are made to the ESOP by the project company, those funds are used to repay the
bankdebt.
5 The bank redelivers the pledged stock when the loan isrepaid.
Converting debt to equity in a leveraged buyout

Wesray used an innovative technique to solve a problem involved in selling a highly leveraged
company, Avis Inc, to an employee-stock ownership plan. Banks were asked to participate
in a one-day US$1 billion bridge loan. That loan was used to pay off Avis high coupon
debt and convert it to equity on Avis books.
Employee stock ownership plans can only buy stock. By converting the debt to equity,
the ESOP was then able to pay for the new, higher equity value of the company. In effect,
employee stock ownership plan financing with a lower interest rate was substituted for the
high coupon debt, lowering Avis debt service and allowing the employee stock ownership
plan to pay more for Avis than other possible buyers.
Downsides of ESOPS
1 Scale ESOPS are really only suitable for medium sized companies, not least because of the
expensive set up costs. Fees of close to US$100,000 to set the ESOP up are not atypical.
2 If an employee leaves, the ESOP has to buy the shares back at a fair price so the ESOP
needs to buffer its liquidity and not to expect significant downsizing of the parentcompany.
3 High profile bankruptcies may have associated ESOPS with poor financial management in
the minds of many people, conflating management of the operating company with employee
benefit losses because the ESOP owned the shares. This illustrates the need to have clear
separation of ownership and control and transparency in these structures.
4 Linked to the last point is the need to offer a clear explanation to all stakeholders but
especially employees about how the ESOP will work and their rights, benefits and any
obligations or actions.
1
Though a particular type of revolver structure, secured by a basket of oil and gas properties has also been used
in borrowing base loans (see Chapter 28).
483

Exhibit 29.5
Use of an ESOP to permit repayment of a bank loan
Bank
1 Bank loan 4 Payment of

US$1 million debt service
Parent Stock Project

company ownership corporation
2 Annual tax 3 Sale of shares

deductible cash of stock for price 3 Purchase price
contribution equal equal to annual for stock in cash
to 25% of payroll contribution
ESOP
Summary
1 Project company borrows US$1 million from abank.
2 The project company makes a tax deductible cash contribution equal to 25% of the payroll which is
approximately equal to the amount of the bankloan.
3 Using the cash contribution, the ESOP purchases stock of the project corporation forcash.
4 Project company repays the bankdebt.

Public-private partnerships and the private finance initiative
Chapter 30
Public-private partnerships and the private

finance initiative
An increasing number of project finance transactions are part of an initiative used by govern-
ments to look at better project contracting, delivery and operation through the use of a
partnership process between the government and private contractors and a special purpose
vehicle (SPV) company, similar to many other forms of project financing described in this
book. One of the attractions of this initiative has been its treatment on government balance
sheets in many cases it has been off-balance sheet and therefore politically expedient
because it has permitted the development of large projects without impacting on perceptions
of the governments overall borrowing requirement or indeed financial liabilities. Although
these arrangements have been used extensively in the UK where the concept originated, the
idea has been employed in other countries where tightening government revenues encouraged
the public procurement process to consider private finance and private sector approaches to
large projects.
In this chapter, we examine a number of forms of these projects and consider the advan-
tages and disadvantages of each. Before doing so, we provide two definitions.
A public-private partnership or PPP (P3 in the US) is generally considered to be a form of
agreement between a public agency or government department and a private sector organisa-
tion (or group of organisations) that exists to procure, build or develop a facility or service
and that shares risks and rewards between the public and private sector partners. These are
very often concession agreements to provide essential services but may sometimes take the
form of a privately funded project also known generically as a PFI.
The private finance initiative or PFI is a term that is generally considered to have origi-
nated in the United Kingdom in 1992, and was defined in a parliamentary research paper
dated 2001 as:
a form of public private partnership (PPP) that marries a public procurement program,
where the public sector purchases capital items from the private sector, to an exten-
sion of contracting-out, where public services are contracted from the private sector. PFI
differs from privatisation in that the public sector retains a substantial role in PFI projects,
either as the main purchaser of services or as an essential enabler of the project. It
differs from contracting out in that the private sector provides the capital asset as well
as the services. The PFI differs from other PPPs in that the private sector contractor
also arranges finance for the project.1
The major difference between a PPP and a PFI is that the former describes the overarching
approach used to assist in more efficient procurement or management of projects that may
485

Project Financing
be only partly privatised. Consequently, some or all of the asset ownership remains in public
hands, and the project is set up to operate the facilities through a concession. In contrast,
PFIs include fund raising for the project and usually a shift in ownership even if only
during the life time of the finance to the private sector. Nevertheless sometimes the terms
are used interchangeably.
So, for a PPP, the government or one of its agencies is the supplier of cash flow via
project service contracts with a government department or agency, or it may underpin project
revenues and thus could be seen as a lender of last resort inasmuch as politically it would
not be expedient for the project to fail. For a PFI, the government or its agencies may be
providing the cash flow, or it may be receiving revenues generated by the project.
1 Background and rationale for public-private partnering

The origins of public-private partnering go back to the early 1990s and a desire by the
then government of the United Kingdom to continue to outsource and privatise business
areas. With a major privatisation program largely over, attention focused on large govern-
ment capital projects where it was perceived that commissioning and procurement could be
improved by a transfer of knowledge from the private sector. In certain areas, particularly
defence programs, significant overspends attracted negative press comment. Initially, PPPs
focused on the design, construction, finance and operation of real estate projects for the public
sector one such project that was among the first was a new Treasury building. Subsequent
UK governments especially under the Labour administration expanded the initiative,
with one driver being the accounting treatment discussed above whereby these projects were
not included in the governments balance sheet. During this time, a range of projects were
completed including military housing, schools, hospitals and highway tolling projects. The
results, which were analysed by the UKs National Audit Office, suggest that the benefits
have not always accrued to the public purse, but maturity in this sector has also generated
standardised contract terms and a body of internal knowledge within the public sector.
More recently, the emphasis has shifted to energy and communication infrastructure
projects and the concepts have been adopted by countries outside the UK.
For example, three contrasting sewage projects in Hungary have included
different approaches.
1 In Budapest, a minority interest is held by the municipality but it also holds a golden
share that allows it to out vote managerial decisions made by the project company. The
majority partner was Suez-Lyonnais and the project included the physical assets of the
water company. Nevertheless, incremental projects were expected to be 100% owned by
the municipality.
2 In Debrecen, the municipality decided to incorporate a separate company and use public
funding and local suppliers which, the project claims, have kept costs down. The European
Investment Bank refinanced long-term commercial debt provided by two local banks and
the project also included UK PHARE funding, European Bank for Reconstruction and
Development (EBRD) funding and some other government money.
486

3 The third project at about the same time period was for Szeged. In this case the munici-
pality formed a majority-owned partnership with a foreign contractor (now known as
Veolia) and the facility was operated by a company with a 70% foreign ownership. This
arrangement has been problematic and was only resolved after eight years of renegotia-
tion. Under the new arrangement, as of 2001, the 51%/49% company makes a rental
payment for the infrastructure assets, and operates and maintains the water and sewerage
system, paying monies into a construction fund which belongs to the municipality. Since
the municipality is liable for a shortfall in the revenues, the construction fund could be
used to cover this a matter of concern for some foreign observers in the early days.2
PPPs are especially interesting in an economic development context and, as such, many PPPs
may include funding from regional development banks the examples above included EBRD
and the European Investment Bank. This funding support may be contingent upon public
ownership or public control and so financings of this type tread a delicate line regarding
structure and ownership (and, of course, now control under the new IFRS regulations) to
ensure eligibility for a mix of differing funding sources.
We can consider PPPs to lie along the spectrum from public to private ownership as
shown in Exhibit 30.1.
2 Key requirements for a PPP transaction

Each PPP transaction has unique characteristics that co-evolve in importance from the moment
of inception to the point where the project has ended. In this section, we group the key
requirements for these partnerships into high-level headings. The long-term nature of these
projects means that capturing and collating key drivers over time produces the following
five key headings.
Value for money.

Reallocation of risk and risk management.
Innovation.
Enhanced performance and more transparent performance management.
Lower cost than an equivalent public sector comparator.
Each of the above could be broken down further.
Value for money

The most important requirement for any of the public-private partnership projects is that
the project has to exhibit value for money for the government or public sector. The defini-
tion of value for money can be problematic and needs to be clarified and contextualised for
each project to ensure transparency around the measurement of the project success. Cost
savings are clearly an indicator of value for money, but a number of projects may also have
requirements to include a certain specified local content, either to ensure that the project
funding is spent in the local economy, through local resourcing of component materials or
487

Exhibit 30.1
Different forms of project ownership in a PPP context
May use existing public sector procurement processes.

1 Public sector keeps it all May raise commercial debt supported by cash flows or uses public sector debt.
in house as an agency/
permanent concession:
May use private techniques such as Design-Build-Operate-Transfer (DBOT); Build-Own-Operate-

Transfer (BOOT) or Build Operate-Transfer (BOT) but ownership reverts to public sector.
2 Public sector ultimate
Owner/private sector May include commercial debt during development and operational stage.
Finance provider/reverting
concession:
May use Design-Build-Finance-Operate (DBFO) concession.

3 Public sector owner or BOOT concession.
controls through a Maintenance concession.
renewable concession/
private sector finance:
May use asset capitalisation model.

Divestiture of public sector assets.
4 Private sector Build-Own-Operate (BOO).
owner/private sector
finance: Most likely to include increased private equity.
Source: Frank J Fabozzi and Carmel F de Nahlik

18/06/2012 07:50
labour, or to look towards technology and skills transfer to the local population. This can
conflict with a need for cost saving.
Value for money begins at the phase where the project model is constructed and needs
to be demonstrated to make a case for a PPP/PFI route. There are many cases where the
cheaper option might have been to use existing public sector resources and a PPP/PFI route
has proved to be more costly.
Once the tendering process starts, then a claim of value for money is supported by
evidence of a strong competitive field. From the contractors point of view, PPP/PFI tendering
may be less attractive because there may be a poor understanding of project design by the
public sector commissioning body, possibly because this is not a route that has been used
before. So, there may be a drain on contractor resources in order to educate the public
sector partner in order to scope a viable project. The tendering process may also be lengthy
and require the preparation and submission of many documents, exposing the contractor
to significant upfront costs with a lack of certainty around the final award of the project.
Even when the project is awarded, reporting requirements may be more onerous than
many private sector projects and require a higher level of disclosure administration costs
may therefore be quite considerable. Project specifications can change prior to the award, or
even in some cases after the award where technological innovation may have a significant
impact on the projects success.
Examples of this might be some of the problematic information technology projects
providing support for government services, especially IT driven projects. These challenges have
resulted in a comparatively small number of contractors that have become highly specialised
in PPP/PFI tendering and project execution, though this in turn leads to risk concentration
problems in contractors and possible challenges to the value for money criterion if all bids
are close in price and specification.
Reallocation of risk and risk management

The second driver for PPP and PFIs is the belief that the private sector understands certain
types of risk rather better than the public sector, and therefore allocation of those risks to
private sector organisations that possess this superior knowledge, together with the extensive
due diligence that accompanies PPP/PFIs, can bring costs down. For this to work, the risks
need to be thoroughly documented, understood and appropriately weighted (Chapters 8, 20,
21 and 22) and in an award of a project to a private sector partner, both sides need to ensure
that an appropriate structure for managing those risks, including penalties if appropriate, is
laid out within the documentation. So, for example, if construction of an incremental project
looks as if it is likely to overrun, this would be identified through the reporting mechanisms
and the agreements would spell out the clear mechanisms for discussing and resolving the
problem with payment penalties as the ultimate sanction. Very often PPP/PFI contracts are
fixed-price in nature and may include the construction element and the operation element
in a single sum if a whole-life cost approach is used. Gain sharing in the construction
contract phase (see Chapter 14) has not been widely reported, though many public sector
organisations have insisted on gain sharing if the project is refinanced.
489

Project Financing
The introduction of standard contract models into PPP/PFIs in countries where this model
is quite widely used (for example, the UK) has also led to better governance and the many
public reports by the UK National Audit Office have also led to a better understanding of
the risks, how to allocate them and mitigate them for different categories of projects.
Innovation
The third driver for a PPP is the introduction of excellence and innovation in design by
taking the best from the private sector and applying it to public sector projects. Evidence
suggests that this is not always the case inexperience, leading to lack of attention to design
specifications by public sector bodies has often meant that the project has ended up following
the form of previous projects. Innovation is often not ranked especially highly when bids
are scored in the tendering process and innovative aspects of one bid will form part of the
intellectual property of that bidder.
There is also a perception that innovation may drive costs up, causing less experi-
enced public sector bodies to choose existing designs structures and delivery models, which
whilst they might minimise the risk, may not ultimately give rise to value for money in
service delivery.
Enhanced performance and more transparent performance management

The fourth driver relates to expectations around PPPs delivering better services as a result
of the absorption of lessons learned from the private sector into the partnership and on into
the public sector.
Service level agreements (SLAs) are now becoming widespread in the public sector,
outlining the service to be provided, costs, availability and the schedule of payments for
the service and so on, and supported by the inclusion in the agreement of penalties should
the service provider fail to deliver. The concept of service level agreements may be novel in
countries undergoing rapid economic transition and the cultural change associated with the
introduction of this type of formalised delivery can require sensitive handling in all cases.
Linked to a PPP/PFI arrangement may well be the transfer of staff to the new operating
company and a transition from public sector employment to private sector employment which
may include a change in terms and conditions of employment. Negotiating these transfers
of professional or clinical staff, especially when trade unions may be involved, cannot be
rushed and emphasises the need to have realistic timetables set at the beginning of aproject.
Lower cost than an equivalent public sector comparator

The fifth and final driver considers whether a public/private sector partnership will save
money for the public purse. To demonstrate this, the proposed PPP/PFI route needs to be
compared with the same project financed through the public sector. In an analysis of one
PFI project, the Norfolk and Norwich University Hospital (NNUH), it says:
490

Therefore the macro-economic rule led to the promotion of PFI projects by the Labour
Government with the micro-economic objective (of providing VFM) being achieved by a
manipulation of the comparisons. This manipulation was mainly carried out by adding on
percentages for cost overruns which were very much higher than the average overruns
(of no more than 13%) experienced on similar publicly-financed projects. Generally the
cost overrun assumed for the PSC has been just high enough to tip the VFM assess-
ment in the favour of the PFI project. The overrun assumed for the NNUH provides a
good example. Not only was it very much higher than 13% but at 34.22% it was
also astonishingly precise.3
The economic argument for the PPP/PFI route suggests that the private company can benefit
from economies of scale and scope because it has considerable experience in delivering
these types of services or indeed these types of projects. This should mean that the provi-
sion would be cheaper than a public sector comparator (PSC) where inefficiencies inside
the public sector would suggest that these economies are not captured. The extraordinary
statement above could be relabelled and apply to many projects where non-financial drivers
may be pointing to a course of action that needs to be justified with numbers. This is an
example of how theories underpinning behavioural finance and psychology can be inserted
into what is believed to be logical, pragmatic and evidence-based decision-making but it is
not confined to PPP/PFIs.
A Canadian study re-analysed a project to look at the public sector comparator (PSC)4
where the private sector project was substantially more expensive and suggested that many
public and private sector alternative financial cases may not be directly comparable. The
private sector project had included various improvements adding to the cost (innovation).
In contrast to the normal public sector process of funding the project as it was being
constructed, the private sector project deferred payments for the project until construction
was completed (evidencing value for money). There was also an expectation that the public
sector sponsor should pay a premium to transfer certain risks to the private sector, further
loading the costs (risk transfer). Finally, the private sector project was discounted at a higher
rate, reflecting its higher cost of capital. Problems like this where the two choices are not
directly comparable can pose difficulties for project selection.
Related to this is a further area of concern by stakeholders the perception that contrac-
tors have been able to reap extraordinary benefits from the projects and that government
officials have not always been able to demonstrate that they have considered both the short-
and long-term implications of the contracts and that as agents for the taxpayer, they may
not have chosen projects that have always demonstrated the best value for money.
Finally, making a direct comparison with a PSC can be further complicated if it is a single
contract for both construction and operation. In such a situation, if costs overrun, they may
be deferred into the operating phase in order to meet completion targets and avoid heavy
penalties. Thus the comparability between the public and PPP alternative may not be clear
cut, further underpinning the need to build and test models under a number of realistic but
complex risk scenarios as suggested in Chapter 20.
491

Project Financing
3 Key components for a PPP/PFI

Just as with other project financing models, public-private partnering projects have the same
requirements which include:
the main SPV project company, often including public sector shareholders, known as a
TOPCO;
the projects assets should be contained in a SPV (known as a CAPCO);
an off-take style contract for the service provision to the end user, or other contract that
records the service to be provided, any performance measures, the payment mechanism and
procedures for the management of any adverse circumstances needs to be clearly defined;
conventionally the operation of the project is carried out by another SPV called an OPCO;
and
there needs to be a mutually agreed upon definition of and allocation of risks among all
partners, usually in the form of a risk matrix.
4 Classic form of a PPP/PFI

Whilst each project has unique characteristics, it is possible to generalise the form of one of
these projects as shown in Exhibit 30.2.
5 Different forms of PPPs and PFIs

In this section we examine the types of PPPs and PFI structures currently in use. Many
projects use a concession structure to structure the cash flow generation process. In common
with other structures in this book, these contract forms have existed for a long time. In the
Roman Empire, tax collection was farmed out and the right to collect taxes in a given
area, or concession, was assigned to groups of individuals known as tax farmers, who were
obliged to collect a specified amount of tax on behalf of the Roman Empire. The farmers were
required to pay over the amount agreed at the time of bidding, but any surplus was theirs
to keep, explaining the negative image of tax collectors in older literature. The concessions
to collect taxes were often auctioned and over time, legislation was enacted to protect the
taxed from over-enthusiastic over-collection in the name of the Emperor. This practice also
existed in Ancient Egypt and the Ottoman Empire and a bureaucracy existed to monitor the
payments. The tax farmer was liable for any under collection of tax revenues.
More recently, concession agreement structures5 have appeared in governmental partner-
ships to exploit and develop natural resources, whereby resource owning governments will
grant or award the rights to explore and develop minerals for a fee (concessions), with a
revenue-sharing arrangement with the concession holder if the exploration is successful. The
concession agreement structure has a long case law, and as such became a useful mechanism
for allowing public sector activities to be conducted by private sector companies.
In a classic concession agreement structure, the first stage is to develop a robust business
case for the transfer of the assets and/or service involved, and to specify any incremental
investments. This is very often when the project may encounter problems later because the
492

Exhibit 30.2
Typical generic structure for a PPP/PFI project
Debt finance may Equity: private Offtake/

Capital asset
change into equity may be concession
input agreement/
securitised debt as come IPO or agreement for
(CAPCO)
project matures trade sale later service provision
Public sector body.

Financing
Note: this can be
providers
more than one entity
Special-purpose
vehicle that owns
the project (TOPCO)
Operating company
Private sector
(OPCO) may be the
contractor
same group as the
partner(s)
private sector partner
Construction Joint-venture
Operating Maintenance
contract may agreement with
contract for life contract for life
include design public sector
of project of project
and build body
Source: Frank J Fabozzi and Carmel F de Nahlik

18/06/2012 07:50
Project Financing
business case is over optimistic or fails to take into account all of the risk factors. Concessions
are long-term agreements, often with limited possibilities for renegotiation of the terms. As
noted in Chapter 20 and 21 where we discussed project modelling, we noted that one of
the challenges in the area of project finance has always been the justification of high sunk
costs on developing a sound project model.
Once the business case has been examined and approved, one of the next stages is to
make sure that the service can be transferred to the private sector under existing legislation.
This may require specific legislation to be enacted, which will take time. Then the tender for
the concession has to be written. Most public sector procurement requires external tendering
for the concession for which there may be both local rules and possibly other external rules
that may need to be followed in order to attract certain financing an example of this
would be following the EU directives on public procurement.
Once the concession is awarded, several SPVs are set up to act as a holding company,
to hold the assets and to provide operating services as shown Exhibit 30.2.
The concession agreement will normally:
specify the terms of the concession including any incremental work to be done to upgrade
the assets to produce the service;
clarify the responsibility for obtaining the finance for maintenance and upgrading (including
any responsibilities of the public sector partner such as providing guarantees for any finance);
set out the terms under which the concessionaire will offer the service to service users
including escalation for inflation; and
address risks such as bankruptcy of the concessionaire, cost overruns, problems in obtaining
planning permission, audit provision for the concession while it is operating, any assignment
of the concession arrangements that are permitted and hand over on termination or expiry
of the concession agreement.
This particular model has been especially popular for road and rail projects as shown in
Chapter 21.
The challenges that early projects have faced have been as a result of over-optimistic
modelling, especially when tolling revenues are collected in a currency other than the host
country currency (a situation likely to pertain where the construction costs may be in a foreign
currency that may be stronger than the local currency, or where there may be exchange
control restrictions). Traffic estimates which relate to projections of economic development
and projected demand have also been over-optimistic in some cases. Existing assets have
required unplanned additional expenditure by the concessionaire in order to bring them up
to levels required for service provision this may only have become clear after handover. Yet
another challenge has arisen where commitments have been made by public sector partners
to the private sector partners, possibly in the form of keep well letters (Chapter 23). When
the project has run into financial problems, the keep well letter has assumed the form of a
guarantee, thus crystallising liabilities that may have been overlooked.
Nevertheless, despite these challenges, the concession model has worked very well in many
cases, and continues to be an attractive option, especially when the public sector partner and
the private sector partner truly work together to deliver the project.
494

Pure concession agreements

In the first type of structure in Exhibit 30.1, the public sector sets up an agency to handle
an activity such as providing mental health services or managing road networks. The agency
is a route to introduce private sector performance metrics in to an activity and to look at
investment and operating cost management through a service agreement or a longer term
concession to provide services. At this point, the ownership remains inside the public sector,
though in the special case discussed next, partnering with private sector bodies can occur.
This is a form of joint venturing (discussed in Chapter 27) with risk taking by all parties.
It is not procurement. Private sector money, grants or other funding sources may be used.
LIFT as a special case

One way to try and manage the inflexibility, especially in healthcare projects where a commit-
ment to a building for 25 years may not be consonant with changes in clinical care over that
time, is to use a local improvement finance trust (LIFT). In this model, a LIFT company is
construed as rather more of a true joint venture than the client/contractor mode commonly
seen in PPPs. The local National Health Service trust is a 20% shareholder of the company
as well as the community health partnership and the private sector. This approach has placed
a number of burdens on health administrators who did not always have the appropriate
expertise to make private sector financial judgements, manage the commissioning process to
develop and include private sector innovation and optimise the opportunities offered through
participation in the governance structures associated with this mechanism. The result has been
that a lot of early LIFT companies had expectations of improvements through the involve-
ment of the private sector, especially around innovation in design that were not always met
because of poor public sector preparedness.
One of the other challenges facing any public sector initiative of this type was that of
major change and a reorganisation as a constant dynamic inside the commissioning organi-
sations. This led to delays in bringing projects to fruition and also in uncertainty about
future supplies of pump-priming funding for projects, impacting the ability to seek private
funding because of the uncertainties. Not all of these projects were privately funded: in the
Rossendale 10 million LIFT scheme, the primary care trust contributed the capital costs
and ownership of the project reverts to it when the partnership terminates.
Other quasi PPP schemes include nominations agreements for residential accommodation
schemes and third party developer lease schemes. These schemes would probably fall into
the first category shown in Exhibit 30.1.
Design-build-operate-transfer and build-operate-transfer projects

The second project grouping shown in Exhibit 30.1 includes design-build-operate transfer
(DBOT) and build-operate-transfer (BOT) projects, alluded to in Chapter 27.
Once more, during the projects life it is controlled by the private partner and owned
by the joint-venture company, although at the end of the project the ownership reverts back
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Project Financing
to the public sector. Consequently, the private sector input comes from the design, construc-
tion and operation.
In the case of DBOT, the project specification may be made by the public sector partner
but, as suggested earlier in this chapter, this may stifle innovation that may be valuable in
terms of delivering an enhanced service or looking at process re-engineering to bring costs
down. DBOT offers a public sector partner a route to a project without incurring all of
the costs upfront, as would be the case in a normal public sector transaction. It also offers
deferred ownership, possibly making it easier to manage within tight budgetary constraints.
Once more, the challenges are to ensure that the public sector partner scopes the project
very carefully, especially around the service contract and that the risk assessment and agree-
ment regarding risk allocation are sophisticated. Some early projects completed under the
schemes have been less successful because start-up has been delayed as a result of changes
to the specification, or risks have been poorly understood at the outset and emerge later as
serious problems for the projects viability.
Transfer at the end of the projects life also needs to be carefully documented so that
there are no surprises. The public sector partner may be considering that revenues raised by
the project will be in the local currency as a part of planning for the transition and, unless
they are prepared to take the foreign exchange risk, this places constraints on contractors
who will need to raise finance locally rather than from larger overseas markets. Given the
long life of projects, and the movement of personnel, unless the documentation and the agree-
ment are really clear at the outset, end of project transfer can be a source of futuredispute.
Another potential area of discord is any revision to the revenue model during the proj-
ects life such as a change to tolling charges. These changes are likely to arise from political
decisions and thus may be in conflict with the expected returns by debt and equity holders.
In a worst case scenario where the debt in a project of this type fails to be serviced, lenders
may need to take over the project. Therefore, at the outset, provisions for this contingency
need to be agreed upon with the public sector entities not always something that is very
palatable politically when lenders may be non-nationals.
Design-build-finance-operate
Design-build-operate (DBFO) projects form the third category in Exhibit 30.1. Ownership
remains vested in the public sector entity during the projects life, so this has similar elements
to a lease. The Highways Agency in the UK has used DBFO structures to build several cross-
ings and a toll road, and the projects have been positively reviewed. The DBFO company
finances and builds the road as well as operating and maintaining it for the period of what
is essentially a concession. The Highways Agency pays the DBFO company a shadow toll
on roads that are not subject to commercial tolling arrangements, based on usage patterns,
maintenance history and the like. This payment is used to service the debt. In order to
manage construction standards, a penalty arrangement exists for lane closures, so the incen-
tive is not to cut costs in construction. DBFO has also been used to construct car parks
at hospitals, where patients and visitors are charged for parking. This has been politically
very sensitive when these projects started off, stakeholders had not thought through the
major financial impact of parking charges on patients with long-term illnesses who require
496

frequent visits to the hospital, and who may not be working as a result of their illness.6
Press coverage of incidents like this has often focused on the PFI structure as the cause of
the problem, especially the negotiation of variation in the contracts.7
In the US, the DBFO approach has been slightly different inasmuch as the more extensive
debt market available to public sector entities has led to debt being raised by the public
sector partner rather than by the private sector partner.8
Build-own-operate
The final category of projects, build-own-operate (BOO) projects, has been the one most
widely developed in the private power sector. Here the public sector benefits from facilities
such as power supply or desalination works, which are built, owned and operated by a
private sector contractor, usually under a concession agreement. A potential attraction for
the private sector might be the long-term possibility of privatisation of this particular service
or asset bundle. The attraction to private sector investors, analogous to the case of BOTs, is
the possibility of long-term growth in the sector and a technology basis that is not thought
to be likely to radically change over the period of the project.
In the specific cases of power and water, projects have been problematic because much
of the facility is difficult and expensive to inspect in order to develop a clear view of the
existing condition of the assets. These are projects where the currency risk of local payments
and external currency funding may be most acute. Very often, equity is hard to come by for
projects of this type in newer environments, making the projects success reliant on enhanced
contributions from local government or grants and other funding from regional development
banks, and the public sector support may not end there. In one early Malaysia water project,
additional government support was required because of the difficulties in collecting the tariffs.
These projects are asset intensive and as such may look at relatively high levels of debt to
equity, such as 60% to 70% debt and additional government support. One notable exception
to this is the English and Welsh water companies who have elected to fund projects like this
through bond issues, possibly as a result of their longer track records.
A BOO project, often a power project, will usually have a long term contract in place
before financial close to provide the cash flow to service the debt.
6 Accounting issues for PPPs and PFIs

An anomaly exists in that, at the time of this writing, many government accounting mecha-
nisms do not recognise PPPs and PFIs as part of the overall government borrowing figures
under the European System of National and Regional Accounts (ESA) and especially the ESA
95 standard. In contrast, many projects are coming back on to public sector financial state-
ments as International Financial Reporting Standards and especially International Financial
Reporting Interpretations Committee 12 (IFRIC 12) which relates to concessions, a popular
structure in PPPs and PFIs, are adopted.
The treatment of PFI and PPP projects from an accounting standpoint will be clarified
over the next few years. As governments seek to deliver state-of-the-art facilities to those
communities that they serve, these mechanisms for financing large public sector projects
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Project Financing
are unlikely to diminish in importance, but the form they may take will be influenced by
accounting issues as well as by costs. A detailed technical discussion of these developments
is outside of the scope of this book. However, we note the following two key lessons that
should be drawn.
1 It is unlikely that, given the long life and size of many of these projects, and their residual
claims on government finances, that they will continue to remain off-balance sheet in public
accounts, not least considering transparency and accountability for spending to theelectorate.
2 The anomaly that appears to exist between the different ways that they are reported in
different sets of accounts is also likely to disappear.
Therefore the future emphasis in these projects is more likely to be more on value for money
and less on financial engineering.
7 Different forms of PFI projects

Here we look at common types of PFI projects.
The freestanding or commercial partnership

In a freestanding or commercial partnership, the private contractor designs, builds and oper-
ates the facility but sells the services to third parties or the general public. An example of
this would be a toll road. The debt is serviced by the revenues from the facility and there
is no governmental support in the form of top-ups to the external cash flows. The govern-
ment contribution to the facility may be in the form of an existing road, or through support
in terms of legislation or planning permissions, the latter including the choice of route for
roads and rail links.
Joint ventures
In the joint venture project, both public and private partners contribute but the private sector
has overall control of the delivery of the project. The public sector contribution can take a
number of forms, similar to those seen in concessions discussed earlier, but it needs to be
very clearly delineated and there also needs to be a very clear allocation and acceptance of
risks. There may be assistance from the public sector partner with any requests for planning
permission. The private sector entity raises the funding and cash flow is derived from end
users or customers to service the debt.
Services sold to the public sector

When public sector activities are constrained by tight budgets, big-ticket items may be viewed
by end-users and the general public as essential, but not be affordable. Such examples might
include new hospital or school buildings and clinical equipment, such as scanners, with or
without expert technicians, or even staffed units, such as drug dependency support services.
498

In this context, leasing might be one possible solution, but another might be the provision
of services by an external contractor to the public sector. An example might be mobile
cancer screening units. The costs to the public sector entity that are passed through by the
private sector contractor need to be assessed for value for money against alternatives. One
cause of concern has been that public sector payments have been cross subsidising the use
of high capital cost medical equipment by other private third-party users, so the contracting
arrangements need extensive scrutiny and reassurance that this is not the case. The third-party
provider of the service will probably seek to raise finance against the public sector contract,
so this is a form of true project financing, but as in other cases, the risks relating to owner-
ship either directly as a lessor or indirectly as a potential debtor in possession need to
be thoroughly assessed. There also needs to be strong safeguards around maintenance of
items of equipment and a careful review of insurance cover relating to the serviceprovision.
8 PFI financing lifecycles: evidence and challenges

The long-term nature of PFI projects (25 to 30 years is not unusual) together with the public
sector expectations around cost control mean that these projects are largely financed on a
fixed term basis using interest rate swaps (see Chapter 25) to lock in the costs of debt for
the project for the public sector borrower. One point of negotiation is likely to be when the
swap takes place and the length of the contract it was only 20 years ago that a number
of UK public sector municipalities required rescuing when swap contracts they had entered
into moved against them. Since then Italian municipalities appear to have similar problems,
suggesting an understanding of the risks associated with swap contracts is not widespread
in many public sector organisations.9
The basic leverage structure has often been of the order of 90% debt to 10% equity,
reflecting the attractiveness of this higher spread quasi-government backed debt and the
relatively thin capitalisation of the companies has meant that returns to equity holders have
been very attractive in many cases. This apparent contradiction with the value for money
criterion that public sector contractors should uphold (mentioned earlier in this chapter) has
been the cause of charges that the private sector parties in PFI contracts have received exces-
sive returns. As credit has tightened, margins have increased with estimates of margins of
250 and 300 basis points over the cost of funds for the senior debt component.10 In addition
to healthy loan spreads, transaction fees and other financing costs such as commitment fees
are starting to make the PPP/PFI a relatively less attractive proposal not only in the UK, but
also in countries where there may be large government borrowing problems.
Historically, US monoline insurers with triple-A credit had offered support to bond issues
as a senior debt component of PFIs. However, following the sub-prime mortgage problems
in the US, this wrapping to support the debt in order to decrease its cost as a result of the
triple-A backup has all but disappeared, leaving projects dependent on senior debt provided
by banks and other long-term lenders.
Some commentators have discussed the use of mini-perms a form of short-term three
to five year finance that bridges the gap between the construction finance and a longer-term
permanent financing in PPPs. Mini-perms are usually structured with a balloon repayment;
a hard mini-perm will have an ultimate maturity date before which refinancing must take
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Project Financing
place, and a soft mini-perm will incentivise refinancing before the final maturity date. Thus
far they have been used in large road and defence contracts.
Once the project is up and running, PFIs are just like other projects in that much of
the risk is front-end loaded. However, the long-term nature of the finance means that the
public sector purchaser may be locked into very expensive financing costs priced to reflect
the high risk at the beginning of the project, and has been unable to exit through refinancing
without payments to the lenders to break the agreements. As the sector has matured, the
new contract forms include the ability to refinance, often with a gain-sharing arrangement
where the gains from refinancing are split between the private and public sector parties to
the contract. Current debates in this area include those around the right of the government
or a public sector agency to demand refinancing once a project is in the operational stage.
In general, governments are able to borrow at a lower cost than most private companies
and so, for those governments that may be able to consider direct capital market funding
for large infrastructure projects as opposed to private sector funding through the PFI, there
may be a shift in the types of project identified inside the four boxes shown in Exhibit 30.1.
Equity exits may take the form of a bundled portfolio of PPP/PFIs held by a private
sector service provider and offering an investor a range of risks in a number of different
projects through the use of routes that are analogous to securitisation and other vehicles
discussed in Chapter 22.
Each PPP or PFI transaction has its own unique characteristics, and a short chapter
cannot cover the many forms that are available.
The key messages common for all projects are:
clarity around the definition, scope and nature of the transaction;

meeting the value for money test;
reallocation and acceptance of risk;
adoption of innovation and best practice; and
introduction of performance management systems and benchmarking of any private sector
project against a public sector comparator.
However, the balance and mix of large numbers of stakeholders can extend the negotiating
phase on projects of this type.
The political nature of a transfer from the public sector to the private sector is very emotive
in many national contexts letting foreigners own core national assets can be negatively
perceived by the electorate. Finally, the long-term nature of the projects and their political
embeddedness will inevitably mean that the negotiation will take place and the financial struc-
tures that support these projects need to be able to have the flexibility to cope withchange.
1
UK Parliamentary Research Paper 01/117 published 18 December 2001.
2
Tool 15-3 Regulatory problems in Yerevan water management contract: http://europeandcis.undp.org/files/uploads/
Milan/cases.doc.
3
Edwards, C, The private finance initiative (PFI) and value for money? A case study of the Norfolk and Norwich
University Hospital (NNUH), 2005, available from c.edwards4@btinternet.com. In the quote, VFM stands for
value for money and PSC is public sector comparator (the reference project).
500

4
Hodge, G, Greve, C, and Boardman, A, (eds), International Handbook on PublicPrivate Partnerships, 2010,
Edward Elgar.
5
Concession agreement structures are outside of the remit of this book, but a useful reference text for lessons
learned is: Guasch, JL, Granting and renegotiating infrastructure concessions: doing it right, 2004, World Bank
Institute Development Studies.
6
One such example is from the website of a cancer support charity Macmillan which is campaigning to get
charges abolished: www.macmillan.org.uk/GetInvolved/Campaigns/HospitalCarParking/Travel_and_parking_costs.
aspx.
7
The BBC reported the scrapping of car park charges in Scotland at most hospitals, but not those where the
hospital or car park had been funded under PFI arrangements, following political pressure: http://news.bbc.
co.uk/1/hi/scotland/7593400.stm.
8
See, for example, the US Department of Transportation Federal Highway Authority site: www.fhwa.dot.gov/ipd/
p3/defined/design_build_finance_operate.htm.
9
Sanderson, R, Dinmore, G, and Tett, G, Finance: an exposed position, Financial Times, 8 March 2010.
10
National Audit Office report (20102011), Financing PFI projects in the credit crisis and the Treasurys response,
HC 287 London: The Stationery Office.
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502

Case studies
Case study updates

Pertamina Blue Sky Project 505
Ilisu Dam Project 505
St Louis Cardinals Stadium 505
Maputo Port Project 506
Dabhol 506
Safaricom CELC secured medium term note 506
The Equate Project 507
Azito 507
Phoenix Park Gas Processors 507
TermoEmcali 507
Case studies
1 Petroleum refinery projects 508
2 Public-private partnerships 528
3 Pertamina Blue Sky Project 541
4 Ilisu Dam Project 545
5 St Louis Cardinals Stadium 554
6 Maputo Port Project 560
7 Dabhol 566
8 Safaricom CELC secured medium term note 574
9 The Equate Project 580
10 Azito 594
11 Phoenix Park Gas Processors 610
12 TermoEmcali 620
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Project Financing
504

Case study updates
The following short updates bring the stories of the older transactions in the cases up to
date as of Spring 2012, as well as illustrating the wider issues we discuss in the book.
Project finance takes a long view and so the ultimate fate of projects is unknown in the
short term. Some of the cases have required some restructuring, as in the case of Dabhol and
TermoEmcali. Ownership may have changed as shareholders reassess the release of value.
External pressures may influence decisions about whether the project is funded and proceeds
or not, as in the case of the Ilisu Dam. Of interest too, are the lessons learned from spon-
sors shared by Safaricom and the darker side of power purchase agreements shown in the
TermoEmcali story.
Pertamina Blue Sky Project

Project development was expected to begin in 2005. Changes to Pertaminas remit suggest
the unusual financing mechanism described in the case where non-Pertamina owned assets
were used as support is no longer available. The Japanese partners pulled out of the Blue Sky
Cilacap refinery project in 2010 and appear to have been replaced by new Kuwaitipartners.
Ilisu Dam Project

The project began with the ceremonial laying of the foundation in 2006, following changes
to funders and suppliers. The continuing controversies surrounding this project, its historic
location and the need to resettle so many people from a politically sensitive group (the Kurdish
people) meant that by 2008, a number of issues arose around compliance with Export Credit
Agency requirements. Foreign export credit funding for the project was halted in 2009 after an
independent expert report confirmed that the project was not meeting various preconditions.
The Turkish government has confirmed its support for the project and expects it toproceed.
St Louis Cardinals Stadium

The Busch Stadium opened in April 2006. Costs slightly overran for the stadium at US$365
million. The new stadium has also hosted concerts and other events to continue to optimise
revenue. The website for the St Louis Cardinals baseball team confirms, in a review completed
in 2010, that the tax revenue produced by the project has exceeded expectations, but the
almost US$20 million annual debt service payment has been criticised by commentators as
restricting the ability of the club to acquire new players. The adjacent Ball Park project is
proceeding slowly.
Other large sports stadia that have been publicly financed have faced challenges as the
economic downturn has adversely impacted stadium revenues. This has necessitated additional
public support for these large project debts, with a consequential effect on the availability
of public funds for other services, attracting negative press comment.
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Case study updates
Maputo Port Project

The initial concession to manage the port granted to Maputo Port Development Corporation
(MPDC) in 2003 was for 15 years with an option to extend for a further 15 years. In 2010,
the concession was extended for another 15 years with the option for another 10 years after
the expiry in 2033. MPDC is now owned by the Mozambican State Railway (3%), Grindrod
(a South African shipping, port management and logistics company and one of the original
partners) and DP World (a UAE based company that manages ports around the world) holding
48.5% each. The port has a current Masterplan Capital Expenditure program of US$749 million
over the next 20 years to upgrade the existing quays and build three new container shipberths.
Dabhol
As predicted in the case study, a post-Enron settlement was protracted. Bechtel and GE (two
of the original foreign shareholders in the project who took over Enrons controlling interest
in the project) went to arbitration in 2003, receiving a panel decision that their interests
were improperly expropriated by the Indian government and triggering an OPIC political
risk insurance payment to each company. The claims to recover the Bechtel and GE invest-
ments in the Dabhol project resulted in compensation agreements and the conveyance of the
shares to leave an Indian majority ownership company in 2005. OPIC was a key player in
the restructuring efforts that ultimately led to the project restarting under the newownership.
Following a five-year closure, the project reopened as Ratnagiri Gas and Power (Ratnagiri),
a new company set up in 2005 and promoted by National Thermal Power Company (NTPC)
and the Gas Authority of India Limited (GAIL India), both majority state-owned companies.
Ratnagiri has the following shareholding structure: NTPC (31.52%); GAIL India (31.52%);
Indian banks (including IDBI Bank Ltd, State Bank of India, ICICI Bank Ltd and Canara
Bank) (20.28%) and MSEB Holding Co (Maharashtra State Electricity Board) (16.68%).
However, notwithstanding this new direction, gas supply problems continue to affect the
ability of the project to deliver power to customers.
Safaricom CELC secured medium term note

The notes were oversubscribed on issue and Safaricom considered the issue a success. A
company spokesman made the following observations in a presentation whilst reflecting on
the transaction, reporting that it underestimated several factors that offer important lessons
for issues of this type:
the increased workload inside the company that an issue like this generates;
the long list of advisers and the volume of documentation produces significant coordination
costs;
the need to manage the substantial excess liquidity in a market with poor returns; and
the need to educate the market.
Other transactions of this type have been completed in Africa.
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Case study updates
The Equate Project

Equate has expanded to include a Greater Equate complex, and is a thriving joint venture
between four shareholders, PIC and Dow Chemical Company with Boubyan and Qurain
Petrochemical Industries Company (QPIC). The project returned a net profit of US$1.05
billion for fiscal year ending December 2011. The Greater Equate projects have included
Islamic finance tranches. Although the original Equate and the publicity the deal attracted
including this case study have made it a pathfinder for the inclusion of Islamic finance
elements in project financings in the Middle East, documentation and legal issues remain
complex in Islamic financing mechanisms.
Azito
Azito continues to provide about one third of the electricity for the Cote dIvoire. In 2003,
Globeleq, a spin out from CDC the UK governments development finance vehicle became
a shareholder in Azito and in late 2010 bought out the shareholdings of ABB and EDF. The
new shareholder intends to convert the plant to a more efficient combined cycle station and
in late 2011 agreed to amendments to the 24-year concession agreement with the govern-
ment of the Cote dIvoire.
Phoenix Park Gas Processors

The PPGP project continues to be successful and the regions main producer of natural gas
liquids. The debt rating continues to be above investment grade and the project has benefited
from strong oil prices. Other expansion has been financed using rated debt, and the bonds
in the case study are due for redemption in 2013. ConocoPhillips remains a shareholder.
TermoEmcali
In 1999, just as the plant was nearing completion, concerns arose about EmCali, the off-taker
for the project. EmCali had given notice that the project was in default under the terms of
the power purchase agreement before construction was completed, though this was resolved
using an independent consultant. However, a downgrade in debt rating was announced for
both entities.
A subsequent default occurred in 2003, and EmCali, a major local employer, was on
the brink of receivership. TermoEmcali renegotiated its 20-year power purchase agreement
with EmCali, following a restructuring plan which included the restructuring of the bonds
scheduled to mature in 2014. The bonds were exchanged for bonds maturing in 2019 in
a transaction completed in 2005. Bechtel and Shell sold Intergen (excluding TermoEmcali)
in 2005, and during the restructuring, the ownership of TermoEmcali by EmCali increased
to 88%. However, in 2010, the US$157 million senior secured notes due in 2019 were
redeemed early and the project was purchased in a US$187 million tender by a consortium
(including the UK Ashmore group) that plans to expand in Colombia. The consortium is led
by Contour Global, a specialist owner-operator of power projects in under-served markets,
backed by investment funds.
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Case studies
Quantitative Evaluation of the Relationship

Between Supply and Off-Take Contracts
in Petroleum Refinery Projects Utilizing
Project Finance
YANG CHU AND TONY MERNA
I
YANG CHU n the last few years, with growing demand industry.The early models for project finance
is an enterprise risk manager in emerging economics like China, India were projects such as power generation,
in Global Risk Management
and Brazil, global oil refining capacity has mining, and water treatment projects, which
at IHG in Denham, UK.
chuyang78@hotmail.com to increase to meet the growing global have proven technology, simple raw material
demand. Now capital formation has become supply, single product, and reasonably predict-
TONY M ERNA paramount to the commercial viability of the able revenue generation. By comparison, the
is a senior partner of Oriel refining industry. As a result, many petroleum petroleum refining industry is far more risky
Group Practice and a visit- companies are turning to different methods of and prone to uncertainty.
ing lecturer in Manchester
Business School at The Uni-
financing new facilities, with project finance
versity of Manchester, UK. becoming an increasingly popular method in TYPICAL RISK IN REFINERY
anthony.merna@manchester.ac.uk the refining industry. Project finance has been PROJECTS
demonstrated as a very efficient way to finance
infrastructure, and can also be used to finance Determining how to finance a refinery
petroleum projects. Global project finance bor- and manage typical risks in order to generate
rowing surpassed $180 billion in 2006, a 29.7% sound economic returns is a major challenge
increase from the $139.2 billion raised in 2005. (Merna and Chu [2007]). Financing a modern
The total amount of funds raised to finance refinery is a risky business. In oil and gas proj-
oil, gas, and petrochemical projects worldwide ects risks can be identified in both upstream
in 2006 using project finance accounted for and downstream phases respectively (Merna
$46.50 billion, mostly in the area of gas pro- and Al-Thani [2005]). Typical risks faced by a
duction. According to the Thomson Financial refinery business are illustrated in Exhibit 1.
First Quarter 2008 Global Project Finance Review, Apart from typical project risks, the risks
the first quarter of 2008 saw the highest-ever associated with different sources of raw-ma-
volume of project finance transactions through terial supplies and final product off-takes are
the world with more than 125 transactions important variables contributing to the profit-
totaling US$56.4 billion. However, following ability of a raw-material process project. For
record high volumes in 2008, global project a particular petroleum refinery project, there
finance transactions dropped significantly may be several crude oil sources that are avail-
during the first quarter of 2009 (Thomson able to an oil refinery. Crude oil from different
Reuters [2009]). This was most likely caused sources has different quality, price, refining
by the global economic crisis. cost, and procurement methods with each
Project finance or off-sheet balance crude oil source having its own risk charac-
financing is relatively new to the refining teristics. Similarly, risk associated with product
76 QUANTITATIVE EVALUATION OF THE R ELATIONSHIP BETWEEN SUPPLY AND OFF -TAKE CONTRACTS SPRING 2011
Reproduced with kind permission from the Journal of Structured Finance.
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EXHIBIT 1
Typical Risks in the Construction and Operation of a Refinery
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
The Journal of Structured Finance 2011.17.1:76-95. Downloaded from www.iijournals.com by Carmel de Nahlik on 03/19/12.
Source: Merna and Chu [2007].
off-take also varies. These risks are the major source of bundling can also be used to bundle crude oil supply
uncertainty in the procurement of a petroleum refinery contracts to produce the optimum off-take contracts,
in terms of security of project cash flow. Diversification in terms of refined products (Merna and Chu [2007]).
of risk profiles between supplies and off-takes within bun- Supply and off-take contracts can be employed in the
dles allows sponsors to finance a petroleum refinery and bundling of supply contracts to determine the cost and
to determine the mixture of debt, equity and mezzanine price structure of the off-take contracts as illustrated in
capital to finance a project by structuring the contracts Exhibit 2. Through this structure, the margin spread
based on the perceived risks (Merna and Njiru [2002]). of a refinery can be determined. For example, on the
supply sides, crude supply contract 1 is bundled with
BUNDLE OF PETROLEUM CONTRACTS crude supply contracts 2, 3, and 4 in order to maximize
the bundle; meanwhile, crude oil supply contract 1 is
Bundling is the grouping of projects, products, also bundled with off-take contracts 1, 2, and 3 in order
or services within one managed project structure in to fix the refinerys margin.
a manner which enables the group to be financed as In order to reduce spread risk, NYMEX in 1994
a simple entity (Frank and Merna [2003]). Similarly, launched crack spread contracts. Basically, the term
SPRING 2011 THE JOURNAL OF STRUCTURED FINANCE 77
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EXHIBIT 2
Typical Bundling of Supply Contracts and their Product Sales
Source: Merna and Chu [2007].

derives from the refining process that cracks crude oil associated with each contract in the bundle. One crude
into its constituent products. In recent years, the use of oil supply contract default may cause a problem within
crack spreads, also called the theoretical refining margin, the bundle. As a result, the overall refinery margin is
has become more widespread in response to dramatic affected.
price f luctuations (NYMEX [2001]). Because a refin-
erys output varies according to the configuration of the MECHANISM
plant, its crude input, and its need to serve the product
demands of the market, futures markets can provide Compared to most raw material-process projects,
f lexibility to hedge various ratios of crude and products. supply and off-take contracts are difficult to structure
Crack spread contracts demonstrate the basic principle of in the procurement of a petroleum refinery because of
bundling. Gasoline output is approximately double that multiple crude supply sources and multiple product off-
of distillate fuel oil, the cut of the barrel that contains takes. A survey carried out by the authors found that
heating oil and diesel fuel products that are almost apart from different sources of crude oils and various
chemically identical. This ratio has motivated many refined products, a petroleum refinery typically enters
market participants to concentrate on 3:2:1 crack spreads into a mixture of market-led and contract-led revenue
as Exhibit 3 illustrates. Each refining company must generation. The major difference between this structure
assess its particular position and develop a crack spread and that of a refinery using a traditional contract-led
futures market strategy compatible with its specific cash agreement is that the refinery may have not only long-
market operation. The authors believe that the ratio can term contracts but also future, forward, and spot market
be implemented by means of bundling contracts such as transactions as illustrated in Exhibit 4. An independent
forwards, futures, long-term contracts, and even bundles refinery that normally relies on cash f lows from long-
of spot purchases. However, the main problem is the risk term contracts will also rely to some degree on more
EXHIBIT 3
Bundle of Future Supply Contracts and Future Off-Take Contracts
Source: Authors.
78 Q UANTITATIVE EVALUATION OF THE R ELATIONSHIP BETWEEN SUPPLY AND OFF -TAKE CONTRACTS SPRING 2011
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EXHIBIT 4
Complexity of Crude Supplies and Refined Product Off-Take for an Oil Refinery
Source: Authors.
volatile, market-led revenue streams. More market-led device to quantitatively evaluate the relationship between
contracts (spot purchase and off-take) can considerably supply and off-take contracts. Any changes in the bun-
increase market risks. Issues related to the certainty of dling relationship between supply and off-take will result
crude supply and product demand, such as the ability of in a change of the risk profile and subsequently will have
the suppliers and off-takers to meet contractual commit- an impact on the economic parameters. The selection of a
ments over the life of the project, the pricing structure suitable arrangement of supply and off-take from simula-
of suppliers and off-takers, and the ability of the project tion results is based on the economic parameters. Min-
to pass on variations in input costs to off-takers need to imum, maximum, 15% probability, and 85% probability
be carefully assessed. of an economic parameter are designed as the criteria to
The future internally generated cash f low of an oil select a suitable arrangement of supplies and off-takes
refinery procured utilizing project finance is extremely as illustrated in Exhibit 6. The optimistic case and 85%
important since it is the source from which loan repay- probability of an IRR ref lects the upside revenue under
ments and dividends will be made. A project procured risks structured by bundles, whereas the pessimistic case
utilizing project finance can conceptually be viewed as a and 15% probability of IRR ref lects the downside in the
nexus of contracts that bring together various parties. In bundles. Organizations can choose their preferred criteria
such relationship-specific investments, investors in project to make their investment decision on refineries based on
finance transactions would not invest without adequate the risk and return they perceive and require.
contractual protection. Lenders and investors focus on When all the supply and off-take contracts (long-
contractual structures designed to protect themselves term, forward, and future contracts) are in place, there
from potential identified risks in order to secure project will be a degree of certainty with respect to overall
cash f low. The effectiveness of risk allocation through revenue generation. The mechanism developed by the
an appropriate contractual structure would hinge on the authors focuses on structuring supply and off-take by
economics of the project and its commercial attractiveness assessing the risks associated with bundles of different
to the various participants (ICRA [2003]). A typical risk supply and off-take contracts. Exhibit 7 summarizes a
allocation contractual structure of a refinery project pro- f lowchart of the mechanism developed by the authors
cured utilizing project finance is illustrated in Exhibit 5. to assess the financial viability of a refinery project. The
The authors believe that unless all these contracts are in mechanism illustrates the logical steps involved in simu-
place and satisfactorily arranged, a project finance trans- lating the risk assessment of a project. This mechanism
action cannot be realized by the promoter. can be applied in the procurement of various raw-mate-
The bundling relationship between supply and off- rial process projects with minor changes based on their
take can be both qualitatively and quantitatively evalu- specific industry characteristics.
ated. The authors use risk associated with bundles and Complex simulations based on the mechanism
its impact on the economic parameters of a project as a need to include a risk simulation program that has
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EXHIBIT 5
A Typical Risk Allocations Contract Structure of a Refinery
Source: Authors.
EXHIBIT 6
Criteria for Choosing Bundles
sufficient capacity to deal with a large number of risk at the end of 2012. The projects technical and financial
variables. However, there are very few stand-alone soft- characteristics are illustrated in Exhibit 8.
ware programs available that assess large numbers of ZDRP is mapped as a set of construction activities
risk variables for a project procured by project finance. and interdependent supply and off-take activities associ-
The authors, therefore, developed the computer pro- ated with cost, revenue, and duration. The major risks
gram Computer Aided Simulation System for Project identified in the procurement of ZDRP are shown in
Finance (CASSPROF) to carry out this simulation, Exhibit 9.
which was verified and validated by using a proprietary In this case study a total of 85 scenarios are exam-
risk software package. ined. These include base case, single supply and off-take,
bundle of supply and off-takes in different petroleum
TESTING THE MECHANISM markets. The case assumption behind the financial anal-
IN A CASE STUDY ysis is that ZDRP would only refine Xinjiang crude
oil and has two major refined products: gasoline and
ZDRP, a proposed refinery in China, is expected heating oil with a crack ratio of 2:1:1. Without taking
to have a capacity of about 220,000 bpd. Assuming con- risks into account, the results illustrate that the base
struction begins in 2008 the project would be completed case of the project appears commercially viable with a
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EXHIBIT 7 payback period of 10.32 years, cash lock-up

Mechanism for Assessment of an Oil Refinery Procured Utilizing $1,817 million, and 19% IRR. The NPV
Project Finance for the base case is $10,618 million, which
would seem commercially viable for both
investors and sponsors.
PURE SPOT MARKET SCENARIO
Pure Spot Market Scenario assumes

that the project sponsor purchases crude

oil and sells its product on the spot market
without any contract protection. This sce-

nario takes risk factors into account. A tri-
angular distribution is used in the model
where variable distributions are not well
known but can be bounded, such as changes
in construction, operation, maintenance,
and tax. However, for the Xinjiang crude
oil spot price, a lognormal distribution is
assigned in order to ref lect the nature of
change of petroleum spot price. A similar
principle is applied to assign ranges to the
spot price of heating oil and gasoline. The
correlation between prices of crude oil and
refined products is assigned.
After simulation, the sensitivity result
in Exhibit 10 shows which typical risks are
most sensitive to the IRR of the project.
Based on results obtained from the sensi-
tivity analysis, the project is more sensitive
to risks in the operation stage rather than
the individual risks in the construction
stage. The sensitivity diagram shows that
Xinjiang crude spot price, gasoline spot
price, heating oil spot price, change in
heating oil off-take, and Xinjiang crude
oil operation risk rank as the five major
risks in the operation stage.
The cumulative probability fre-
quency distribution (CPFD) illustrated in
Exhibit 11 shows that there is 85% likeli-
hood that the IRR will not exceed 16.14%
and 15% likelihood that the IRR will be
less than 9.15%. Compared with the orig-
inal prediction of an IRR of 19.02% in the
base case, clearly, pure spot supply and off-
take (SSO) is seen to have a greater degree
Source: Authors.
of uncertainty. This result indicates that
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EXHIBIT 8 there is a great chance that the project cannot meet a

Key Data of ZDRP minimum acceptable rate of return (MARR) of 12%
as required.
Exhibit 12 shows the major economic parameters for
the pure SSO scenario. The cumulative cash flow diagram
(Exhibit 13) for the pure SSO scenario is not very prom-
ising from either a lenders or promoters point of view.
When the simulation process was applied to pure
long-term supply and off-take (LSO) and pure future
supply and off-take (FSO) scenarios, it was found that

none of the scenarios can meet the financial requirements
of lenders and sponsors expected MARR of 12%. The

above results show that the ZDRP project under single
procurement/off-take methods (such as pure SSO, pure
LSO, and pure FSO) is deemed to be very risky.
BUNDLE OF SUPPLIES AND OFF-TAKES
Previous tests prove that the project can be very

sensitive to change in the supply and off-take contracts.
The following tests further explore how the financial
viability of ZDRP could be affected by using different
bundles of crude oil supply and off-take. The bundle
of supply and off-takes scenario examines the financial
Note: Estimated maintenance cost varies between 3% and 8% of the plant
investment (In this case study, we use an average value of 4.5%); Esti- viability of ZDRP under different bundles of LSO
mated Local Tax: 1% of the plant total investment per year, insurance: and SSO. The economic parameters are analyzed by
0.5% total plant investment). changing the bundling relationship between supplies and
EXHIBIT 9
Identified Risks Exposed in ZDRP
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off-takes. The authors plot all the results into a compre- The results illustrated in Exhibit 14 show that as
hensive diagram as shown in Exhibit 14 in order to assist the percentage of long-term contracts increases from 0%
comparisons of the probability analysis, the worst case, to 40%, the worst-case IRR shows a gradual improve-
best case, and standard deviation of IRR under different ment, whereas the best-case IRR shows a significant
bundles of SSO and LSO structure. decrease. When the bundle of 40/60 LSO/SSO struc-
ture is considered, the worst-case IRR
improves to 6.77%, which is 2.41%
EXHIBIT 10 higher than the worst-case pure SSO
Sensitivity Analysis Result for Pure SSO Scenario and 1.04% higher than the worst-case
pure LSO. However, after the point of

40/60 LSO/SSO, an increase of long-
term contracts does not improve the

worst-case IRR. With increasing per-
centage of long-term contracts, the
IRR at the 15% probability point
increases, whereas the IRR at the 85%
probability point decreases. After the
point of 40/60 LSO/SSO continual
increases of long-term contracts would
improve IRR at the 85% probability
point.The results indicate that the bun-
dling of supplies and off-takes can be
extremely valuable in downside protec-
tion of IRR in exchange for truncating
the upside IRR for ZDRP. The results
clearly illustrate that the best-case and
worst-case IRR are relatively sensitive
to the change in the bundling relation-
ship of SSO and LSO, whereas for the
IRR at the 85% and 15% probability
EXHIBIT 11 points, it does not show great change as the percentage
Cumulative Probability Frequency Distribution of long-term contracts increases.
for Pure SSO Scenario Similar tests are applied to bundles of three types
of contracts: long-term contracts, future supply/off-
take, and spot supply/off-take. It was found that under
EXHIBIT 12
Economic Parameters for Pure SSO Scenario
Stdev: standard deviation.
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EXHIBIT 13 lenders need to make investment decisions

Cumulative Cash Flow for 100% Spot Purchase Scenario based on risk and return. A decision to mini-
mize the worst-case IRR scenario needs to
be balanced against a potential loss in the best
IRR scenario; similarly the best-case IRR
needs to be balanced against loss in IRR in
the worst-case scenario. The authors suggest
there are three types of investors and spon-
sors, those being: risk averse, risk rational,
and risk seekers as shown in Exhibit 15.

Based on the results produced in sce-
nario I, the authors chose the 40/40/20

LSO/FSO/SSO as the better solution from
a risk-averse point of view. With the selected
solution (40/40/20 LSO/FSO/SSO) for risk
averse, the cost of financing can be added
into the proposed case. Comparing sen-
sitivity results of pure SSO, the sensitivity
chart in Exhibit 16 shows that the bundling
of 40/40/20 LSO/FSO/SSO balances the
40/40/20 LSO/FSO/SSO, the worst case of IRR can risks associated with crude supplies and
be improved to 8.32% which ranks highest among the product off-takes. As the sensitivity chart shows, the
worst cases of IRR in 65 scenarios. After analysis of the project becomes relatively less sensitive to the change
65 scenarios the elements of the decision problem are in petroleum prices and changes in supply and off-take
explored under uncertainties using different bundling than those in the pure SSO scenario. Operation risk,
combinations of supplies and off-takes. Sponsors and
EXHIBIT 14
Comparison of IRRs for Bundle of SSO and LSO
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EXHIBIT 15
Decision Making Reference Table
Source: Authors.
** denotes major parameters, * denotes less important and no stars means not important. Depending on their risk attitudes, investors and sponsors make
decisions utilizing different parameters.
environmental risk, and changes in interest rate rank risk of Xinjiang long-term contract become the most
highest in terms of sensitivity. important variables which contribute to the change of
After successful implementation of risk mitiga- IRR after RMM.
tion methods (RMM) for each of the risks encountered, A comparison between probability analysis results
there is a significant reduction in the effect of the risk before and after RMM is summarized in Exhibit 17. The
on the IRR. However, it is found that the risk profile overall results highlight a reduction in the uncertainty sur-
changes significantly after RMM. The price risks after rounding the ZDRP after RMM; the difference is only
RMM rank higher than before RMM, which ref lects 2.69% between the15% and 85% probability points.
the difficulties of mitigating those price risks. Xinjiang The cumulative cash f low diagram is significantly
environmental risk drops from 1st to 8th on the list of improved after RMM as illustrated in Exhibit 18. The
the sensitivity chart, but Xinjiang crude operation risk, NPV for the best case is $11,406 million, but for the
political risk on heating oil future contract, spot price worst case it is $6,192 million. The payback time for
risk of heating oil, change in interest rate, and price the best case is 10 years and the worst case of payback
EXHIBIT 16
Sensitivity Analysis Before RRM Under 40/40/20 LSO/FSO/SSO with 80/20D/E
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EXHIBIT 17
Comparison of Probability Analysis Before and After Introducing RMM
Note: B: before RMM; A: after RMM.

period is reduced to 13.7 years from 19 years. The best the standard deviation will be; meanwhile, the higher
case and base case are very promising from a lenders and the standard deviation, the greater the IRR difference
promoters point of view after RMM, but it has a slightly between the 15% and 85% probability points. The IRR
lower worst-case IRR of 11.98%, which is lower than the difference is about 4.23% between the 15% and 85%
MARR. Therefore, if the project lenders and sponsors probability points in the risk seekers option, which
are risk averse, the results illustrate that the project is not is significantly higher than the risk adverse and risk
commercially viable for the worst case after RMM. rational options. It ref lects that the uncertainty under
A similar analytic process is applied to the risk 20/20/60 option is much higher than the other two
rational (60/30/10) LSO/FSO/SSO and risk seekers options. Reduction of standard deviation after RMM
option (20/20/60) LSO/FSO/SSO. It is found that indicates the success of implementing risk mitigation of
both options are economically viable from different risk the three options. Thus, the significant change of stan-
rational and risk seeker points of view. The three options dard deviation confirms the important role that long-
illustrate how financial decisions can be made based on term contracts and future contracts play in the financial
the risk exposure of the project under different bun- viability of a refinery project. The lenders and sponsors
dles of supplies and off-takes. Exhibit 19 clearly shows should carefully assess the risk associated with different
that the higher the risk the investors take, the higher crude oil supply sources and potential product off-takers
EXHIBIT 18
Cumulative Cash Flow After RRM Under 40/40/20LSO/FSO/SSO with 80/20 D/E
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EXHIBIT 19
Standard Deviation and Risk for Three Options
before making any investment decision. The mechanism believe that accurate assessment of these risks associated
developed by the authors supports this risk assessment with each procurement-off-take method is fundamental
and contracts selection process. to the arrangement of supply and off-take and to the
The detailed analysis of 65 typical bundling supply financial viability of a project.
and off-take structures demonstrates how sensitive the Secondly, long-term contracts and future con-
project is to the change in the bundling relationship of tracts can be used to hedge a certain degree of price
supply and off-take. The following are findings from risk; however, too great a percentage of these contracts
these tests: can significantly reduce the chance of generating high
First of all, the ZDRP project under single pro- profits. In other words, supply and off-take contracts
curement/off-take methods (such as pure SSO, pure can be extremely valuable in downside protection of
LSO, and pure FSO) is deemed to be very risky. Long- IRR in exchange for truncating the upside IRR for
term contracts can be useful if the price difference ZDRP. The tests based on the mechanism clearly show
between long-term supply contract and off-take con- how the risk profile and economic return are balanced
tract has competitive advantages over the spot supply and with adjustment of the bundling relationship of supply
off-take. However, the risk associated with long-term and off-take.
supply contracts or long-term off-take contracts such Thirdly, the authors distinguish between the risk
as default risk and political risk, which may offset their variables and decision variables in over 65 scenario tests.
price advantage, can possibly make the project more Risk variables are defined as the variables that cannot
risky than if the project is operated under a pure SSO be controlled such as price risk, whereas the decision
structure. The impact of any risks associated with the variables are the variables such as the percentage of LSO,
long-term contract on the project could possibly damage FSO, and SSO which can be controlled by the project
the bundling relationship of supply and off-take con- sponsor. Therefore, two types of sensitivity analysis were
tracts, which could increase the risk of mismatching carried out: sensitivity analysis of risk variables and sen-
prices between crude oil and the refined products. In sitivity analysis of decision variables. Sensitivity analysis
other words, the refining margin, which is determined of risk variables can help to determine which variables
on the bundling relationship between supply and off- potentially have the most impact on the ZDRP. Risk
take, would be affected by either long-term supply con- variable sensitivity analysis combined with decision vari-
tract default or long-term off-take contract default. This able sensitivity analysis demonstrates that the change
explains the reasons why many oil refineries are reluc- in the bundling relationship of supply and off-take can
tant to make long-term commitments to crude suppliers significantly affect the risk profile during the operation
and refined product off-takers. However, the above tests stage. The project shows a greater sensitivity to the risk
prove that well structured and assessed arrangements variables in the operation stage rather than to the risks
of the bundle of supply and off-take can balance risks in the construction stage.
among these supply/off-take methods and significantly Then, the project is sensitive to change in certain
improve the financial viability of the ZDRP project. ranges of decision variables. For example, when the SSO
From the above tests, the authors summarize the com- is fixed at 20%, the worst-case IRR is relatively sensitive
parison of major risks between long-term contract and to the change of the bundling relationship between LSO
spot purchase and off-take in Exhibit 20. The authors and FSO, whereas with increasing percentage of SSO
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EXHIBIT 20 implementation of RMM is crucial as this

Comparison of Major Risk Between Long-Term Contracts will allocate some of the risks, and reduce
and Spot Supply/Off-Take risks that may occur during the procure-
ment of ZDRP.
SCENARIO II
In scenario II the authors exam-

ined how the time line factor associated
with long-term contracts could affect

the return and risk of ZDRP. The risk
ranges associated with crude supply con-

tracts and product off-take contracts vary
from period to period. The longer the
(fixed at 40%, 60%, and 80%) the project is less sensitive to contract duration, the greater the risk
the change in the bundle of LSO and FSO. It implies that associated with these contracts as illustrated in Exhibit
risk associated with certain percentages of these decision 21. For example, the long-term supply contracts risk
variables would have a significant impact on the project. range in the first 5 years will be different from the long-
Similar to the sensitivity analysis of risk variables, the term supply contracts risk range for 20 years. The reason
for this is because within a relatively short period, for
authors believe that the benefit of performing sensitivity
example 5 years, crude oil spot price and product spot
analysis for the decision variables is that it can help to
determine which decision variables potentially have the price do not change as much as the prices change over a
20-year period according to historical WTI crude data
greatest negative impact on the project and which deci-
as shown in Exhibit 22. Therefore, there is relatively
sion variables play the most important role in improving
lower risk that suppliers and off-takers withdraw from
the financial viability of a project.
the project. Similarly, during the operation period from
Lastly, without implementing the appropriate
the 5th to the 10th year, long-term contracts would have
RMM to minimize or manage the risks, the economic
parameters of ZDRP in any tested scenario are not a relatively higher risk range than for the first 5 years
promising. In order to make the project applicable, the but would have a lower risk range than the operation
EXHIBIT 21
Default Risk and Duration of a Long-Term Contract
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EXHIBIT 22
WTI Spot Price from 1986 to 2007
Data from EIA database, adapted with Microsoft Excel by the authors.
period from the 10th to the 20th year because in 20 years) to 6.18% (first 6 years 100% LSO and 100% SSO
years time the crude oil price would probably change for the remaining 14 years), whereas after the 6th year
significantly. the worst-case IRR continues to increase and reach its
After simulation, the authors plotted these results, highest at 8.75% (first 9 years 100% LSO and 100% SSO
which include the best, worst, standard deviation of for the remaining 11 years). These fluctuations also occur
IRR, IRR at the 15% and 85% probability points on in other combinations of supply and off-takes in Scenario
the diagram as shown in Exhibit 23. Examination of I tests. The authors believe these f luctuations are caused
the graph makes it clear how these parameters change by the crude oil price mismatching with product price.
by changing time decision variables. As Exhibit 23 illus- For the IRR at the 15% probability point, the period
trates, by extending the period of using the long-term extension of using long-term contracts can improve the
contracts, the worst-case scenario can be improved from IRR from 9.67% (1st year 100% LSO and 100% SSO for
4.05% (100% LSO for 1st year and 100% SSO for the the remaining 19 years) to 12.62% (First 13 years 100%
remaining 19 years) to the highest 8.73% (100% LSO LSO and the remaining 7 years 100% SSO). However,
used in first 9 years and 100% SSO for the remaining 11 after the 13th year, there is a clear trend of decreasing
years). The results clearly show that the worst-case IRR IRR, which implies that extending the period of long-
starts to decrease after the 9th year. This is caused by term contracts does not improve the IRR at the 15%
the increasing risk associated with long-term contracts, probability point after the 13th year. The results in
which contribute to a reduction of the worst-case IRR. Exhibit 23 show that there is no significant difference
By extending the long-term contract period, the price in IRR at the 85% point by extending the period of
competitive advantage of using long-term contracts is long-term contracts. However, the extended long-term
gradually offset by the risks associated with long-term contract period can significantly reduce the best-case
contracts. IRR. The standard deviation decreases by extending the
It appears that the worst-case IRR shows certain period of long-term contracts, but after the 11th year, the
fluctuations when extending the long-term contracts. For standard deviation starts to increase due to the increasing
example, the worst-case IRR dropped from 6.75% (first risks associated with the long-term contracts.
5 years 100% LSO and 100% SSO for the remaining 15
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EXHIBIT 23
Combination of Long-Term Contracts and Spot Against Time
The structure of the first 9 years 100% LSO and future contracts. It implies that 100% percent of LSO
the remaining 11 years 100% SSO appears to be the best (9 years) is the major factor which determines the risk
solution in terms of worst-case IRR from a risk-averse profile for ZDRP.
point of view. The authors consider the combination of
the first 9 years 100% LSO and 50/50 FSO/SSO for the PROBABILITY ANALYSIS
remaining 11 years as a better solution. Apart from risk
ranges of long-term contract, other assumptions remain The probability analysis result shows that there is
the same as in the previous scenario. A debt-equity ratio 15% likelihood that the IRR will be less than 10.89%
80/20 is assumed in this case. with 85% probability that the IRR would not exceed
14.64%. Although there is improvement in IRR at both
SENSITIVITY ANALYSIS the 15% probability and 85% probability points com-
pared with options in Scenario I, there is still finan-
It is found that environmental risk, operation risk, cial uncertainty accompanying the project as illustrated
long-term contract price risk, and interest rate risk asso- in Exhibit 24. Unless the promoter takes measures to
ciated with Xinjiang crude oil become the top five risks. reduce or allocate risks identified, the chance of the
The project becomes relatively less sensitive to the price lender agreeing to finance ZDRP is low.
risk and supply/off-take risk associated with spot and
EXHIBIT 24
Comparisons of IRR at 15% and 85% Probability Points with Options in Scenario I
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Exhibit 25 The cumulative cash flow diagram

Probability-Band Cumulative Cash Flow Before RRM is improved significantly after RMM,
as shown in Exhibit 28. The worst-case
IRR is improved to 13.06% which is
0% higher than the MARR and the worst
case of any previous scenarios; mean-
100%
while, the best case IRR also shows a
significant improvement after RMM.
85%
The NPV for the base and best case
50% are $9,420 million and $11,459 million

respectively and for the worst case, it
15% is $6,083 million as shown in Exhibit

27. Compared with probability-band
100% cumulative cash f low in Exhibit 25,
50% 85% Exhibit 28 shows that there is significant
15%
reduction of each probability-band of a
cash f low, for instance, there are 100%
probability that the cumulative cash
f low will fall between $6,083 million
and $11,459 million after RRM (before
RRM it was between $2,843 million
and $10,718 million), which demon-
strates the effects of implementation of
RMM.
Exhibit 25 demonstrates the probability-band A comparison between the prob-
cumulative cash f low. It shows the different probabili- ability analysis before and after implementing the RMM
ties of achieving the expected cash f low. For instance, is summarized in Exhibit 29. It demonstrates that the
there is a 100% chance that the project real cash f low chances of increasing the financial performance of
would fall in the best and worst case envelope; there is a ZDRP are substantial after RMM. After implementing
0% probability that project real cash f low would remain RMM, the difference is only 2.4% between the 15% and
exactly the same as the base case. The cumulative cash 85% probability points. The overall financial evaluation
f low diagram shows that the IRR for the base case and of ZDRP under this structure of 100% for the first 9
best case are 16.89% and 17.47% respectively; the IRR years LSO and 50/50 FSO/SSO for the remaining 11
for the worst case is 7.12%. The NPVs for the base and years indicates that ZDRP is suitable for private finance
the best case are $9,420 million and $10,718 million as it will satisfy all sponsors and lenders requirements.
respectively, but the worst case is $2,843 million and Scenario II clearly shows how the project is sensi-
the payback period for the worst case is 17.16 years as tive to extending the time period and using long-term
shown in Exhibit 26. contracts throughout. It is found that a reduction of
Exhibit 26 Exhibit 27
Economic Parameters for ZDRP Before RMM Economic Parameters for ZDRP After RMM
Spring 2011 The Journal of STrucTured finance 91
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Case studies
Exhibit 28 refinery project. The authors simulated

Probability-Band Cumulative Cash Flow After RRM each bundle of supplies and off-takes
and compared the different economic
outputs for each bundle, in a total of
85 typical scenarios. The assessment
0%
clearly illustrates the best, worst, and
100% base case economic parameters of bun-
dles with the impact of both supply/
85% off-take risk and typical refinery risks.
The detailed analysis of the bundling

50%
relationship between supplies and off-
15% takes provides a better understanding

100%
of how the characteristics of different
85%
bundling relationships can be used to
define the properties of investment
15% 50% opportunities, which is paramount to
investors and sponsors.
The assessment offers a detailed
method for assessing the financial via-
bility of a refinery procured utilizing
project finance. Sponsors and investors
in refinery projects can assess specific
risks affecting crude oil supply and off-
take in relation to the overall project
economic parameters. The mechanism
can aid stakeholders in the decision-
Exhibit 29 making process regarding a bundle of crude oil supply
Comparison of Probability Analysis Before and off-take contracts and the choice of financial instru-
and After RMM ments based on the risk and return. A similar method
can be applied to determine the multiple crude oils to
be purchased and their percentages within a bundle of
crude oil supplies.
There are numerous combinations of crude oil
supply and product off-take bundles. The risks associ-
ated with supply and off-take are extremely complex.
the duration of long-term contracts can be very impor- The tests have shown that economic viability is very
tant in mitigating the risk associated with contracts and sensitive to changes in the bundling relationship of
strengthening the financial viability of ZDRP. With crude oil supply and off-take. Clear bundling struc-
the appropriate duration, long-term contracts can play tures of supply and off-take contracts should be built in
a very important role in determining the financial via- order to manage the risk associated with the crude oil
bility of the project. supply and product off-take and strengthen the financial
viability of a project. The choice of a bundle of crude
REVIEW OF THE CASE STUDY oil supplies and product off-takes is paramount to the
commercial viability of a refinery, thus making risk
The case study demonstrates that the mechanism management an integral part of refinery procurement
combined with CASSPROF can be successfully applied and operation.
to assess risk and evaluate the financial viability of an oil
92 QuantitativeevaluationoftheR elationshipBetweensupplyandoff-takeContRaCts spRing2011
524

Case studies
CONCLUSION economic returns, from which a suitable structure can

be arranged. The structure of supply and off-take then
The authors draw the following conclusions, which provides a basis for evaluating the commercial viability
are discussed in detail after the bullet point summary: of a petroleum refinery project.
Bundles of supply and off-take contracts can be
The security package structured by contractual assessed to determine uncertainty in different combi-
arrangements can significantly affect the financial nations of supply contracts. Although supply and off-
package. take contracts can be used to mitigate a certain degree
Long-term contracts may have competitive advan- of supply risk and demand risk, the risk associated with
tages in hedging price risk, but supplier or off-taker
these contracts themselves must be carefully evaluated.

default risk can be a crucial factor in decreasing the Different contracts have different risk characteristics. As
value of these contracts. a result, different bundles of supply contracts and off-take
Spot market purchase and off-take is more f lexible contracts have different risk profiles. No conclusion can
but demand risk and price risk are high. be drawn that long-term contracts must have lower risk
The bundling of supplies and off-takes can be or spot market purchase must involve higher risk. Risks
extremely valuable in the downside protection of associated with supply and off-take vary from contract to
IRR in exchange for truncating the upside IRR. contract and should be systematically assessed. Long-term
Any changes in the supply contract would inf lu- supply and off-take contracts do not necessarily provide
ence off-take contracts because the bundling rela- lower risk profiles nor do they secure better revenue gen-
tionship is built on the basis of the crack ratio, and eration characteristics.
vice versa. The authors conclude that several major condi-
Evaluating the bundling relationship through risk tions have to be met for project finance in long-term
and its impact on the economic parameters is a contracts:
breakthrough for further research in developing
contractual arrangements for project f inance The supplier or off-taker has high credibility.
transactions. There is a suitable price mechanism for reducing
The time factor can significantly affect the risk the price mismatch between supply contracts and
range of supply/off-take contracts. long-term off-take contracts.
The mechanism tried and tested for structuring A stable crude oil supply is available.
supply and off-take contracts provides a standard Project revenue can be secured on the basis of the
approach against which a petroleum refinery project crack ratio between long-term supply contracts and
procured by project finance can be appraised. long-term off-take contracts. It implies that each
long-term supply contract should have its corre-
The research clearly illustrates that although many sponding off-take contracts to secure the margin.
projects have been procured utilizing project finance There is long-term political stability both inter-
worldwide, no mechanism currently exists specifically nally and externally. If there is a long-term con-
for structuring the arrangement of supply and off-take tract signed with an oil-exporting country, the
contracts in the procurement of refinery projects. Based political relationship between the two countries
on the authors research, the mechanism developed is the is important. If the long-term contracts are signed
first standard model developed specifically for evalu- with local oil producers, political interruption on
ating the supply and off-take contractual arrangement the upstream crude exploration should be consid-
in project finance transactions. The mechanism tested ered. The same can be applied to the long-term
for structuring supply and off-take contracts provides product off-take.
an approach against which a petroleum refinery project Long-term contracts must have competitive price
procured by project finance can be appraised. The advantages; otherwise, there is little justification
mechanism initially provides the framework for inves- for using them.
tigating the bundling relationship between supply and
off-take contracts by assessing risk and its effect on the
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Case studies
If any of the above conditions are not met, there the research. It was found that any changes in the supply
would be a high risk associated with the contract. The contract would inf luence off-take contracts because the
value of using a contract should be carefully evaluated. bundling relationship is built on the basis of the crack
When a refinery enters into long-term contracts or other ratio. The risk characteristics associated with different
contracts, the investors and promoters should consider: supply and off-take methods are different, which deter-
mine the overall risk profile of a bundle of supply and
Does it have competitive price advantages? off-take contracts. The upside of a supply and off-take
Does it bring additional risks to the project? contract that has high risk and high return can offset
Can the overall risk and return associated with the the downside of a supply and off-take contract that has
contract be improved by using alternatives? low risk and low return under certain circumstances.
How much revenue can be guaranteed by using After bundling, the overall risk of supply and off-take
long-term contracts? can be reduced in terms of worst case scenario economic

return. The case study results indicate that the bundle of
Futures contracts and other derivatives have proved supplies and off-takes can be extremely valuable in the
to be useful instruments in mitigating the risk associated downside protection of IRR in exchange for truncating
with crude oil supply and off-take in the petroleum and the upside IRR.
natural gas industries. These derivatives allow investors There can be two types of revenue streams in a
to transfer risk to others who could profit from taking refinery project procured by project finance. The rev-
such risk. However, the price, duration, and availability enue stream produced by buying crude oil and selling
of future contracts are major constraints in making long- petroleum products in the spot markets can be consid-
term investment decisions. In addition, dealing with ered as a market-led revenue stream, whereas a revenue
futures requires skilled practitioners. stream generated under long-term contracts or other
One of the major points of project finance is to forms of contract can be regarded as contract-led rev-
ensure the commercial viability of a project in the face enue generation. Market-led revenue streams are not
of its risk exposure. Any risk that cannot be mitigated secured revenue because of volatility in the spot market.
could result in failure to repay debt. A petroleum refinery However, the spot market gives an opportunity that the
project faces many risks and mitigation methods must refinery may make more profit because of the associ-
be taken to ensure that these major risks are efficiently ated high risk and high return. In the authors opinion,
managed before the project is sanctioned. In project pursuing the high risk and high return is not the purpose
finance, risks can be efficiently allocated or managed of project finance when applied to a refinery. Oper-
when they are assumed by the party best able to manage ating a refinery is not a speculative business, especially
them. If a projects risk can be clearly identified, ana- a refinery procured utilizing project finance, and the
lyzed, and mitigated, then an efficient way to finance nature of project finance does not allow a refinery expo-
the project can be found. sure to high risk. Investors and promoters should con-
In the case study the authors classified the key sider all the upside and downside risks involved when
aspect of risk exposed in different purchase and off-take financing a capital-intensive oil refinery. If the project
methods. Long-term contracts may have competitive fails, the loss of investment could be huge. Therefore,
advantages in hedging price risk, but supplier or off- market-led revenue streams should not be a major part
taker default risk can be a crucial factor in decreasing of the revenue generation of a refinery financed using
the value of these contracts. Spot market purchase and project finance. A refinery procured by project finance
off-take is more f lexible but demand risk and price risk should focus on the baseline return.
are high. The mechanism presented provides a method In project finance, the financial package is mainly
to systematically assess these risks and to support the determined by the risk to which a project is exposed.
decision making on the choice of bundles of supply The authors suggest that the security package structured
contracts. by contractual arrangements can significantly affect the
The quantitative method for assessing the bundling financial package. The bundle of supply and off-take
relationship between supply contracts and off-take con- contracts with high risk will require more equity and
tracts by using risk and return is successfully addressed in bonds, whereas a low-risk bundle will require more
JSF-CHU.indd 94 4/8/11 7:45:47 PM
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Case studies
debt. The cost of financing varies from instrument to Merna, A., and C. Njiru. Financing Infrastructure Projects.
instrument. The authors suggest that by evaluating risk/ London: Thomas Telford, 2002.
return profiles of various bundles of supply and off-take
contracts, project sponsors can raise funds more effi- Merna, T., and F.F. Al-Thani. Corporate Risk Management:
ciently. To raise adequate funding, sponsors must settle An Organisational Perspective. London: John Wiley and Sons,
2005.
on a financial package that both meets the needs of the
project in terms of projects risks and at the same time Merna, T., and Y. Chu. Risk Modelling of Supply and Off-
is attractive to lenders and investors. take Contracts in a Petroleum Refinery Procured through
The duration of a contract can be important in Project Finance. In CME 25: Construction Management and
making investment decisions. The longer the contracts Economics: Past, Present and Future, edited by Will Hughes.
duration, the higher the risk involved in a refinery project Reading, UK: Taylor and Francis, 2007.
related to change in the petroleum price. However, the

authors suggest that a certain proportion of contract-led NYMEX. Crack Spread Handbook. New York Mercantile
revenue should cover at least the payback period or at Exchange, 2001.
least bring the project through the breakeven point in
a project finance transaction in order to ensure debt Thomson Financial. First Quarter 2008 Global Project Finance
service. Review.
Crude oil prices are unpredictable; however, an
Thomson Reuters. 2009 Global Project Finance Review.
equitable pricing mechanism between two parties can be
established between oil producers and the refinery or the
refinery and off-takers. An equitable pricing mechanism To order reprints of this article, please contact Dewey Palmieri
in the contract is one of the major factors for success in at dpalmieri@ iijournals.com or 212-224-3675.
supply or off-take contracts.
REFERENCES
Frank, M., and T. Merna. Portfolio Analysis for a Bundle of

Projects. The Journal of Structured and Project Finance, Vol. 9,
No. 3 (2003), pp. 8087.
ICRA. Rating Methodology for Project Finance Transactions.

ICRA Rating Feature (an Associate of Moodys Investors
Service), 2003.
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Case studies
improving economic efficiency

of Public-Private Partnerships for
infrastructure Development by
Contractual Flexibility analysis
in a highly uncertain Context
The Journal of Structured Finance 2010.16.1:87-99. Downloaded from www.iijournals.com by FRANK J FABOZZI on 03/19/12.
Feng Dong anD nicola chiara
T
Feng Dong raditionally, governments (the eff iciency, compared with conventional
is a PhD candidate in public sector) usually have split infrastructure delivery systems.
the Department of Civil
infrastructure development into After a considerable number of research
Engineering at Columbia
University in New York, two separate working packages: and survey projects over almost a decade,
NY. design and construction. They contract out there is agreement that whether PPPs can
fd2151@columbia.edu design and construction to private design be economically efficient depends on how
firms and construction companies, or simply project risks can be allocated and handled
nicola chiara to a single design-build company, through a among stakeholders within an infrastruc-
is an assistant professor in
the Department of Civil
bidding process (Koppinen and Lahdenpera ture project. Actually, PPPs, as a long-term
Engineering at Columbia [2008]). The challenge of coping with contractual relationship between the public
University in New York, growing demands on public infrastructures and private sectors, usually have a rigid con-
NY. with a strapped budget is compelling govern- tractual structure. This principle can reduce
chiara@civil.columbia.edu ments worldwide to seek alternative delivery transaction costs but sacrifice opportunities
systems (ADS) for not only designing and to make PPPs more economically efficient
constructing but also for financing, plan- by allocating and addressing future down-
ning, operating, and maintaining packages. side risks appropriately and f lexibly during a
Consequently, public-private partnerships long-term concession, which is full of unpre-
(PPPs) have been sought as one of the most- dictable uncertainties that cause the failure
popular ADS to address the governmental of many infrastructure development projects
budget constraints. In addition, proponents under PPP procurement. This article aims
claim that PPPs ensure for the taxpayers the to present a novel type of proactive uncer-
key objective of public sector procurement, tainty management, contractual f lexibility
economic efficiency (Aziz [2007]), which analysis (CFA), which can improve the eco-
is defined as reducing economic costs to nomic efficiency of PPPs by incorporating
achieve specific economic benefits compared f lexibilities into the current way of contract
with traditional delivery methods. Although structuring.
PPPs have gained great success in some infra-
structure development projects, various prob- The CriTiCal SuCCeSS
lems have occurred in other projects as well, FaCTor oF PubliC-PrivaTe
resulting in many opponents of PPPs. Almost ParTernShiPS
all of the doubts focus on whether PPPs can
fulfill their key objective of economical The process through which an infra-
structure project is developed to create goods
528

Case studies
or services can be roughly broken down into four prin- need for PPPs (Garvin [2009] and Levy [2008]). On
cipal tasks: 1) defining and designing, 2) financing the the other hand, there is no disputing the fact that some
capital cost, 3) building the physical assets (e.g., roads, PPPs have not performed as well as projected. After the
highways, ports, etc.), and 4) operating and maintaining failure of some PPP projects in Latin American countries
the infrastructure assets in order to deliver the product (Guasch et al. [2005] and Estache [2006]) and Asian
or service (Daniels and Trebilcock [1996]). Tradition- countries (Gomez-Ibanez and Meyer [1993]), various
ally, the public sector often contracts out tasks 1) and 2) critics of PPPs have alleged that they are a means to
sequentially with the designer and then with the con- disguise conventional contractual undertakings that are
tractor by a design-bid-build (DBB) procedure (Zhang subject to standard budgeting processes, as some new
[2005a]). A more integrated delivery method is design- undertakings are carried outside the budget, rather than
build (DB), where the public sector packages tasks 1) and an advanced way to achieve economic efficiency (Sadka
2) together to contract with a single source to design and [2006]).

build an infrastructure project individually. No matter The mixed opinions on PPPs economic efficiency
which delivery system is implemented, the public sector can be explained in many ways. Through a variety of
is responsible for financing, operating, and maintaining quantitative research projects and questionnaire surveys
the project. (Zhang [2005b]), which aim to identify critical success
Infrastructure project expenditures in the world factors (CSFs) to improve the economic efficiency of
economy have been growing substantially over the last PPPs in infrastructure development, researchers note
two decades. The worlds glaring infrastructure deficit that the most significant CSF, which determines whether
manifests itself in the obvious need for new facilities an infrastructure project would be more economically
decaying public transit systems and recreational facilities, efficient and successful, is to allocate and address down-
dilapidated bridges, deteriorating schools and hospitals, side risks appropriately among stakeholders within an
and outmoded waste treatment facilities, in developed infrastructure project by implementing advanced finan-
countries such as the United States. Many factors con- cial engineering techniques. Li et al. [2005] identified
tribute to the current deficiencies in infrastructure, appropriate risk allocation as one of the six CSFs for PPP
including age and economic and population growth. projects. Carrillo et al. [2008], according to the U.K.
The public sector, which traditionally has shouldered experience, mentioned that transfer of risks by well-
the burden of infrastructure finance through a variety defined contracts is one of the CSFs. Zhang [2005b]
of public-financing structures, must face the daunting classified CSFs into five categories, one of which was
challenge of balancing the huge spending demand with a appropriate risk allocation. The most recent research is
constrained budget (Augenblick and Custer [1990]). The from Abdel Aziz [2007], which proposed perception of
U.K. government pioneered the policy of private finance risk allocation to be a CSF.
initiative (PFI) in 1992 by permitting the private sector
to act as private project promoters to be involved in tasks alloCaTing anD aDDreSSing
1) and 2), as well as 3) and 4), in order to relieve the budget DownSiDe riSkS by ConTraCTual
problem of the public sector. Following PFI, a number FlexibiliTy analySiS
of PPPs have appeared, including the most popular and
typical one, build-operate-transfer (BOT), and its vari- An infrastructure project, to some extent, can be
ants such as build-transfer-operate (BTO), design-build- called a contract structuring project, because the way
finance-operate (DBFO), build-own-operate (BOO), contractual agreements are crafted determines viability
design-build-operate-maintain (DBOM), and others and economic rewards of an infrastructure project,
(Zhang and Kumaraswamy [2001] and Koppinen and legally regulates stakeholders relationships and respec-
Lahdenpera [2008]). tive responsibilities, and controls the allocation of risks
On the one hand, a great range of infrastructure (see Exhibit 1).
projects have been successfully developed through PPPs Therefore, for the purpose of economic efficiency
with significantly increased value, such as the first eight improvement, the public sector and private project pro-
DBFO roads in the U.K. (Highways Agency [1997]). moters of in an infrastructure development project face
Thus, many people in the academic circle stress an urgent the tough task of deciding how to allocate and address
88 i mproving economic efficiency of p ublic-p rivaTe parTnerShipS for i nfraSTrucTure developmenT Spring 2010
529

Case studies
exhibit 1
The Standard Contract Structure for a PPP Development Project
risks in the best way by an appropriate contractual unpredictable demographic changes in the wake of glo-
structure. The PPP in an infrastructure development balization, rapid regulatory changes, etc.), it is hard to
project is for a relationship-specific investment, where assign and handle future downside risks appropriately
both the private sector and public sector are better off at the very early stage via long-term and rigid con-
completing the infrastructure project together than ter- tractual agreements. Consider that some stakeholders
minating the relationship and starting to trade with other might not be satisfied by the irreversible final results
parties. Thus, the consequence of relationship-specific of an infrastructure development because of the down-
investments is that transaction costs arise because of bar- side risks of the future uncertainty, while others might
gaining and opportunistic behavior. The way to reduce be over-satisfied by results that are better than their
the transaction costs is to write long-term, firm con- expectations due to the upside potential of the future
tracts, which is also very common in PPPs (de Bettignies uncertainty. However, based on a win-win principle,
and Ross [2004]). However, an infrastructure develop- each of the stakeholders should have a happy ending
ment project, by its very nature, has a characteristic of in an economically efficient and successful project. This
high uncertainty. It is almost impossible for the public problem can be solved by a proactive uncertainty man-
sector and private project promoters to foresee the situ- agement approach, including the incorporation of f lex-
ation and environment of an infrastructure project in ibilities, which take the form of contingent claims, into
the distant future (e.g., the operating phase) when they the contractual structure of a PPP infrastructure project.
are at the early appraisal stage. Consequently, with the Significant transaction costs thereby can be avoided, and
high level of uncertainty from initial phase to the dis- the best value can be obtained for each unit of economic
tant future (e.g., unforeseeable advances in technology,
530

Case studies
cost in an infrastructure development when selecting of endogenous f lexibility that does not present itself but
PPPs as the procurement method. can be created and then added into an infrastructure
development project by innovative financial engineering
real option analysis techniques. Real options in projects mostly refer to the
f lexibility in physical design (Zhao and Tseng [2003],
To better understand f lexibility in contractual Gesner and Jardim [1998], de Neufville et al. [2006], de
structuring, we are inclined to summarize another sim- Neufville et al. [2006], etc.). An example of real option
ilar proactive uncertainty management approach, real in is bridge in bridge (Gesner and Jardim [1998]).
option analysis (ROA). ROA, a derivative of financial The original designers can build the bridge stronger
option theory, has drawn attention from researchers and than originally needed, strong enough so that it could
practitioners to manage uncertainty by considering some carry a second level if there is a higher-than-expected
forms of f lexibilities in infrastructure development proj- traffic demand in the future. Another example con-
ects for decades. ROA was initially developed by Dixit cerns parking-garage design (de Neufville, Sholtes, and
and Pindyk [1994], Trigeorgis [1996], and Amram and Wang [2005]). The structural designers can include a
Kulatliaka [1999], etc. De Neufville [2003] proposed real option in the design by strengthening the footings
a well-known definition and categorized real options and columns of the original building so that they can
into real options on and in a project, as shown in add levels of parking easily when demand rises. ROA is
the upper half of Exhibit 2. In short, according to Wang becoming a more and more mature approach to improve
[2005], real options on projects are thought to be a economic efficiency in PPPs (de Neufville, Lee, and
kind of exogenous f lexibility that has already existed in Scholtes [2008]).
an infrastructure development project and is waiting for
people to exploit. Real options on projects are mainly Contractual Flexibility analysis
concerned with valuation of investment opportunities
such as an option to defer, option to abandon, option to CFA, first proposed by Chiara and Kokkaew
switch, and time-to-build option (Amram and Kulatilaka [2009] and derived from financial option theory, evalu-
[1999], Leslie and Michaels [1997], etc.). Comparatively, ates the endogenous f lexibility from the perspective of
real options in projects are considered to be a type a project level, because while real options in proj-
exhibit 2
evolution of real options analysis and Contractual Flexibility analysis
90 i mproving economic efficiency of p ublic -privaTe parTnerShipS for infraSTrucTure developmenT Spring 2010
531

Case studies
ects consider the endogenous individual f lexibility in a the private project promoter during the delivery period
single project shareholder, CFA refers to the endogenous to repeatedly exercise the contingent claims to receive
interdependent f lexibility within a contractual structure a greater or lesser amount of construction materials
of multiple shareholders (see the lower half of Exhibit 2). under pre-determined volume delivery constraints, so
As a foregoing statement, an infrastructure development that price and volume risks of construction materials can
project can be thought to be a long-term, relationship- be transferred from the project promoter to the supplier
specific investment with a high level of uncertainty. partly when the downside risks of the price and volume
Allocating and addressing risks by rigid long-term uncertainty attack the project promoters.
contracts without f lexibilities can result in a disaster to
some shareholders or even to the whole infrastructure Flexibility analysis Procedure

project. In order to make an infrastructure project more
economically efficient, long-term irreversible contracts The procedure of f lexibility analysis in PPPs of
have to be drafted innovatively with f lexibilities to pro- infrastructure development is a two-step procedure:
vide shareholders with contingent claims to adjust risk 1) discovering and incorporating individual exogenous
allocation over the whole project lifecycle. Through and endogenous f lexibilities by ROA, and 2) adding
CFA, the rigid terms in these long-term contractual proper endogenous interdependent f lexibilities between
agreements can be replaced by the corresponding well- parties by CFA (see Exhibit 3).
defined f lexible terms, by which the major merit of rigid In step 1, a stakeholder tries to take advantage of
contracts can be kept, minimizing transaction costs, and real options on projects and takes into account real
some shareholders obtain the rights to shift their pos- options in projects to ensure he is individually f lex-
sible future downside risks to some other contractual ible enough to mitigate future downside risks. In step 2,
parties that can deal with it more cost-efficiently and a shareholder uses his best knowledge to reach contracts
help the original risk-bearing shareholders to mitigate embedded by suitable interdependent f lexible terms
the risks down to an acceptable level. An example of with his counterpartywhich take the form of con-
CFA is a take-or-pay contract. Such a contract allows tingent claims in contractual agreementsto make the
exhibit 3
Procedure of Flexibility analysis in PPPs
532

Case studies
infrastructure development project more economically text (Chiara [2009]). It is assumed that a stakeholder in an
eff icient. Suppose some future downside risks are infrastructure project can be represented by a structural
incurred by Party A, who is vulnerable to the sudden element. When a structural element is subjected to some
appearance of the impacts, during an infrastructure external force at a certain level, the structural element
development lifecycle. Fortunately, according to the pre- response is a certain force impact. Following on the
defined f lexible terms, Party A choose to exercise some structural analogy, we may think that shareholders A and
of the contingent claims embedded in the contractual B are subjected to a certain level of downside risk respec-
agreement between Party A and Party B to transfer the tively (see Exhibit 4 (a and b)). The system response to
downside risks to Party B , who is less vulnerable or even these downside risks can be expressed as shareholder As
immune to the risks transferred to her. and Bs initial risk impacts, I0. The initial secant stiffness
of the shareholder is the slope of the straight line OC1 in
Structural analysis analogy of Contractual Exhibit 4 (a and b). Another important risk element is
Flexibility analysis the tolerated risk impact of a shareholder, the upper limit
of the expected loss that shareholder A or B is willing
Structural analysis analogy can be introduced to to accept. Exhibit 4 (and b) describes the risk file of
explain how contractual f lexibility functions in this con- shareholder A and B that will prompt both shareholder
exhibit 4
Structure analysis of Contractual Flexibility in PPPs
92 i mproving economic efficiency of p ublic-p rivaTe parTnerShipS for infraSTrucTure developmenT Spring 2010
533

Case studies
A and B to be reluctant to participate in the project. Brief ly, the four types of f lexible clauses fall into
By calculating ROA in step 1 of the f lexibility analysis, two dimensions: timing f lexibility and right f lexibility.
shareholders A and B install inside springs that play A contract that allows shareholders to shift risks over a
as individual elements of f lexibility in the structure of specified timing zone (e.g., American option contract
the project (see Exhibit 3). Therefore, the new stiffness type) can be regarded as more timing-f lexible than one
of shareholder A and B changes to be the slope of the that specifies a predefined future time (e.g., European
straight line OC2 in Exhibit 4 (a and b). The new risk option contract type). Similarly, an agreement that
profile of shareholder A and B implies that the new cor- permits shareholders one opportunity to transfer risks
responding risk impact is below the shareholder As risk (e.g., American option contract type) is thought to be
toleration but still above Bs risk toleration. Therefore, stricter than one allows more than one opportunity
now shareholder A is willing to join in the project, but (e.g., multi-exercise American option contract type).
shareholder B still chooses to leave it. CFA in step 2 is In spite of this limited number of f lexibility dimen-
on a project level. From the perspective of the entire sions, the principle of Chiara and Kokkaews research
infrastructure development project, the organization provides an enlightening source for us to extend their
of which is linked by project contracts, shareholders A work further. So far, following in the footsteps of the
and B can set up an interdependent f lexibility as a con- pioneering researchers, the number of f lexibility dimen-
necting spring between them (see Exhibit 3). sions in contractual structuring has been expanded into
When an external force at a certain level attacks six dimensions (see Exhibit 5), involving strike prices,
shareholder B, through this connecting spring share- right type, right holder, and breach of clause, in addition
holder B can shift an amount of external force to to timing and right.
shareholder A, who has surplus ability to shoulder extra Contractual f lexibility allows shareholders to either
force in addition to what shareholder A has already initialize strike prices to be a stream of deterministic
taken. As shown in Exhibit 4 (c and d), now the changing strike prices or set up the strike prices following a pre-
of the stiffness happens to shareholders A and B, and the defined function relative to future project status. Con-
slope of the straight line OC2 turns into OC3 by incor- tractual f lexibility in the number of right types allows
porating this interdependent f lexibility. Shareholder Bs a shareholder to hold more than one type of contingent
downside risk impact is reduced below its tolerated risk claims at the same time. Contractual f lexibility in the
impact under the same risk level, while shareholder As number of right holders allows contingent claims to be
risk impact increases, but still remains below its toler- held by more than one shareholder in a sole contrac-
ated risk impact. tual agreement. Contractual f lexibility even allows the
possibility for shareholders to breach some clauses in
Some examples of Contractual Flexibility a contract if those clauses can lead to shareholder risk
analysis in a certain scenario, yet the breaching of the clauses
usually involves a penalty as a form of compensation to
The main constraint of Chiara and Kokkaew the counterparty. Examples of these contractual f lex-
[2009] is that it contains only four types of f lexible ibilities are listed in Exhibit 5. We intentionally do not
contractual terms: forward, European option, American give an exact number of f lexible dimensions in con-
option, and multi-exercise American option. These far tractual f lexibility analysis. Because possible types of
from satisfy the needs of uncertainty management in f lexibility dimensions are unlimited, we intentionally
infrastructure projects in a highly uncertain environ- do not give an exact number of them in contractual
ment. In order to realize the economic efficiency of a f lexibility analysis.
privatized infrastructure, a variety of more f lexible terms
have been developed to assign and mitigate risks appro- Theory of valuation Contractual Flexibility
priately under a highly uncertain and complex context.
We would like to shed light on the four types first before Recognizing and valuating the benefits of the con-
analyzing and discussing more f lexible contractual terms tractual f lexibility is important, because there should
completely and symmetrically. be no free lunch (Sing, Ong, and Sirmans [2003]).
According to Exhibit 6 (a and b), it makes sense that
534

Case studies
exhibit 5
Some Types of Contractual Flexibility
However, valuation of these economic benefits of

exhibit 6 contractual f lexibility tends to be extremely difficult
Mechanism of valuation Contractual Flexibility for both academic researchers and practitioners, because
benefits usually include economic benefits, which are
considerably easier to quantify in money terms, as well
as social benefits, which are, to some extent, impos-
sible to price monetarily. An example of the former is a
construction-material supplier who offers a project pro-
moter a take-or-pay purchase contract. For obtaining
this contract, the project promoter has to pay the value
of the contract to the supplier for the possible downside
risks hedged by the supplier. Although quantification
of the monetary value is difficult, it can be achieved by
a sophisticated method, Monte Carlo Simulation-Sto-
chastic Dynamic Programming (Chiara et al. [2007]).
By contrast, consider an instance of the latter case. An
the beneficial shareholder is supposed to compensate the infrastructure project usually has a positive net social
counterparty who offers these benefits (risk mitigating value to the local economy (Faiz [1999]). For the pur-
in Exhibit 4 (d)) by sacrificing her own benefits (loss pose of improving local public welfare, a local govern-
in Exhibit 4(d)). If there is more than one contingent ment is inclined to provide some forms of assistance
claim holder, the shareholder who benefits more should to the privatized infrastructure sponsore.g., govern-
compensate the counterparty for the beneficial differ- mental guarantees. If we dig below the surface of so-
ence (see Exhibit 6(c)). called free governmental assistance, we can find that the
local government is compensated by the social benefits
94 i mproving economic efficiency of p ublic-p rivaTe parTnerShipS for infraSTrucTure developmenT Spring 2010
535

Case studies
from the infrastructure project. Although the approaches lessor can be burdened by higher future traffic demands
to quantifying social benefits are still more subjective than projected. CFA allows the contractual agreement
than those for economic benefits, a more systematic between the public lessor and the private lessee to be
analysis would improve the understanding of the social embedded in an American put option and an American
benefits brought by an infrastructure project (Behrman call option. The private lessee needs an American put
and Stacey [1997]). option, which entitles the private lessee to lease the pool
of projects back to the public lessor to hedge the down-
an illuSTraTive exaMPle side risks that the underlying projects may generate lower
revenues than expected, and allows the private lessee to
The illustrative case study examines a brownfield reinvest its capital into a more profitable opportunity.
service-based project, where the public sector leases a For comparable reasons, the public lessor would require
pool of several public highways to a private highway an American call option to avoid missed gains when
management company in the form of a concession. the underlying projects generate higher revenues than
Therefore, the private company is responsible for oper- expected. Through this American call option, the public
ating the pool of highways and compensated by col- lessor can terminate the leasing contract and release the
lecting fees from highway users during the concession project pool at a reasonable price, consistent with the
period. The key objective of the public sector in con- updated expected revenues. Moreover, a complementary
tracting out the operation phase to the private com- advantage for drafting this type of leasing contract lies in
pany is to improve the economic efficiency of PPPs protecting both parties from loss resulting from risk-free
in transportation service delivery by taking advantage rate f luctuations (see Exhibit 7).
of the private sectors skills, innovations, and manage- The American callable and putable options
ment. However, the leasing concession period can be embedded in the leasing contract, acting as the con-
as long as 99 years (Chicago Skyway). Even in a more necting spring between the public lessor and private
conservative situation, the concession can last 30 years lessee, give both parties rights to shift the downside risks
(South-North Highway in Malaysia, Bangkok Nighway to the respective counterparty (see Exhibit 7) if the cor-
in Thailand, and No. 3 Route in Hong Kong). Even responding future risky scenario happens. For example,
if this is a brownfield infrastructure project, which when the traffic volume is much higher than projected,
bears fewer risks than a greenfield or a rehabilitated the public lessor fails to obtain the rent it is supposed
brownfield infrastructure project, there are functional to get. In this situation, the private lessee over-reaps its
difficulties with almost all of the forecasting models profits from the public users and the objective of PPPs
in such a long-term concession due to a high level of for infrastructure development fails to be fulfilled. At
uncertainty. The private lessee is subject to less future that moment, the public lessor can choose to exercise
transportation demands than expected, while the public the embedded American call option to call the projects
exhibit 7
The PPP leasing Contract embedded by american Callable and Putable options
536

Case studies
back. It is as if structural element A can transfer some operation stage, a mean reverting stochastic process,
external force at a certain level to structural element Ornstein-Uhlenbeck, is used to simulate future revenues
B by the connecting spring (see Exhibit 7). in this case study. Similarly, the annualized risk-free
Because this pool of highway projects is a branch interest rate follows the generic Vasicek model process.
of very stable brownfield infrastructure projects at the The assumed leasing contract specifies that the term
exhibit 8
input Parameters for the illustrative example
exhibit 9
value of america Callable and Putable leasing Contract
96 i mproving economic efficiency of p ublic -privaTe parTnerShipS for infraSTrucTure developmenT Spring 2010
537

Case studies
period equals
period equals 10 10 years.
years. Suppose
Suppose that that the
the private
private lessee
lessee of the
of the contractual
contractual fflexibility
lexibility under
under aa highly
highly uncertain
uncertain
can collect
can collect 100%
100% of of the
the user
user fees
fees semi-annually.
semi-annually. There There environment.
environment.
isis aa six-month
six-month grace grace period
period forfor both
both parties.
parties. Both
Both leasing
leasing
contractual parties,
contractual parties, thethe public
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Pertaminas Blue Sky Project

Heralds Return of Innovative
Project Financing in Indonesia
GEORGE K. CROZER
I
GEORGE K. CROZER ndonesia has undergone considerable BACKGROUND
is a partner at White & economic, political, and social change in
Case LLP in Hong Kong. Indonesias rapid population growth and
the aftermath of the 1997 financial crisis.
gcrozer@whitecase.com industrial expansion has led to environmental
Major trade, structural, and macro policy
reforms have led to a more stable economy degradation in the country; in particular, use
and the return of foreign investment. In 2003, of leaded gasoline has caused serious pollution
the Government of Indonesia approved $13.2 problems. Atmospheric lead pollution in Jakarta
billion in foreign direct investment in a total has been measured at 1.3 micrograms (mg) per
of 1,024 projects.1 One successful example of cubic meter (cu m), well above the World
such investment is the $280 million Blue Sky Health Organization limit of 0.5-1.0 mg/cu m.
project, which is the first major structured The World Bank has identified lead emissions
finance deal in Indonesia in nearly four years. from gasoline as the greatest environmental
Sponsored by Pertamina, the project danger to Indonesians.
involves the upgrade of the oil refineries at In order to combat the problem, the gov-
Balongan and Cilacap, both in Central Java, ernment launched the Blue Sky initiative in
to enable the production of larger quantities 1996, with a target of zero leaded gasoline by
of unleaded gasoline for the domestic market.2 January 2000. The initiative included plans to
With the goal of ending Indonesias reliance on install a catalytic reformer and isomerization
leaded gasoline, the Blue Sky project is unit at Balongan, and to modify the catalytic
expected to reduce air pollution significantly reforming unit and install an isomerization
in Jakarta and other urban areas by advancing unit at Cilacap.
the development of environmentally friendly However, the project received a setback
energy resources. in 1997-1998 as the Asian economic crisis
For structured and project finance pro- derailed Pertaminas plans for financing. The
fessionals, the deal is also notable because it crisis also exacerbated environmental prob-
applies a trustee borrowing scheme structure lems as regulations were set aside and people
in which an offshore trustee acts as the bor- opted for less expensive, though more envi-
rower and is paid directly by the offtaker, and ronmentally damaging, production and har-
because the source of repayment of the proj- vesting methods.
ect debt is not connected to the work that is After three years of delay, an intermin-
being financed by the debt. isterial committee chaired by the Minister of
Transportation resurrected the Blue Sky Pro-
gram in July 1999. The Minister of Mines and
Energy subsequently issued a decree specifying
8 PERTAMINAS BLUE SKY PROJECT HERALDS RETURN OF INNOVATIVE PROJECT FINANCING IN INDONESIA SPRING 2004
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January 2003 as the lead phase-out date. This set in motion agreement into a trustee account (denominated in U.S.
the financing and contracting processes. dollars) established under the trust agreement between
The plant upgrades are scheduled to be completed Pertamina and JP Morgan. The cash waterfall mechanism
in 2005. Under the engineering, procurement, and con- in the trust ensures the repayment of the debt as a priority
struction (EPC) contract, the Japanese company Toyo over any other expenses and thus covers the refining
Engineering Corporation is upgrading the two refineries margin risk.
at Balongan and Cilacap in partnership with Indonesias The trustee borrower scheme originally was devel-
PT Rekayasa Industri. The key element is the addition oped in the late 1980s to provide off-balance sheet, non-
of facilities to produce high-octane mogas component, recourse financing for projects sponsored by Indonesian
or HOMC, an additive that can replace lead for raising government entities. New York has typically been the
the octane level of gasoline. The Blue Sky initiative will location of choice for the trustee, as New York law per-
add a combined total of 73,500 b/d in new HOMC pro- mits the trustee to own the cashflow from the offtaker.
duction facilities. The Blue Sky contractual structure also is distinct
The scope of the Toyo Engineering and Rekayasa because the source of repayment of the debt is not con-
consortium work includes design, supply of the equipment nected to the work that is being financed by the debt.
and materials, construction, and commissioning supervi- Rather than being serviced by income from the sale of
sion. Items to be constructed at the refineries include a unleaded petrol from the Balongan and Cilacap refineries
naphtha hydrotreater (52,000 BPSD), a PENEX isomer- themselves, the project debt is serviced from sales of unre-
ization plant (23,000 BPSD), and a CCR reformer (29,000 lated products produced at the Pertamina refineries. These
BPSD), along with related offsite facilities, such as storage five refineries were chosen as the source of the debt ser-
tanks for raw materials and the refined product. vice because they produce oil products in which the proj-
Pertamina will supply low-sulfur waxy residue ect offtaker (Mitsui & Co.) was willing to take a large
(LSWR) and decant oil produced from its five existing position. Although the offtaker is obliged to take and pay
refineries (including Balongan and Cilacap) to Mitsui. for the refineries output, its risk is reduced because of
The proceeds from the sale of these petroleum products the marketable nature of the products. As debt service is
will be paid to, and allocated as, the sole source of debt not dependent on the completion of the Blue Sky proj-
service of the loan. ect, no construction guarantees were needed.
While not a completely new concept, the debt ser-
FINANCING vicing structure is rare. In Indonesia, several other deals
have had similar characteristics; for example, one of the
The total project cost is US$280 million, with $200 Bontang LNG expansion projects allowed contingent debt
million in financing and $80 million provided by Per- service support from other trades, but this was never called
tamina. Mitsui was selected by Pertamina as lead arranger upon. Also the original Balongan refinery project financing
for the financing and product offtaker in December 2001, provided for debt service to be paid from sales of a slate
and the agreements were concluded after more than a of products from other Pertamina refineries.
year of negotiation. The financing comprises a $120 mil- The Blue Sky contractual structure is as follows and
lion direct loan from Japan Bank for International Coop- illustrated in the Exhibit:
eration (JBIC) and a separate tranche of $80 million in an
uncovered commercial bank loan co-arranged by Crdit Loan Agreement Between the Lenders and the Trustee:
Lyonnais (coordinating bank), UFJ Bank Limited (tech- Lenders advance the entire loan amount under the
nical bank and facility agent), Bank of Tokyo-Mitsubishi, Loan Agreement to the Trustee. Revenue from the sale
and ING Bank N.V. The four banks lent to the project of products under the Product Sales and Purchase Agree-
on a club basis, committing $20 million apiece. ment forms the source of debt service for repayment of
The commercial and JBIC loans have a 4.5-year the loan.
tenor and are provided pari passu, with the commercial
facility priced at 275 bp over LIBOR. JBICs loan is in
support of the EPC contract with Toyo Engineering.
Under the trustee borrowing structure, Mitsui pays
all the proceeds under the product sales and purchase
SPRING 2004 THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 9
542

Case studies
EXHIBIT 1
PERTAMINA
Long-Term Offtake
of LSWR/Decant Oil 5 Refineries Plant Construction
1. Cilacap Refinery
(including Cilacap and
2. Balongan Refinery EPC
Balongan)
Payment
Excess Cash of EPC

Sale Proceeds of Cost
Mitsui LSWR/Decant Oil Trustee
Repayment Loan
Lenders
Special Purpose Vehicle
Commercial Banks (established by Mitsui)
Repayment Loan
JBIC
Product Sales and Purchase Agreement Between are very basic, such as not to breach the Product Sales
Pertamina and Mitsui: Under the Product Sales and Pur- Agreement, to insure the relevant refineries, and the like.
chase Agreement, Pertamina supplies low-sulfur waxy However, the Lenders bear a number of major risks,
residue and decant oil from refineries (including the two including market, buyer default, and force majeure.
refineries that are being upgraded) to Mitsui. The sales
proceeds are paid into a trustee account established under EPC Contracts Between Pertamina and the EPC Contractor:
the Trust Agreement. Under the two EPC contracts (one contract for each re-
finery), the EPC contractors agree to carry out the up-
Trust Agreement Between Pertamina and the Trustee: grade works to the Balongan and Cilacap refineries on a
Under the Trust Agreement Pertamina appoints a lump sum turnkey basis.
Trustee in New York. The lenders enter into the Loan
Agreement with the Trustee and disburse the entire loan
amount to the Trustee. RISK MITIGATION
Operators Agreement Between Pertamina and the The Blue Sky project was financed at a time when
Lenders: Pertamina and the lenders enter into an Oper- many international investors were concerned about polit-
ators Agreement under which Pertamina provides certain ical and socioeconomic conditions in Indonesia, as well
undertakings to the lenders in relation to the project. To as the fact that a new law regulating the Indonesian oil
the extent a default by Pertamina in the performance of and gas industry was not yet fully implemented. The new
these undertakings causes the sales proceeds under the law caused uncertainty regarding Pertaminas status, specif-
Product Sale and Purchase Agreement to be insufficient ically on the issue of whether the company would con-
to meet the Trustees payment obligation under the Loan tinue to be the owner of the refineries against which the
Agreement, Pertamina is obligated to pay the Lenders an funds were being lent.
amount equal to the shortfall on a repayment-period-by- A number of features gave lenders sufficient reas-
repayment-period basis; i.e., the debt cannot be acceler- surance to lend on an uncovered basis, including the use
ated against Pertamina. These undertakings to the lenders of the trustee borrowing structure and the presence of
10 PERTAMINAS BLUE SKY PROJECT HERALDS RETURN OF INNOVATIVE PROJECT FINANCING IN INDONESIA SPRING 2004
543

Case studies
EXHIBIT 2
CONCLUSION
Blue Sky: Project Information
Given recent economic
Sponsors: Pertamina
conditions in Indonesia and the
Total project costs: US$280 million importance of developing dom-
estic fuel resources on an envi-
Project debt: US$200 million ronmentally friendly basis, the
Lead Arrangers: Mitsui and Co. (arrangers for the US$120 million Japan Bank for
Blue Sky project is of particular
significance. The projects use of
International Cooperation funding)

a trustee borrowing scheme and
Arrangers: The Bank of Tokyo-Mitsubishi Ltd., Crdit Lyonnais, ING Bank N.V., and UFJ the fact that the project work is
Bank Limited (arrangers for the US$80 million commercial lenders portion) unconnected from the repay-
EPC Contractor: Toyo Engineering Corporation, PT Rekayasa Industri
ment of the debt sets a prece-
dent for innovative structuring
Sponsor counsel: White & Case LLP and financing. Moreover, World
Bank lending stipulations that
Lender counsel: Paul, Weiss, Rifkind, Wharton & Garrison
prohibit state companies from
providing security for new bor-
JBIC. These are important factors since this uncovered rowings will ensure that trustee
loan is one of the few recent Indonesian bank facilities to borrowings similar to those implemented in the Blue Sky
close without political risk insurance or some form of project will continue to be utilized in Indonesia.
ECA or multinational guarantee. A banker involved in
the financing recently stated that, partly because of JBICs Editors Note
involvement, the banks took the view that political risk Hong Kong partner George K. Crozer is a project finance lawyer
insurance cover would not have added a lot to the deal with White & Case LLP. White & Case represented Pertamina
and would have meant higher pricing with little addi- in the Blue Sky financing, which was named 2003 Asia Pacific
tional benefit. Oil and Gas Deal of the Year by Project Finance International.
Political risk also is mitigated by the geographic
diversification of the five refineries locations. Two are on ENDNOTES
the island of Java (Balongan and Cilacap); two are on 1
Jan. 20, 2004, Indonesia Reports Jump in Foreign Invest-
Sumatra (Pakning and Dumai); and one on Kalimantan
ment Approvals But Few New Projects, Agence France-Presse.
(Balikpapan). The arrangement gives the lenders addi- 2
White & Case previously represented Pertamina on the
tional security because even if two of the five refineries green field Balongan and Cilacap expansion projects as well as
responsible for repaying the debt are not operating, debt subsequent upgrades and debottlenecking projects in Cilacap.
service could continue as planned. In addition, all of the
refineries have long track records of successful operations.
Another feature reducing financing risk is that the To order reprints of this article, please contact Ajani Malik at
debt is to be paid before capital and operating expendi- amalik@iijournals.com or 212-224-3205.
tures. Also, in order to mitigate price risk on petroleum
products, the lenders decided to assume a low level of
crude oil price as a worst case and to fix the minimum
volumes to be delivered by Pertamina under the Product
Sales Agreement at a level allowing a repayment of the debt
without having to modify the initial repayment schedule.
544

Case studies
International Project Finance:

The Ilisu Dam Project in 2004 and the
Development of Common Guidelines and
Standards for Export Credit Agencies
SELMA STERN
E
SELMA STERN xport credit and investment insur- Western Europe. Water-rich countries are
is a qualified lawyer and ance agencies play an important role those that maintain 10,000 cubic meters of
LLM candidate at the
in international project finance in water per capita annually. This is well above the
Centre for Energy,
Petroleum and Mineral developing countries, and have a 1,830 cubic meters per capita in Turkey.
Law and Policy at the Uni- strong impact on sustainable development. Turkeys energy consumption is growing
versity of Dundee, U.K. One of the largest sustainable develop- by about 5.7% a year on average. The total
selma.stern@gmx.net ment projects in the world is the GAP or electricity consumption in Turkey peaked at
Southeastern Anatolian Project (Gneydogu 126.9 billion KWh in 2002. It is projected to
Anadolu Proje). It consists of 22 irrigation rise to 265 billion KWh by 2010 and to 528
dams and 19 hydroelectric power plants. The billion KWh by 2020.1
GAP, using the water resources of the Hydroelectric power plants in Turkey
Euphrates and Tigris Rivers, covers develop- account for about 40% of Turkeys electricity
ments in several areas: electricity, agriculture, demand. At the end of 2001, Turkey main-
social, economic, and environmental devel- tained 125 hydroelectric power plants with a
opment. The total financial requirements of total capacity of more than 10.2 gigawatts
the GAP were $32 billion. With its focus on (GW). The construction of more than 300
the human dimension and sustainability, the additional plants is planned to make use of the
GAP aroused international interest. U.S., potential remaining hydroelectric sites in
Canadian, Israeli, French, U.K., and other Turkey.
European export credit agencies (ECAs) as After providing an overview of the South-
well as the World Bank are providing financial eastern Anatolian Project, this article focuses
support to the Project. on the Ilisu Dam Project. It provides an
The Ilisu Dam Project, part of GAP, will overview of international guidelines and stan-
be the largest hydro project on the Tigris dards on the financing of dam projects, and
River. Several ECAs are considering financial traces existing conflicts surrounding the
support for this project. Yet, the Ilisu Dam and financing of dams in developing countries by
its financing are controversial mainly because ECAs. It cites and evaluates different reports
of the land that would need to be flooded and considering the Ilisu Dam Project. Finally, the
the (mainly) Kurdish people who would need article provides an independent evaluation
to be resettled. examining the Projects compliance with inter-
Turkey is not rich in freshwater resources. national standards and guidelines such as those
The country has approximately one-fifth of established by ECAs, the OECD, and the World
the water that is available in water-rich coun- Commission on Dams. The article concludes
tries such as those in North America and with observations and recommendations.
46 INTERNATIONAL PROJECT FINANCE: THE ILISU DAM PROJECT IN 2004 SPRING 2004
545

Case studies
GAPA SUSTAINABLE Drinking water usually is pumped from ground-

DEVELOPMENT PROJECT water wells dug from springs near rivers. Ensuring
adequate water supplies and developing infrastruc-
At the borders of Syria and Iraq, the GAP region ture related to improvement of water quality are
extends over an area of 75,358 square kilometers (km), important objectives of the regional development
which is 9.7% of Turkeys territory. The region contains programs. Presently, waste water in the Project area
10% of Turkeys population. Twenty percent of the 8.5 is discharged directly into creeks or rivers, or flows
million hectares (ha) of economically irrigable land in into simple drainage holes.
Turkey is in the GAP region, which consists mainly of the In 1993, intestinal infections, usually associated with
vast plains in the basins of the lower Euphrates and Tigris.2 inadequate water supply, sanitation, sewage systems,
The GAP is the largest development project ever or personal hygiene, were considered to be the most
undertaken in Turkey. It was initiated by the Turkish Gov- widespread diseases in the area.
ernment in 1978 with the aim of bringing the living stan- Almost all of the land that is suitable for agriculture
dards of nine southeastern Anatolian provinces is farmed.
Adiyaman, Batman, Diyarbakir, Gaziantep, Kilis, Mardin, The cultural heritage of the area is historically sig-
Siirt, Sanliurfa, and Sirnakup to the level of the Turkish nificant. The town of Hasankeyf, which has a famous
national socioeconomic average. As an integrated devel- citadel, was capital of the Artukids Kingdom during
opment project, the GAP is intended to enhance the the Middle Ages.
energy, agriculture, transportation, communication, In 1997, approximately 2.9 million people lived in
housing, education, and health sectors. the five provinces around the Project area. The pop-
The Project includes a huge irrigation and ulation in this area is growing at a higher rate than
hydropower scheme, consisting of 22 dams, 19 hydro- the national average.
electric plants, and several irrigation systems, as well as A total of 19,600 persons are estimated to live in
the construction of high-voltage transmission lines and settlements that will be flooded either partially totally
substations.3 Irrigation of 1.6 million ha and a hydropower or partially.
production capacity of 7,400 MW are projected, which
amounts to an annual production of 27 billion kWh. This
FINANCING THE ILISU DAM PROJECT
constitutes 22% of the national hydropower potential, and
would yield a total energy production of 27,000 Public investment designated for the entire GAP
GWh/year without considering irrigation release.4 totaled US$32 billion. By 2001, $14.8 billion had been
spent on the Project. Of that amount, $2.1 billion
THE ILISU DAM PROJECT stemmed from foreign sources such as the World Bank
and various international governments. The United
The Ilisu Dam is part of the Southeastern Anato- Nations Development Programme and international ECAs
lian Project (GAP) and is currently the largest hydropower had contributed almost $12 million in grants. The Euro-
project at the Tigris River. It will consist of a reservoir pean Union had approved a grant totalling 43.5 million
with a maximum volume of 10.4 billion cubic meters and to finance small businesses, cultural assets, and rural devel-
a surface area of 313 km. The Ilisu power station will opment projects.7
have a capacity of 1,200 MW and is expected to produce Financing the Ilisu Dam Project was considered by
3,800 GWh of power per year.5 ECAs of nine countriesAustria, Germany, Italy, Japan,
Project area:6 Portugal, Sweden, Switzerland, the U.K., and the U.S. The
U.K. government announced in 1999 that it was likely to
Along the 385 km of its Turkish course, the Tigris approve a $200 million investment guarantee via its Export
River drains an area of 39,000 km. It emerges at ele- Credits Guarantee Department (ECGD). However, Balfour
vations between 2,000 and 3,500 meters (m) in the Beatty, a prospective borrower, withdrew from the project
mountains of eastern Turkey. The Tigris River enters in November 2001 and the U.K. government is therefore
the reservoir area downstream of Bismil, surrounded no longer involved in the Ilisu Dam Project.8 The German
by 1,000 to 1,500 m high mountains, collecting the government, despite recent implementation of socioeco-
waters of the Batman, Garzan, and Botan Rivers. nomic guidelines for its ECA Hermes Brgschaften that
546

Case studies
might have prevented it from doing so, commented that it a loan adversely. Yet, it had no obligation to consider the
would continue supporting the Ilisu Dam Project.9 environmental impacts of its investments or the contribu-
tion they would make to development; no obligation to
International Standards and Guidelines ensure that all its projects complied with a set of manda-
tory human rights, environmental, and development guide-
Few infrastructure development projects have caused lines; and no obligation to screen out projects with adverse
as much international controversy in recent years as the social and environmental impacts. Few ECAs maintain any
Ilisu Dam Project. The Project was opposed by a pow- internal requirements to assess the environmental and social
erful coalition of nongovernmental organizations (NGOs) impacts of projects. One notable exception, however, is
that argued that the Project did not meet international the ECDG with its Business Principles on Sustainable
standards and guidelines. Export credit agencies were Development & Human Rights and its Principles on
plagued by mounting controversies over the lack of cri- Developing Countries.15 As far as guidelines on sustain-
teria for providing financial guarantees for dam projects.10 able development are concerned, the Export-Import Bank
Environmental and human rights groups such as Friends of the United States (U.S. Eximbank) is a good example
of the Earth say that ECAs should incorporate the guide- of an ECA with high standards.16 In 1995, the U.S. Exim-
lines of the internationally respected World Commission bank was forced by the U.S. Congress to adopt environ-
on Dams into their decision-making.11 mental criteria for project approval. U.S. companies, since
Export Credit Agencies (ECAs). ECAs are the largest that time, feel disadvantaged by the more stringent rules,
public lenders to large-scale infrastructure projects, and are urging common international standards.17
exceeding by far the total annual infrastructure loans from However, up to date, ECAs are not bound by a
multilateral development banks and bilateral aid agencies. common legal framework and mandatory international
ECAs offer multiple benefits: guidelines.
Organisation for Economic Co-operation and Devel-
The service they offerinvestment guarantees, opment. In 1999, OECD ministers urged ECAs to
insurance against political risk, and export credits strengthen common environmental approaches. The 1999
are precisely those required to secure the private G8 Communiqu stated that G8 governments would
sector investment needed to get projects off the work within the OECD towards environmental guide-
ground. lines for export credit agencies. Finally, on December
ECAs have an institutional culture that respect con- 18, 2003, OECD countries announced an agreement to
fidentiality and protects business interests. strengthen their common approaches for evaluating the
Last but not least the services by most ECAs, the environmental impact of infrastructure projects, supported
U.S. Export-Import Bank and Overseas Private by their governments ECAs, and for ensuring that these
Investment Corporation being an exception, come approaches meet established international standards. The
with hardly any environmental and social standards.12 agreement is the result of a review of the 2001 established
Common Approaches that have been implemented by
ECAs often have been accused of harmful invest- most of the OECDs Export Credit Group (ECG) mem-
ments.13 Recent infamous examples of ECA-backed pro- bers.18 However, the agreement takes the form of an
jects include the massive Three Gorges Dam on the Yangtze OECD Recommendation and is not legally binding.19
River in China, for which an estimated 1.3 million people Compared to the 2001 Common Approaches,20 the
will have to move; the Maheshwar dam in India, which has latest agreement is enhanced in following respects:21
provoked widespread public protest; the San Roque
hydropower and irrigation dam in the Philippines, which will Projects should, in all cases, comply with the envi-
disrupt the lives, economy, and environment of the regions ronmental standards of the host country. In case
Ibaloi people; and the Urucu gas and oil project in the there are more stringent international standards
western Amazonian region of Brazil, which will cut through against which the project has been benchmarked,
some of the least disturbed rainforests in the region.14 these standards shall prevail.
The ECDG, for example, was required under the The relevant international standards are those of the
1991 Export and Investment Guarantee Act to take account World Bank Group and the regional development
of all economic and political factors that might influence banks. Members may also benchmark against any
547

Case studies
higher internationally recognized environmental ating rules, public notifications, dam safety, moni-
standards such as those of the EC. toring, and periodic review.
The applicable environmental standards with regard Stage 5: Project operation: adapting to changing contexts.
to sensitive projects will be reported and monitored
by the ECG, and exceptional deviations below inter- World Bank. The World Banks involvement in large
national standards will have to be justified. dams has been declining over the past 30 years, and now
For the most sensitive projects, ECG members will is focusing more on financing dam rehabilitation and safety
seek to make environmental information, particularly than on financing new dams. Loans for dams provided by
Environmental Impact Assessment Reports, publicly the World Bank currently make up approximately 0.6%
available 30 calendar days before final commitment. of the entire worlds financing for new dam projects. At
the beginning of 2001, about 1.3% ($1.5 billion) of all

World Commission on Dams. The World Com- World Bank loans were provided for dam-related costs,
mission on Dams (WCD) was set up by the World Bank and about 0.9% ($1 billion) was issued for new dams.
and the International Union for the Conservation of The World Bank has established the following guide-
Nature (IUCN) in 1997. The WCDs guidelinesWorld lines referring to loans for dam projects:24
Commission on Dams, Dams and Development: A New
Framework for Decision Making22were published in World Bank Operational Policy 4.01, Environ-
November 2000. ment Assessment;
The WCD Report suggests the following decision- World Bank Operational Memorandum,
making process in order to safeguard rights, reduce the risk 3 December 1999;
of conflicts emerging, and lower overall costs:23 World Bank BP 17.50, Procedures on Disclosure
of Operational Information;
Stage 1: Needs assessment: validating the needs for water World Bank Operational Directive 4.30,
and energy services. The outcome of Stage 1 should Involuntary Resettlement;
be a clear statement of water and energy service World Bank Draft Operational Policy 4.12,
needs at local, regional, and national levels that Involuntary Resettlement;
reflects decentralized assessments and broader World Bank Operational Directive 4.20,
national development goals. Indigenous Peoples;
Stage 2: Selecting alternatives: identifying the preferred World Bank Operational Policy Note No. 11.03,
development plan. Management of Cultural Property in
Stage 3: Project preparation: verifying that commitments Bank/Financed Project, World Bank, August 1999.
are in place before tender of the construction contract. Clear-
ance to tender the construction contract is given by With regard to the WCDs Report, the World Bank
the relevant authority and includes conditions for the has stated that it believes that the Report is a great con-
award of the contract and operations. Mitigating tribution and fully shares the Commissions goals of equity,
and monitoring measures are formalized into con- efficiency, sustainability, participation, and accountability.
tracts among responsible parties, and compliance The World Bank believes that the Report is a valuable
arrangements are in place. guide that will be transferred into an action plan. It is
Clear arrangements with the people who need to working with its partners in implementing the Reports
be resettled will be required before any project recommendations.25
preparatory work begins. When these negotiations
stall, an independent dispute resolution process is Reports Considering the Ilisu Dam Project
required.
Stage 4: Project implementation: confirming compliance Environmental Impact Assessment Report 2001.26
before commissioning. Issuance of the license to operate The sponsors prepared an Environmental Impact Assessment
will be contingent upon compliance with mitiga- Report (EIAR) for the ECAs and foreign banks having to
tion measures in addition to technical requirements. evaluate the Ilisu Dam Project. OECD Good Practices for
The license will contain a number of conditions for Environmental Impact Assessment of Development Projects
the operating stage, including compliance with oper- as well as the Environmental Procedures and Guidelines of
548

Case studies
the U.S. Eximbank were used as the main guidelines. The scheduled once the Turkish government makes a
sponsors took a substantial amount of information from final decision on the beginning of the construction
previous reports and documentation issued by the Regional works.
Development Administration of the Southeastern Anato- The Project will generate various regional and local
lian Project (GAP-RDA). Field missions were conducted economic spin-offs as well as substantially improve
in November 1997, February 1998, Spring 2000, and the energy supply for the whole country.
November 2000. The sponsors held numerous meetings
with officials of the General Directorate of State Hydraulic Social Review of the Ilisu Dam Resettlement Action
Works (Devlet Su Isleri [DSI]) and of the General Direc- Plan 2002.27 The Social Review of the Ilisu Dam Reset-
torate of Rural Services (GDRS) in Ankara. They con- tlement Action Plan (SRIDRAP) is a desk review of the
sulted experts at Ankara University and at Dicle University Resettlement Action Plan (RAP) for the Ilisu Dam Project,
in Diyarbakir, representatives of the Ministry of Culture, undertaken for the U.K. ECGD. The RAP was prepared
the Turkish General Directorate of State Hydraulic Works by Turkish consulting firm Seminar Organizasyon
(Devlet Su Isleri [DSI]), and the Southeastern Anatolian Danypmanlyk ve Turizim A.P. and is the property of the
Project (Gneydogu [GAP-RDA]) officials as well as spe- Turkish General Directorate of State Hydraulic Works
cialists working in Sanliurfa and Ankara. (Devlet Su Isleri [DSI]). The Review includes an assess-
In summary, the Report draws the following con- ment of the RAP in relation to international guidelines and
clusions: an evaluation of the likely social impacts on affected areas.
The Review states that the DSI has not yet prepared
As eutrophication of the reservoir is anticipated, a detailed plan for the resettlement, though the project
mitigation measures should be integrated to enforce requires involuntary resettlement. International guidelines
appropriate irrigation rates and duration, fertilizer are not observed although both a policy and a legal frame-
use, as well as implementation of adequate agricul- work for resettlement exist. The Review finally concludes
tural practices in the area. that the DSI could produce a comprehensive plan for reset-
The new reservoir area will attract wintering pop- tlement that is compatible with international guidelines.
ulation such as ducks and geese. Permanent islands In brief, the Review ends with following recom-
should be used to protect rare or endemic plants and mendations:
might provide appropriate habitats for nesting birds.
One hundred eighty-three settlements (towns, vil- Consultation should take place with local stake-
lages and hamlets) will be affected. Of these, 82 will holders before and after contracts are signed.
be totally flooded and 101 partially flooded. Seven- Local stakeholders should be involved in different
teen thousand eight hundred persons could claim stages of the resettlement plan.
expropriation or resettlement rights in totally The problems of land title, deeds, and forced land
impounded settlements. Further, 10,400 persons confiscation need to be addressed adequately.
could claim either expropriation or resettlement rights Particular attention should be given to the needs of
in partially affected settlements, where a portion of the poor.
farmland will be flooded but no houses affected. Monitoring of resettlement should take place.
Though Hasankeyf was occupied for 2,000 years, it The Ilisu Dam should be conceived as a develop-
acquired its historical significance during the Middle ment initiative for the benefit of local stakeholders.
Ages when it became the capital of the Artukids Achievement of that objective will require various
Kingdom. Relocation of this important and out- measures in resettlement planning to increase the
standing site should be planned thoroughly. Struc- support of the resettled population before and after
tures of no archaeological value in the area of the relocation and to ensure improved livelihoods.
reservoir operation should be dismantled.
Although no large-scale consultation program has Statement of the Turkish Ministry
been implemented so far, information on the project of Foreign Affairs
and opportunities for residents to express their view-
points has taken place. Public meetings have been The Turkish Ministry of Foreign Affairs, on its web-
held in the Hasankeyf area. Other meetings will be site, provides the following information:28
549

Case studies
The Ilisu dam is not designed for irrigation but for decisions to define their goals, policies and strategies for
power generation only. The water passing through rehabilitation. 32 This approach complies with the rec-
the turbines will flow back into the river. ommendations made in the EIAR,33 the SRIDRAP34 as
New sewage facilities will be built in the upstream well as the WCD Report.35
towns to improve water quality. With regard to the cultural heritage of the Hasankeyf
Ilisu will be used as a regulator, storing water during area, it should be noted that almost every town in Turkey
the winter floods and releasing it during the summer is a major archaeological site. Therefore, to enable the 65
droughts. million people living in Turkey to live a modern lifestyle,
Hasankeyf is the only town that will be affected by giving preference to economic development over archae-
the Project, and only the lower parts will be flooded. ological interests sometimes will be inevitable.36 How-
The historically important citadel will stay above the ever, with regard to Hasankeyf, the Turkish government
water. Archaeologists and scholars from Turkey and seems to be making all efforts to preserve as much cul-
several other countries are at work on a project to tural heritage as possible. The Turkish Ministry of Cul-
excavate, record, and preserve as much as possible. ture, the DSI, and the Middle East Technical University
A comprehensive program of resettlement and com- Centre for Investigation of Historical Environmental Her-
pensation is planned. Families to be resettled will itage signed a framework protocol in 1998. According to
be provided a choice between agricultural and urban this protocol, some of the archaeological heritage will be
settlement. preserved on-site where possible, some movable items
Contrary to allegations by certain NGOs, people will be transferred to appropriate places, and what cannot
of various ethnic origins are affected by the Project. be moved will be documented to preserve historical
Resettlement and compensation will be provided knowledge for future generations.37 This Turkish approach
equally for all Turkish citizens. goes along with the recommendation made by the Ilisu
Ilisu will have major environmental benefits. It will Engineering Group in the EIAR.38
prevent the emission of millions of tons of green- It seems that parties involved in the Ilisu Dam gen-
house gases from alternative thermal power plants. erally agree on the controversial issues concerning con-
struction and financing of the Ilisu Dam. The Turkish
CONSIDERATION government recently has made clear statements referring
to the concerns that have been raised by foreign experts,
The following consideration is based on a desk governments, and the WCD. Moreover, it should be noted
examination of the Project; the author has not visited the that Turkey too is a member of the OECD agreement
Project area. on common environmental guidelines for ECAs, which
Both the Environmental Impact Assessment Report was signed in December 2003. Briefly, uniform standards
(EIAR) and the U.K. Secretary of State have expressed and a common decision-making framework for projects
concern for requirements to ensure that the water quality financed by ECAs are emerging, and Turkey is not the
is maintained.29 Here, the Turkish Ministry of Foreign only party to those agreements.
Affairs, in 2003, makes a clear statement that new sewage The Ilisu Dam Project has been criticized harshly by
facilities will be built in the upstream towns to improve certain NGOs. However, thanks to the Ilisu Dam Project,
water quality.30 As stated in the U.K. Select Committee the paper raises two issues: 1) the demand by NGOs, a few
on Trade & Industry Sixth Report, while the imple- ECAs (such as the U.S. Eximbank) and private companies,
mentation must be closely monitored, there is no reason some governments and international organizations for
to doubt that it can be fulfilled.31 common standards and guidelines on sustainable develop-
With regard to resettlement, the DSI, in its ment projects in developing countries, and 2) the financing
Response on the World Commissions on Dams Final of the Ilisu Dam Project in particular. The latest develop-
Report, states that a legal framework for resettlement ments show that parties are willing to collaborate in order
and expropriation does exist and will be used for the to set up reasonable projects based on common standards.
public benefit. The response further states, To ensure Remaining questions should be solved by good deci-
that resettlement takes place in a well planned way, and sion-making. The WCD as well as the OECD have been
to minimize its adverse effects, it is necessary for people, working out a good framework for doing so. It is normal
NGOs, and institutions which run the country and make for the parties involved, during this period, to acquire an
550

Case studies
understanding of each others requirements, to negotiate to construct a dam that will cause harm but one that will
the terms on which the contract and financing will be benefit its economy and its citizens.
undertaken.39 Bank experience shows that even the The Ilisu Dam Project, which is the largest dam
most complex resettlement issues can be resolved ade- project on the Euphrates and Tigris Rivers and a major
quately if identified and addressed early in the project project within the GAP, needs to be viewed from the per-
preparation process.40 spective of Turkeys aim to develop its economy and to
provide its citizens a living standard equal to that of the
CONCLUSION EU countries. Turkeys energy consumption is rising about
5.7% per year due to rapid urbanization and industrial-
Keeping in mind that she has not visited the Project ization. Total electricity consumption peaked to 126.9
area, the author draws the following conclusions on the billion KWh in 2002 and is projected to climb to 265
financing of the Ilisu Dam. billion KWh in 2010 and 528 billion KWh in 2020.
During the 20th century, large dams emerged as Turkey intends to satisfy these rising needs in several ways.
one of the most significant and visible tools for the man- Hydropower is especially appealing because it is cheap
agement of water resources. More than 45,000 large dams and environmentally friendly, i.e., free from harmful pol-
around the world have played an important role in helping lution. Besides, Turkey is neither an oil- nor a gas-pro-
communities and economies harness water resources for ducing country. Therefore, the country is compelled to
food production, energy generation, flood control, and make the best use of its available water resources.
domestic use. Current estimates suggest that some 30%- Furthermore, by using the waters of the Euphrates
40% of irrigated land worldwide now relies on dams, and and Tigris Rivers, Turkey aims to irrigate land for agri-
that dams generate 19% of the worlds electricity as well.41 culture to meet food requirements of its people.45 Partic-
Export Credit and Investment Insurance Agencies ularly in this respect, numerous further facts supporting
play a critical role in the financing of dam projects in the construction and finance of the Ilisu Dam could be
developing countries, and therefore may have a great mentioned if this report were not restricted in length. For
impact on sustainable development. The environmental example, the region has been suffering from long-lasting
and social standards that bind ECAs are not even remotely droughts. The construction of the Ilisu Dam will balance
close to those established by the World Commission on uncontrolled water flows, thus repairing natural destruc-
Dams.42 Activists around the world have argued that tion. Storing water from the winter floods and releasing
without common guidelines, governments compete it in summer seems more than reasonable.
against each other in a race to the bottom to finance Turkeys use of water resources for energy supply is
socially and environmentally destructive projects in devel- in compliance with the Implementation Plan of the Johan-
oping countries. One such example of ignoring envi- nesburg Summit, where the member states agreed to sub-
ronmental and social standards is the Three Gorges Project stantially increase the global share of renewable energy
in China. After the U.S. Eximbank declined support for sources with the objective of increasing its contribution
the Three Gorges Project in China, citing lack of infor- to total energy supply. The use of hydro-energy was
mation on environmental and social mitigation, other highlighted particularly in this context.46 Furthermore,
ECAs, with lower thresholds of social and environmental as the Ilisu Dam will avoid greenhouse gas emissions, the
acceptability, stepped forward to issue loan guarantees to Project should be of interest to countries that are signa-
corporations. This phenomenon is especially relevant to tories of the Kyoto Protocol.
the financing of large dam projects where ECAs are sup- From a foreign policy and global peace point of
porting projects declined by other funding agencies on view, economic development and higher living standards
environmental grounds.43 of the people in the regionespecially of the Kurdish
No doubt that private-sector financial flows from majority living in the areawill create a climate of peace
industrial nations have significant impact on sustainable within and beyond national borders. Construction of the
development worldwide. Governments should help pro- Ilisu Dam will bring a higher living standard and new
mote sustainable practices by taking environmental fac- business opportunities to a region that badly needs them.
tors into account when providing financing support for The general aim should not be to prevent export
investment in infrastructure and equipment.44 However, ECAs from financing the Ilisu Dam Project, but rather to
it should be pointed out that Turkey too does not want focus on furthering the project in a way that is compat-
551

Case studies
ible with international standards such as the guidelines of briefing/14ecas.html, (last updated April 2002).
the World Commission on Dams. The concerns raised and 13
Mutume, Gumisai, Environmentally Damaging Credit
recommendations made by both experts evaluating the Agencies Under Fire, IPS Terraviva, Vol.8 No.137, (27 July
project and environment and human rights campaigners 2000).
seem solvable and achievable, and should result finally in
14
Friends of the Earth International, Corporate Account-
ability, The Ilisu Dam and Export Credit Agencies, (September
the construction and operation of the Ilisu Dam in a way
2002), http://www.rio/plus/10.org/en/info/corporate_
that will benefit all parties involved, especially the majority accountability/65.php.
of Kurds living in the Project area. From a global per- 15
Export Credit Guarantee Department, http://www.ecgd.
spective and with regard to Turkeys EU accession, con- gov.uk/ecgdbusprinciples.pdf.
ducting the Ilisu Dam Project in compliance with
16
Export-Import Bank of the United States, http://www.
international standards is a good opportunity for the exim.gov.
Turkish government to demonstrate that indeed it does 17

Alden, Edward, U.S. urges green guidelines, Finan-
take care of the concerns of its Kurdish citizens and that cial Times, (4 May 2001).
it is respecting human rights. 18
The ECG includes the following OECD countries
(having signed the Agreement): Australia, Austria, Belgium,
Canada, Czech Republic, Denmark, Finland, France, Ger-
ENDNOTES many, Greece, Hungary, Ireland, Italy, Japan, Korea, Luxem-
1
Turkish Ministry of Foreign Affairs, The Looming Global bourg, Mexico, Netherlands, New Zealand, Norway, Poland,
Water Shortage and Turkeys Water Management in a Transboundary Portugal, Slovak Republic, Spain, Sweden, Switzerland,
Context, NATO Parliamentary Assembly 48th Session, 15-19 Turkey, United Kingdom, and United States.
November 2002 in Istanbul.
19
U.S. State Department, OECD Pact on Environment
2
Nemrut, M. T., General Information of GAP and Ataturk Review Sets Clear Rules, U.S. Says, (19 December 2003),
Dam, http://www.adizamanli.org/gap/info_on_gap.htm. http://usinfo.state.gov/utils/printpage.html.
3
Ilisu Engineering Group, Ilisu Dam and HEPP, Envi-
20
Recommendation on Common Approaches on Envi-
ronmental Impact Assessment Report, Executive Summary, ronment and Officially Supported Export Credits,
April 2001. www.exim.gov/news/21684464.pdf.
4
Saysel, Ali Kerem, Barlas, Yaman and Yenign, Orhan,
21
Organisation for Economic Co-operation and Devel-
Environmental sustainability in an agricultural development opment, OECD Adopts Stronger Environmental Common
project: a system dynamics approach, Journal of Environmental Approaches for Export Credits, Press Release, (18 December
Management, 64 (2002). 2003), http://www.oecd.org/document/56/0,2340,en_2649_
5
Turkish Ministry of Foreign Affairs, Ilisu Dam, (22 July 201185_21688824_119690_1_1_1,00.html.
2003), http://www.mfa.gov.tr/grupa/ac/aci/aci/IlisuDam.htm.
22
World Commission on Dams, Dams and Development,
6
Ilisu Engineering Group, Environmental Impact Assess- A New Framework for Decision-Making, The Report of the
ment Report, (2001), www.ecgd.gov.uk/home/pr_home/ World Commission on Dams, (November 2000),
pr_ilisu/pr_ilisu-ilisu_dam_project.htm. http://www.dams.org//docs/report/wcdreport/pdf.
7
nver, Olcay I. H., Southeastern Turkey: Sustainable
23
International Rivers Network, Summary Excerpts from
Development and Foreign Investment, prepared for the OECD the World Commission on Dams Final Report,
China Conference on FDI in Chinas Regional Development, http://www.irn.org/wcd/eca.shtml.
11-12 October 2001.
24
World Bank, http://www.worldbank.org.
8
Export Credit Guarantee Department, Ilisu Hydroelec-
25
World Bank, The World Bank & The World Com-
tric Power Dam in Turkey, (17 September 2003), mission On Dams Report Q & A, http://lnweb18.world-
http://www.ecgd.gov.uk/home/pr_home/pr_ilisu.htm. bank.org/ESSD/ardext.nsf/18ByDocName/WorldBankWorld
9
Ilisu-Projekt ohne Grobritannien, BUNDmagazin, CommissiononDamsReportQA/$FILE/WB&WCDQ&A.pdf.
No.3, (2001).
26
Ilisu Engineering Group, Environmental Impact Assess-
10
World Commission on Dams, Export Credit Agencies, ment Report, (2001), www.ecgd.gov.uk/home/pr_home/
A Dialogue Begins with Changes En Route, the WCD pr_ilisu/pr_ilisu-ilisu_dam_project.htm.
Newsletter, No.7, (August 2000).
27
Morvaridi, Behrooz, Social Review of the Ilisu Dam
11
Evans, Rob and Hencke, David, Anger at Plea for Dam Resettlement Action Plan, (June 2002), http://www.ecgd.gov.
Funds, Guardian, July 12 (2001). uk/ilisusocialreviewreport240602.doc.
12
Hildyard, Nicholas, Corner House Briefing 14, Snouts in
28
Turkish Ministry of Foreign Affairs, Ilisu Dam, (22 July
the Trough; Export Credit Agencies, Corporate Welfare and Policy 2003), http://www.mfa.gov.tr/grupa/ac/aci/acia/IlisuDam.htm.
Incoherence, (June 1999), http://www.thecornerhouse.org.uk/
29
552

Case studies
ment Report, (2001), www.ecgd.gov.uk/home/pr_home/ A New Framework for Decision-Making, The Report of the
pr_ilisu/pr_ilisu-ilisu_dam_project.htm; Select Committee on World Commission on Dams, (November 2000), p. 189.
Trade & Industry Sixth Report, Session 1999/2000, entitled http://www.dams.org//docs/
Application for Support from ECGD for U.K. Participation in report/wcdreport/pdf.
the Ilisu Dam Project, http://www.parliament.the-stationery- 44
Final Communiqu of G7 Heads of State, Denver, Col-
office.co.uk/pa/cm199900/cmselect/cmtrdind/cmtrdind.htm. orado, 1997; Ilisu Dam Campaign, the Corner House Briefing
30
Turkish Ministry of Foreign Affairs, Ilisu Dam, (22 July 14, Snouts in the Trough; Export Credit Agencies, Corporate Wel-
2003), http://www.mfa.gov.tr/grupa/ac/aci/acia/IlisuDam.htm. fare and Policy Incoherence, http://www.ilisu.org.uk/snouts.html.
31
International Development Committees Sixth 45
Turkish Ministry of Foreign Affairs, The Looming Global
ReportECGD, Development Issues and the Ilisu Dam, Water Shortage and Turkeys Water Management in a Transboundary
July 2000, http://www.parliament.the-stationery-office.co.uk/ Context, NATO Parliamentary Assembly 48th Session, 15-19
pa/cm199900/cmselect/cmintdev/211rep/21102.htm. November 2002 in Istanbul.
32
DSI, Response to the Final Report of the World Com- 46
World Summit on Sustainable Development, Johan-
mission on Dams, http://www.unep-dams.org/document nesburg, 26 August-4 September 2002.
.php?cat_id=4.
33
ment Report, (2001), www.ecgd.gov.uk/home/pr_home/ To order reprints of this article, please contact Ajani Malik at
pr_ilisu/pr_ilisu-ilisu_dam_project.htm. amalik@iijournals.com or 212-224-3205.
34
Morvaridi, Behrooz, Social Review of the Ilisu Dam
Resettlement Action Plan, (June 2002), http://www.ecgd.gov
.uk/ilisusocialreviewreport240602.doc.
35
A New Framework for Decision-Making, The Report of the
World Commission on Dams, (November 2000), http://www.
dams.org//docs/report/wcdreport/pdf.
36
Turkish Ministry of Foreign Affairs, Ilisu Dam, (22 July
2003), http://www.mfa.gov.tr/grupa/ac/aci/aci/IlisuDam.htm.
37
DSI, Response to the Final Report of the World Com-
mission on Dams, http://www.unep-dams.org/document
.php?cat_id=4.
38
ment Report, (2001), www.ecgd.gov.uk/home/pr_home/
pr_ilisu/pr_ilisu-ilisu_dam_project.htm.
39
International Development Committees Sixth
ReportECGD, Development Issues and the Ilisu Dam,
July 2000, http://www.parliament.the-stationery-office.co.uk
/pa/cm199900/cmselect/cmintdev/211rep/21102.htm.
40
World Bank, Conversion Of The World Banks Policy
on Involuntary Resettlement, Frequently Asked Questions,
(March 15, 2001), http://wbln0018.worldbank.org/Net-
works/ESSD/icdb.nsf/D4856F112E805DF4852566C9007C27
A6/788266BB4D7FBD3385256A10007C8ED2/$FILE/OPBP
+412+FAQs.pdf.
41
A New Framework for Decision-Making, The Report of the
World Commission on Dams, (November 2000), Executive
Summary, p. XXiX. http://www.dams.org//docs/report/
wcdreport/pdf.
42
CIEL, Export Credit Agencies and Sustainable Devel-
opment, A Center for International Environmental Law Issue
Brief, for the World Summit on Sustainable Development, 26
August-4 September 2002.
43
553

Case studies
Home Run! A Case Study

of Financing the New Stadium
for the St. Louis Cardinals
CYNTHIA A. BAKER AND J. PAUL FORRESTER
O
CYNTHIA A. BAKER n the morning of December 23, loan from St. Louis County, $30 million gen-
is a partner at Chapman and 2003, the City of St. Louis, Mis- erated from the sale of various tax credits, a tax
Cutler LLP in Chicago, IL.
souri awoke to a banner on the abatement by the City of St. Louis, and an
cbaker@chapman.com
highway ramp closest to Busch equity investment by the Cardinals owner-
J. PAUL FORRESTER Stadium in downtown St. Louis trumpeting shipwas not the leveraged lease financing
is a partner at Mayer, Brown, This Ramp is Coming Down, a line of bull- described in the Post-Dispatch on the morning
Rowe & Maw LLP in dozers on the lot next to Busch Stadium, and of the closing. Unbeknownst to the Post-Dis-
Chicago, IL. a St. Louis Post-Dispatch front-page headline patch, and notwithstanding months of intense
jforrester@mayerbrownrowe.com
reading Cards Are Set To Announce Stadium efforts in pursuit thereof, the leveraged lease
Financing Deal Today. When the St. Louis financing had been abandoned a week earlier
Cardinals (Cardinals) closed on the financing because it could not be closed within the time
and broke ground for their new stadium adja- available.
cent to the current Busch Stadium, it was the The structured transaction that did close,
culmination of many years of considerable effort illustrated in Exhibit 1, was the largest private
by the Cardinals. Earlier plans for a publicly placement of debt for a Major League Base-
funded stadium encountered the same public ball (MLB) stadium, the first MLB stadium
opposition found in other cities. With a stag- transaction using a bankruptcy-remote struc-
nant economy, and state and city budgets ture, the first set of cash flows from a baseball
stretched thin, new sports facilities are not a stadium to be rated investment grade by both
budget priority. Only two other Major League Moodys and Standard and Poors and insured
Baseball teams have privately financed ballparks. to AAA by Ambac Assurance, and only the
Against this background, the Cardinals retained third privately financed MLB home stadium.
Banc of America Securities Sports Finance How is it that the Cardinals, who are not
Advisory Team in the Spring of 2003 to act as located in a major media market, were able to
advisor and placement agent. Banc of America bring home such a major-league financing?
Securities and the Cardinals developed an inno- What is the structure of the financing that
vative hybrid securitization/project finance/ closed and how is it different from the lever-
leveraged lease structure to turn the Cardinals aged lease structure? Why was the hybrid lever-
strong fan base into an investment-grade credit aged lease structure abandoned, and what were
that would support the 20-year financing for the obstacles to closing such a transaction? This
the new $330 million stadium. Notably, the article examines these issues. The article will
structured financing that closed on December not examine why public financing ultimately
23including $200.5 million of private place- was not available for the stadium or that the
ment bond debt, a $45 million subordinated stadium is only a part of an impressive rede-
SUMMER 2004 THE JOURNAL OF STRUCTURED FINANCE 69
554

Case studies
EXHIBIT 1
Final StructureCardinals Transaction
SPV Cardinals Ballpark, LLC Ground Lease with

Owner of Ballpark Ballpark Site
Owns/retains exclusive right to Dedicated Property Holdings, LLC
Loan Proceeds
Generates Contracts for use of Dedicated Property
License of Ballpark excluding
Dedicated Property Acts as Servicing and Marketing
Agent for Dedicated Property

Agrees to play in the Ballpark
St. Louis Cardinals, LLC

Licenses Ballpark for use for MLB Activities
Acts as Servicing and Marketing Agent for SPV
Transfer of Security Interest

Investors
velopment plan (known as Ballpark Village) for a por- driven in part by league revenue-sharing rules that require
tion of downtown St. Louis in the shadow of St. Louis teams to share ticket revenues but not luxury-suite rev-
symbolic Gateway Arch. While interesting for their own enues. Major League Baseballs revenue-sharing rules do
reasons, these subjects are beyond the scope of this article. not provide such incentives. Instead, managers of baseball
In the current market, major league sports arenas stadiums are driven solely by the premiums that can be
and stadiums often are funded by monetizing contrac- charged for luxury suites (and club seats) with additional
tually obligated income or COI. Stadium naming amenities. Generating contractually obligated income that
rights, luxury suites, sponsorships (i.e., signage within the will be eligible for monetization requires a strong fan base
stadium), pouring rights, concessions, and other multi-year and strong corporate and community support for a sports
contracts that result in future revenue streams are exam- team or franchise.
ples of COI. Premium seats, sometimes known as club The St. Louis Cardinals have such a strong fan base
seats, also may be COI if sold pursuant to multi-year and strong corporate and community support in spades.
subscriptions. These revenues may be substantial. For The Cardinals, the first team west of the Mississippi, began
example, naming rights for Minute Maid Park, home of play in 1875, first as the St. Louis Brown Stockings, then
the Houston Astros, is at the high end, generating an as the Browns, then as the Perfectos, and finally, in 1900,
average of $6.07 million per year for 28 years. Naming as the Cardinals. Their overall record, second only to the
rights for Safeco Field, home of the Seattle Mariners, still New York Yankees, includes 8,514 wins with 20 first-
generates on average $2 million per year for 20 years, even place division finishes, 15 National League Champi-
though it falls at the low end of the range for ballparks onships, and 9 World Series Championships. The team
that have sold naming rights.1 Luxury suite prices for has produced 48 hall-of-fame players and coaches
MLB teams vary widely, with the Toronto Blue Jays including Enos Slaughter, Rogers Hornsby, Red Schoen-
charging prices ranging from $37,000 to $120,000 per dienst, Dizzy Dean, Stan The Man Musial, Bob
season and the New York Yankees charging $300,000 per Gibson, Lou Brock, and Ozzie Smith. Twice in the past
season. Suite prices in the Cardinals current home, Busch five years, most recently in 2003, the Cardinals were des-
Stadium, are reported to range from $79,000 to $205,000.2 ignated as MLBs fan-friendliest teams by the United
Teams typically offer luxury-suite contracts with 3-, 5-, Sports Fans of America. The Cardinals rank second among
7-, or 10-year terms and often include incentives for all MLB teams in tickets sold over the past 20 seasons with
renewal. In the National Football League, the trend in average annual ticket sales in excess of 2.8 million. The
recent years to build new stadiums with luxury suites is Cardinals have projected sales of 19,300 season tickets for
70 HOME RUN! A CASE STUDY OF FINANCING THE NEW STADIUM FOR THE ST. LOUIS CARDINALS SUMMER 2004
555

Case studies
EXHIBIT 2 employees and its constitutive documents prohibit it from

Traditional Securitization incurring any debt or conducting any activities other than
those necessary for the related securitization. In addition,
Sponsor/Originator its constitutive documents and the transaction documents
require it to maintain at least one independent director,
Generates and Sells Receivables
unrelated to the originator or any of its affiliates, whose
Sale and Contribution of affirmative vote is required for the SPV to seek or con-
Purchase Proceeds
Receivables sent to relief as a debtor under the United States Bank-
ruptcy Code. The SPV finances its purchase either by
SPV issuing securities (typically, debt securities), by selling an

undivided interest in the receivables to a commercial paper
Purchases Receivables and Funds through

Secured Loan or Sale of Undivided Interest in conduit, or in some instances through a borrowing
Receivables arrangement with a commercial paper conduit. Such a
sale of receivables, combined with certain corporate sep-
Transfer of Undivided Interest / Loan/Purchase arateness and organizational limitations placed on the SPV,
Security Interest in Receivables Proceeds works to isolate the receivables from the bankruptcy and
credit risks of the originator and can allow the receiv-
Investors / Commercial Paper Conduit ables to be self-financing at a higher credit rating than
that of the originator. In the case of a ballpark, however,
a classic sale-securitization structure may not isolate the
the 2004 season. This compares to 28,000 projected by COI from the bankruptcy risk of the originator because
the San Francisco Giants, 18,000 by the Baltimore Ori- of the executory nature of most, if not all, of the related
oles, 17,000 by the Boston Red Sox, 14,000 by the COI. Failure of the originator to perform on those con-
Chicago Cubs, 11,000 by the Chicago White Sox, and tracts most likely will excuse the related obligors from
8,000 by the San Diego Padres. Cardinals games have having to pay, such that the contracts are subject to rejec-
been broadcast by KMOX, a megawatt AM station that tion in the bankruptcy of an originator. Accordingly, dif-
can be heard nearly coast to coast, since the 1950s. It was ferent techniques must be used to isolate the COI
Harry Carays broadcasts of Cardinals games on KMOX receivables from the credit risk of the team.
to which Luke Chandlerthe young protagonist in John In the structure developed with Banc of America
Grishams bestseller A Painted Housewould tune in every Securities, the Cardinals formed a special purpose vehicle,
Saturday evening when growing up in rural Arkansas in Cardinals Ballpark, LLC (Ballpark LLC), with the typ-
the 1950s. Although St. Louis ranks only18th among met- ical organizational limitations and independent directors.
ropolitan areas in United States, it ranks 7th in the nation However, Ballpark LLC itself will originate the contracts
for corporate headquarters. The Cardinals seat deposit giving rise to the COI pledged to support the ballpark
program for season tickets in the new ballpark has been financing. In the final transaction, Ballpark LLC, as lessee,
over-subscribed and letters of intent for 10-year, luxury- entered into a long-term ground lease with Ballpark Site
suite contracts were signed in the summer of 2003 for all Holdings, LLC (Site Holdings) for the site and will own
52 suites then offered. The Cardinals well-established, all improvements when complete. As the owner of all
sustained relationship with the local community has improvements and rights to use of the site, Ballpark LLC
resulted in strong corporate sponsorship for the team. also holds all rights that give rise to contractually oblig-
The Cardinals strong fan base turned into an invest- ated income associated with the site, including naming
ment-grade credit through creative application of struc- rights, luxury suites, and rights to post signs and adver-
tured finance techniquesthis despite the fact that the tisements, conduct concession activities, and all other activ-
organization itself is unrated. In a typical securitization, ities on the site and its improvements. Under a license
illustrated in Exhibit 2, an operating company originates agreement with Ballpark LLC, the Cardinals have the right
receivables by signing up and performing contracts. That (and are required to) conduct Major League Baseball games
originator then sells fully performed receivables to a spe- and related activities in the stadium and on the site. The
cial purpose vehicle (SPV) formed solely for the purpose license agreement gives the Cardinals only a subset of the
of purchasing the receivables. An SPV generally has no rights giving rise to COI. Ballpark LLC retains for itself
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Case studies
EXHIBIT 3
Lease StructureCardinals Transaction
Ground Lease with

Owner Trust Ballpark Site
Loan Proceeds
Lessor of Ballpark and Sublessor of Site Holdings, LLC
Security interest in Triple-net Lease
Dedicated Property
SPV Cardinals Ballpark, LLC
Lessee of Ballpark and of Site

Owns/retains exclusive right to Dedicated Property

Generates Contracts for use of Dedicated Property
License of Ballpark excluding
Dedicated Property Acts as Servicing and Marketing
Agent for Dedicated Property
Agrees to play in the Ballpark
St. Louis Cardinals, LLC

Licenses Ballpark for use for MLB Activities
Acts as Servicing and Marketing Agent for SPV
Transfer of Security Interest

Investors
naming rights, rights to conduct concession activities, issued by the owner trust and the debt portion of rent
rights to license luxury suites and certain club seats, and achieving the same ratings, except that the dedicated prop-
certain sponsorship (signage) rights (collectively, the ded- erty would have been pledged by Ballpark LLC to sup-
icated property). The dedicated property is marketed and port its rent obligations under the lease.
serviced by the Cardinals under a contractual arrange- Participants in the structured finance markets may
ment, much like a publicly owned stadium might con- find the abandoned leveraged lease structure of some
tract with a service company. The dedicated property interest. The introduction of securitization techniques to
effectively is isolated from the credit risk of the Cardinals, big-ticket leasing is the point where securitization, project
because it never was owned by the Cardinals. finance, and lease finance converge.
Contractually obligated income from the dedicated A leveraged lease financing structure may offer a
property is pledged to the bondholders and was sufficient number of benefits to the sponsor/lessee. A lease introduces
to earn the bonds an underlying investment-grade rating another source of capital to a structureequity capital
by both Standard and Poors (BBB) and Moodys (Baa3). provided by the owner participant (OP). The tranche
The bonds also are supported by a leasehold mortgage of capital provided by the OP is subordinate to debt and,
on the site, and a security interest (and backup mortgage) since the OP is the owner of the leased property, it is enti-
on the stadium and other site improvements. Revenues tled to the tax depreciation and other related tax benefits.
from the dedicated property are directed to a lockbox and These tax benefits subsidize the lease rate offered to the
applied through a priority-of-payments waterfall, much lessee to the point where the cash-on-cash return required
like a typical securitization. Ballpark LLC is further cap- by the OP is commonly less than the senior debt rate. The
italized by a $45 million subordinated loan from St. Louis tax benefit subsidization reduces the all-in, pre-tax lease-
County and a substantial equity investment by the Car- financing rate to less than comparable debt financing rates.
dinals owners. The bonds were wrapped to an AAA The lease structure can provide a higher percentage of the
rating by Ambac Assurance Corporation. The proposed aggregate capital needs of the project than can debt alone
leveraged lease transaction, shown in Exhibit 3, would in some cases 100% or more of the cost of the leased asset.
have adopted most of this basic structure, with the debt Another important consideration for sports facilities is that
557

Case studies
the required rate of return for the institutional OP may be have held all rights that give rise to contractually obligated
less than the entrepreneurially driven return requirements income associated with the facility, including the dedi-
of a sports franchise owner. A lease can allow a franchise cated property. As in the debt structure described above,
owner to deploy its equity capital into more lucrative or Ballpark LLC would have licensed the stadium and site to
shorter-term investment opportunities. the Cardinals for the purpose of conducting Major League
The hybrid leveraged lease structure appeared to Baseball games and related activities and retained for itself
offer many advantages to the Cardinals over the struc- the sole ownership of the dedicated property and related
tured debt transaction described above. Ownership of a revenue streams. Lockbox arrangements and a pledge of
sports stadium offers certain tax benefits. A major league the COI and dedicated property would have supported
sports team typically is held by a limited liability com- Ballpark LLCs obligation to pay rent to the owner trust.
pany, limited partnership, or other tax-pass-through entity, The senior debt and subordinated county debt issued by
with the owners being some combination of individuals, the owner trust would have been secured by a leasehold
family trusts, and corporations. Because of the usually mortgage and security interest on the site and improve-
diverse tax status, including rules limiting the efficacy of ments and a further assignment of the secured rents. This
passive tax losses, team owners are often inefficient (or structure would have required debt and equity to look to
at least uncertain) users of tax benefits. The question of the credit of Ballpark LLC and the dedicated property,
whether a hybrid leveraged lease provides the best after- and not the Cardinals, for repayment.
tax financing rate only can be answered if it is known Why abandon a transaction that offered 100%
whether the franchise owner can make efficient use of financing, a subsidy of cash payments by the equity
the tax benefits associated with ownership of the related investors use of tax benefits, and a lower-cost source of
facilities. Given the favorable attributes of the leveraged equity capital? The answer: timeor lack thereof. The
lease structure and its ability to accommodate the struc- construction schedule (driven by a completion date tied
tured finance techniques described above, a hybrid struc- to the opening of the baseball season in 2006), necessary
ture seemed to be the logical choice. work on an interstate interchange (the ramp serving the
Generally, debt and equity investors in a traditional new stadium), the subordinated loan from St. Louis
leveraged lease are looking to the corporate credit quality County, the sale of tax credits to fund site remediation,
of the lessee/sponsor for repayment. An owner trust buys and state funding of infrastructure improvements in sur-
or builds the asset to be leased and funds that price through rounding areas all required that the private financing close
an investment by the OP (approximately 20% of the value before the end of 2003. The timing explanation, however,
of the asset under tax rules) and by borrowing money is incomplete. A question remains as to why a hybrid
through bank loans or the issuance of bonds or other debt transaction would take more time and be more difficult
securities. The asset is leased to the sponsor with rent pay- to complete than the structured debt transaction.
ments due under the lease being exactly the amount nec- With the clarity of 20/20 hindsight, several expla-
essary to pay debt service and a fixed rate of return to the nations appear. Within financial institutions and within
OP. The rent due is determined through a black box law firms, those involved in structured finance transactions
calculation that, after taking into account the deprecia- tend to specialize, whether in securitization, project
tion deductions, optimizes the amount and timing of rent, finance, or lease finance. Each specialty has its own par-
debt service, equity cash flows, and all of the related tax adigm, and specialists approach a new structure in light
attributes for the OP on one hand, while minimizing the of that often unspoken paradigm leading to frequent mis-
present value of payments due by the lessee on the other. understandings and miscommunication. For example, in
The Cardinals lease transaction would have largely securitization the investors credit decision is based on an
followed this traditional structure, with a few important analysis of the credit quality of the asset and the effec-
variations. An owner trust, as lessee, would have entered tiveness of the structure to isolate the asset. In project
into a long-term ground lease with Site Holdings for the finance, investors look to the strength of the contracts
site and contracted for the construction of improvements. that support the asset being financed and the credit quality
At closing, the owner trust would have entered into a of the contracting parties. If there are gaps in the contracts
triple net lease with Ballpark LLC covering both the site that support the project financing, the investor has to eval-
and the improvements. As the lessee with the right to use uate gap risk, including in some cases an evaluation of
all improvements and the site, Ballpark LLC also would the operational risks of the related asset. In contrast, gen-
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Case studies
erally speaking, OPs look primarily to the corporate credit might staff its deal team from across specialty areas. For
of the lessee/sponsor. In a hybrid structure, which by its example, a securitization/project finance/lease hybrid that
very nature requires a change in this fundamental para- cannot be sold to a pure lease investor might be more
digm, a difficulty lies in harmonizing the approach across attractive to project finance-type investors. Alternatively,
these different disciplines. financial guaranty companies already bridge knowledge
Differences in the paradigms may heighten traditional and risk assessment gaps in the market. In a hybrid secu-
points of controversy. Particularly in transactions where ritization/project finance/lease structure, a financial guar-
buyout rights give the lessee the ability to capture upside anty provider might be asked to wrap the entire rent due
appreciation in the asset, OP equity looks more like sub- under the lease, and not just the related debt. Obtaining
ordinated debt than traditional equity. Accordingly, stan- a rating of the equity cash rent might be another solution.
dard senior-subordinated points of controversycontrol, The Cardinals achieved a rare result: competitive,
consents, and foreclosure rightsplay out as debt-equity attractive financing for a cutting-edge, but retro-look, ball-
issues in leveraged leases. But, differences in paradigm can park with modest financial support from state and local gov-
make all the difference. Tranches of debt and equity in ernments and manageable equity support by the franchise
securitizations are very common, with senior classes taking owners. The transaction advanced the state of the art for pri-
all of the cash flow from, and controlling decisions with vately financed sports and entertainment venues. Fans of
respect to, the assets following a default or early amortiza- the St. Louis Cardinals and of Major League Baseball will
tion event. Because all parties are looking to asset perfor- be the ultimate winners. Finally, the lessons learned from
mance, and discretion to manage the assets is circumscribed the Cardinals stadium transaction will benefit the financing
by contract, they may be relatively less concerned about and construction of other stadiums with ever-more-effi-
which party holds control over the assets. In contrast, an cient blends of capital sources to better balance and serve
investor relying on a corporate credit alone typically will the goals of team owners, players, municipalities, and the
require greater and greater control over a borrower/lessees fans, while meeting the requirements of financial investors.
actions the further down that credit falls on the ratings
ladder, particularly after default. Standard foreclosure Editors Note
rights differ substantially between the securitization and Ms. Baker was formerly a partner with Mayer, Brown, Rowe &
leveraged lease markets. These differences, and others, may Maw LLP. The authors represented Banc of America Securities
exaggerate the ordinary senior/subordinated tensions. A Sports Finance Advisory Team, as structuring agent, and the pri-
securitized-debt investor may reject as off-market an vate placement debt investors in the financing described. All infor-
OPs insistence on restricted or delayed foreclosure rights. mation with respect to the specifics of the transaction or the Cardinals
So too, a leveraged-lease investor may reject as off-market has been publicly reported in various sources. The analysis of the
the debtholders insistence on all control and consent rights issues and the conclusions drawn herein are those of the authors, and
following default. Both are right within their respective not the views of Mayer, Brown, Rowe & Maw LLP or any of its
paradigms, but a hybrid requires a shift in the market. To clients. Our special thanks to Jim Nash and Tucker Sampson of
add to the confusion, the jargon of each field uses similar Banc of America Securities, David McIlhenny and Gareld Gray
terms that mean different things, and these differences can of Banc of America Leasing, and O. Kirby Colson III of Armstrong
be material. Without a means of bridging the differences Teasdale LLP, counsel to the St. Louis Cardinals, for their helpful
in perspective and communication, a lease equity investors insights and comments. Any errors are those of the authors alone.
credit committee may never get comfortable with a below-
investment-grade sponsor regardless of the credit quality ENDNOTES
of the assets supporting the transaction. Similarly, without
a bridge, a securitization investor looking solely to asset 1
Street & Smiths Sports Business Journal, By the Num-
value, along with its usual expansive rights to take control bers 2004, p. 10.
of the liquid assets supporting the financing, may never be
2
Street & Smiths Sports Business Journal, By the Num-
bers 2004, pp. 106 and 107.
comfortable with sharing operational control with subor-
dinated lease equity investors.
The different approaches each financing discipline
brings to a hybrid structure can be addressed in a number To order reprints of this article, please contact Ajani Malik at
of ways. An institution considering such a transaction amalik@iijournals.com or 212-224-3205.
559

Case studies
Letting the Crown Jewels

Fall into Private Hands
A Case Study of the Maputo Port Project
SIMON NORRIS AND CONSTANTINE OGUNBIYI
T
SIMON NORRIS he Government of the Republic of sortium was selected as preferred bidder and
is an associate at Cad- Mozambique (GOM) recognised established a local project company under the
walader, Wickersham &
the importance of upgrading the name Sociedade de Desenvolvimento de Porto
Taft, LLP in London.
transport infrastructure in the de Maputo S.A.R.L., or Maputo Port Devel-
CONSTANTINE OGUNBIYI Maputo Corridor and in 1997 invited inter- opment Company (MPDC), to carry out the
is an associate at Cad- national bidders to tender for the Port of Project. Subsequently, a Memorandum of
walader, Wickersham & Maputo with a view to privatisation under a Understanding was signed setting out the broad
Taft, LLP in London. long-term concession. The Maputo Corridor terms under which a Concession Agreement
is the route between Maputo, Mozambique, would be negotiated and signed with Caminhos
and Johannesburg, South Africa; it includes de Ferro Moambique (CFM), the national rail
the N4 Platinum Toll Road and the Ressano- and port operator.
Garcia railway link as well as the Port of The Port of Maputo had, prior to
Maputo. All of these transport projects were Mozambiques independence and the Mozam-
included in the Maputo Corridor Project, a bique civil war (1976-1992), handled about
concept launched by the Mozambican gov- 15 million tons of cargo, with a high per-
ernment and supported by Nelson Mandelas centage coming in exports from what was then
South African government that aimed to known as the Transvaal. By comparison, the
develop the infrastructure and transport links port of Durban, South Africa, handled 22 mil-
in the region through the use of public-pri- lion tons of cargo at that time. Since then,
vate partnership (PPP) projects. Maputos traffic has decreased drastically for a
A consortium consisting of The Mersey number of reasons, notably a lack of invest-
Docks and Harbour Company, the listed U.K. ment; the ravaging effects of the war, drought,
port operator; the investment arm of the famine, and floods; and a lack of managerial
Swedish construction giant Skanska; Grindrod and technical resources within CFM. The
Limited, the South African freight and logistics result of these negative factors is a quayside
company (which later left the consortium); Lis- eaten away by erosion and poor maintenance,
cont Operadores de Contentores S.A., the Por- an ancient and only occasionally operational
tuguese container terminal operator; and collection of machinery and equipment, a
Mozambique Gestores S.A.R.L, a local partner, poorly trained and under-utilised staff of
submitted a tender offer to GOM on December around 6,000 people, and an annual tonnage
17, 1997, to take on the role of rehabilitating closer to three million tons.
and then operating the Port of Maputo under The Concession Agreement was signed
the terms of a concession (the Project). Fol- in September 2000. Under the terms of the
lowing a competitive tender process, the con- Agreement, MPDC has the right to conduct
SUMMER 2003 THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 47
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Case studies
port services and finance, manage, operate, maintain, PUBLIC SECTOR RISK
develop, and optimise the port concession area for an ini-
tial period of 15 years, which can be extended by a fur- In any concession arrangement relating to infra-
ther 10 years, subject to certain conditions. structure that continues to rely, to a greater or lesser extent,
Shortly before MPDC took over the port on April on a conceding authority or other public-sector entity
14, 2003, out of more than 50 cranes to be found in the providing a service to a certain standard, the private-sector
port, only a handful were functional; the majority were concessionaire and the Project itself are at risk to the
worthless or even a liability because the costs of disposal extent that the conceding authority or other public-sector
outweighed their scrap value. The only cranes of any entity fails to perform. In the concession for a port, the
value were those built in Germany around the turn of concessionaire is reliant, inter alia, on the access channel
the 20th century, which a German museum was interested being properly dredged and properly kept in a safe con-
in returning to their country of origin. dition (lights, buoys, channel markers, etc.); ships being
The Project is particularly sensitive to the annual cargo piloted into the harbour in a proper, safe, and timely
attracted by the port. The business and financial analysis of manner; and services such as stevedoring being properly
the Project indicated that it was a worthwhile venture that provided. To the extent that any or all of those obligations
would yield increased trade for Mozambique (increasing are assumed by a public-sector entity that is incapable of
volumes to 12 to 15 million tons within three to four years), performing them to a sufficient standard (preferably in
generate new jobs and skills within the economy over the accordance with good industry practice, applicable laws,
longer term (it is estimated that each job in the port will and international norms), there is an obvious risk to the
generate six jobs in supporting industries in the first 10 cash flow the project can generate and, indeed, is required
years), strengthen the links between Mozambique and South to generate to meet debt service requirements.
Africa (as mentioned above, the port forms part of the Further, to the extent a public-sector entity fails in
Maputo Corridor Project, a concept supported by former some way and a contract party is able to recover damages
South African president Nelson Mandela), and provide a rea- or some other compensation from that entity (pursuant
sonable return on equity for the sponsors. to the concession agreement or otherwise), the issue
Despite these facts and despite the obvious poor becomes one of creditworthiness of that entity. In the case
state of the port, the limited worth of its assets, the lack of a port, the most significant risk is, probably, blockage
of business it was generating, and GOMs decision to pri- of the access channel, which may result if a vessel is
vatise the port, financial close was reached finally in April grounded or in some other way is stranded in the channel.
2003. Had the consortium been aware of this time frame If the public-sector entity has the obligation to cure such
and the resulting development costs in December 1997, an event and fails or even delays in doing so, the effect of
the Project is unlikely ever to have materialised. that interruption on the business could be catastrophic.
There are obvious mitigating factors that can be
employed, such as procuring and maintaining appropriate
Maputo is believed to be the first insurance and robust compensation provisions in the con-
cession agreement. However, to the extent the insured
full privatization of a port and a party is perceived to be a significant risk due to its lack of
port authority role in Africa or technical and financial capacity (as may be the case with
a public-sector entity in an emerging market), the cost of
any other emerging market. insurance will be significant, even prohibitive. The sol-
vency risk of the public entity is also an issue, as discussed
Why did a project with such obvious merits take above. Can this public-sector risk be totally avoided? In
over five years from the date of the initial tender to reach this Project, the private sector proposed to draft new leg-
financial close? This case study considers a number of the islation that took the port authority powers away from
challenges faced by the consortium and its advisers and CFM and granted them to the Project company, MPDC.
looks at the innovative solutions that were created to The legislation would also grant MPDC the exclusive
achieve what is believed to be the first full privatisation rights to perform all land-side and water-side services.
of a port and port authority role in Africa or any other This proposal was accepted by GOM. The new legislation,
emerging market. combined with the rights granted under the concession
48 LETTING THE CROWN JEWELS FALL INTO PRIVATE HANDS SUMMER 2003
561

Case studies
agreement, effectively privatised not just the operation of agreement, namely the concession fee. To the extent that
the port facility, but the entire function of the port a value is to be ascribed to the assets transferred to the con-
authority within a delineated area in Maputo Bay. As stated cessionaire that is outside the scope of the concession fee
above, this is believed to be the only example of a full port structure, the basis for valuation may prove to be a chal-
privatisation outside the Western world. lenge. This challenge proved to be a significant hurdle to
completion of the Project.
PUBLIC LAND ISSUES Because of the mechanics of the Projects Conces-
sion Agreement, the potential problem of asset valuation
Under Mozambican law, it is not possible for a pri- in relation to those assets to be transferred back at the end
vate person or entity to own public land; neither is it pos- of the term to GOM (as conceding authority) was avoided.
sible to grant security in relation to the land itself. First, However, this may not be the case in every concession sce-
the issue of ownership of the land would prove to be a nario, depending on the concession model utilised. It is
significant obstacle to overcome because MPDC, to fully perhaps artificial to support the view that a concession
enjoy its rights and interests and perform its obligations fits squarely into a model format and therefore it is more
under the Concession Agreement, would require a realistic to look at each concession agreement on its own
binding legal interest over the land (which it was not pos- merits. Nevertheless, it may be of some academic interest
sible to grant by way of the concession agreement alone). to consider briefly at this point whether the different
Secondly, for the Project to present a bankable structure classic models include the concept of transfer back and,
to its lenders, some form of security in relation to MPDCs as a result, the potential challenge of asset valuation.
rights over the land would need to be granted. Although the build-operate-transfer (BOT) model
assumes the transfer back of the assets, compensation for
SPECIAL LICENCE that transfer is not automatic as the concessionaire is not
the owner and therefore cannot expect compensation. In
To ensure that any rights over the land to be granted a strict build-own-operate (BOO) model, there is no con-
to MPDC would be as robust as possible and, given that cept of transfer back as full ownership in the assets is
the ultimate owner of the land is the Republic of Mozam- granted to the concessionaire. Build-own-operate-transfer
bique, the aim was to enshrine MPDCs rights in law. (BOOT) schemes, however, may well assume that, fol-
This necessitated the drafting of new legislation that would lowing ownership of the assets by the concessionaire, they
grant sufficient rights to MPDC, would be recognised will be transferred back against payment of a mutually
and accepted by GOM, and would be capable of regis- agreed indemnification for the residual asset value.
tration within the existing land registration system in Returning to the Maputo Port Project, when a
Mozambique. The result of negotiation with the Ministry methodology was agreed with CFM for valuing the fixed
of Planning and Finance was the drafting of a special and moveable assets to be transferred to MPDC, the
licence that satisfied all of these requirements and also potentially difficult issue of attributing value to the assets
would provide for the ability to assign the special licence to be used for the concession term seemed to have been
to the Projects lenders or a third party, namely a replace- resolved. When the figure proposed by the consortium and
ment operator nominated by the lenders pursuant to their supported by an independent valuer proved to be signif-
step-in rights on the occurrence of an event of default icantly lower than the value proposed by CFM for the
under MPDCs finance package. very same assets, it quickly became apparent that the port
was not seen as a degrading asset that could have a fair
VALUATION OF ASSETS market value ascribed to it in such an objective manner.
It was clear that, despite the apparent agreement on
Depending on the type of concession concerned, the methodology, the port was seen as part of Mozambiques
question of valuing the assets to be conceded and assets crown jewels and the valuation of its assets and privatisa-
to be transferred back at the end of the term (if any) often tion of its functions were an emotive subject. This was
can prove to be contentious. The price payable for the ini- compounded by the fact that the assets were intended to
tial transfer of the assets to the private-sector concession- purchase (by contribution in kind) CFMs proportion of
aire or project company may well be included in the the Project companys equity.
overall price payable under the terms of the concession
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Case studies
EQUITY RESTRUCTURING international financiers and combines:
The solution to this problem was to restructure the 1. Equity and sponsor loans (see above). The sponsors
equity requirement of the Project so that the overall equity equity and shareholder loans are being backed by
or quasi-equity injected remained at a sufficient level to political risk guarantees from the Multilateral Invest-
maintain the debt-equity ratio required by the Projects ment Guarantee Agency.
lender group. However, the breakdown of equity was 2. Tranches of senior debt amounting to up to US$27
altered such that the share capital in MPDC was propor- million and provided by FMO (the Netherlands
tionately reduced to ensure that the agreed value of the Development Finance Company), Standard Cor-
transferred assets was equal to the value of CFMs share- porate Merchant Bank (SCMB), and the Develop-
holding in the Project company. The shortfall in the overall ment Bank of Southern Africa. SCMB is backed by
equity financing was met by the injection of shareholder a political risk and partial commercial risk guarantee
loans made by the consortium members. Inevitably these from the Swedish International Development
were required to be deeply subordinated to the senior Agency. The guarantee protects SCMB from the
debt to qualify as quasi-equity (and not affect MPDCs effects of political events within Mozambique,
debt-equity ratio). This technical solution not only sat- thereby reducing SCMBs exposure while increasing
isfied the Projects lenders but also removed any poten- the tenor of SCMBs debt and keeping the interest
tial sensitivity associated with requesting CFM to inject rate/margin affordable.
further equity in cash. 3. FMO also is providing a tranche of subordinated
debt of up to US$5 million.
FINANCING 4. Mezzanine debt has been secured by MPDC issuing
a Note Instrument to a group of export credit agen-
As mentioned above, the concession structure (par- cies.These include Swedfund, Nordic Development
ticularly in relation to termination scenarios and the pay- Fund, and Finnish Fund for Industrial Corporation
ment of compensation) ensures that only minimal risks are Limited. The Note Instrument is best characterised
left with MPDC. Taking an example, expected returns of as an equity participating mezzanine loan instru-
the Project are based on a structure consistent with current ment and therefore does not negatively impact on
tax legislation in Mozambique. Under the Concession the debt-equity ratio, which relies on senior debt
Agreement, adverse changes in tax legislation and appli- only. The Note Instrument has a contingent ele-
cable rates that impact on MPDC financially are borne by ment that acts as a standby facility, which can be
GOM, either through compensation to MPDC or by utilised in place of sponsor support and therefore
MPDC setting off any such additional tax against other has the benefit of providing MPDC with additional
sums owing to GOM (e.g., the concession fee). Further, the financing without increasing the burden on the
Concession Agreement ensures that there will be no restric- sponsors balance sheet.
tions on the payment of debt-service sums, management and
other foreign-exchange-based fees/costs, and distributions The concession and financing structures are robust,
to shareholders (whether of dividends or repayment of share- providing lenders with an effective security and sponsor
holder loans). However, given the market and the political support package, and passing on major risks (including
risks associated with Mozambique, it was necessary to attract construction risks) to third parties. In relation to con-
funding from development finance institutions (DFIs). struction risks, Skanska International Civil Engineering
Securing this would provide the necessary comfort and plat- is acting as MPDCs construction manager, with the obli-
form to attract commercial lenders. gation to procure completion of the works, ensuring that
The capital investment programme for the Project all works, surveys, and environmental assessments are car-
is for approximately US$75 million, with about US$40 ried out by suitable and competent contractors in time and
million of long-term project financing and the remainder to costs and standards specified. Cost overruns risk is being
provided by a combination of equity funding and internal guaranteed by Skanska International Civil Engineering,
cash generation from MPDCs operations. Tenor for subject to certain conditions.
the finance packages is between 10 and 12 years. The The Exhibit illustrates the range and complexity of
financing structure involves a syndicate of regional and the Projects contractual structure.
563

Case studies
EXHIBIT
Maputo Port Project
Sida
MOU
Guarantee
Mersey Docks
Skanska
Sponsor
Liscont
Support
DBSA
Government
CFM FMO
of
(parastatal) SCMB
Mozambique
Offshore
Shareholders Agreement
Loan
Agreement
Concession Offshore
Agreement Shareholder
Construction
Offshore Manager
Shareholders Agreement
Construction
Management
Agreement
MPDC
Rail Operating
Agreement Management
Sub-concession Services Agreement
Agreements
Rail Service
Operator Provider
Sub-concessionaires
LACK OF GOVERNMENTAL CAPACITY little experience in project finance techniques proved a sig-
nificant barrier to progress. This lack of experience derives
GOM was granted a line of credit by the World from the fact that, at the inception of the Project, no other
Bank to fund the costs associated with implementing its concession for an infrastructure project or a major PPP had
decision to concession certain elements of the countrys been successfully completed in Mozambique. Indeed, even
infrastructure (including Maputo Port) to the private sector in 2003, the number of successful PPPs in Mozambique is
as part of the Maputo Corridor Project. In the feasibility limited with few notable exceptions, such as the Cahora
stage and during the tender phase, GOM received external Bassa dam and the N4 Platinum Toll Road from Maputo
advice, the costs of which were funded by the World to Johannesburg, which is about to be refinanced.
Bank. However, once negotiations between the consor- The challenge of successfully negotiating with the
tium and GOM and CFM commenced, there no longer very entity to be privatised through the concession pro-
appeared to be any external legal counsel to GOM or cess was, with hindsight, the single largest contributing
CFMor, at least, external legal counsel was not present factor to the slow progress made toward the eventual close
at the negotiation meetings. of the Project in April 2003. The incumbent public port
Although there is no doubting the ability of the authoritys negative feeling toward the prospect of its pri-
Mozambican negotiating team, the fact that the team had vatisation and its resistance to change are both natural and
564

Case studies
understandable. Indeed, this attitude is a pervasive and of other more minor governmental agencies were invited
potentially emotive issue in many privatisations, particu- to join the IAC on an ad hoc basis to address specific issues.
larly so in a former communist regime in an emerging The second element of the proposed solution to the
market where the attitude towards private-sector man- lack of capacity issue was to engender a team approach
agement throughout society is greeted with suspicion at between the consortium advisers and the representatives
best and violent reaction at worst. of the Inter-Agency Committee. This approach resulted
in a series of workshops that enabled the consortiums
legal and financial advisers to share information and expe-
The challenge of successfully rience of project finance techniques in general and the
negotiating with the very entity to Project specifically with their Mozambican counterparts.
The workshop sessions developed and encouraged a non-

be privatised through the
confrontational approach to the negotiation process and,

to some extent at least, reduced the inevitable suspicion
concession process was, with of the private sector that certain representatives otherwise
hindsight, the single largest may have felt. It was also interesting to note that a number
of the concepts and issues discussed in the open forum of
contributing factor to the slow the workshop sessions were quickly absorbed, understood,
progress made toward the and applied by the IAC team in subsequent negotiations.
eventual close of the Project. THE BENEFITS DERIVED
Despite the lengthy delays experienced throughout

The lack of capacity within CFM was further com-
the Project, the fact that arguably the most important
pounded by a lack of capacity throughout the relevant gov-
strategic asset within the Mozambican economy has now
ernmental ministries and agencies required to approve
been successfully placed in the hands of the private sector
elements of the Project. This issue is not unique to Mozam-
is an enormous benefit for the country and the region.
bique or to Africa; rather it is present in many emerging-
The job and wealth creation for Mozambique over the
market countries where there is a fundamental lack of budget,
long term will be significant.
resources, and training not just at the governmental level
The closure of the Project doubtless will encourage
but throughout the economy and the educational system.
the government to continue with its policy of privatisa-
A further factor causing delay in the transaction was
tion using the concession model. Indeed, this is high-
the bureaucratic procedures required by many of the gov-
lighted by the fact that the Concession Agreement for
ernmental agencies involved in the approval of the Proj-
the Project is, according to the authors understanding,
ect and the numerous licenses and consents required to
being used as a precedent for other concession projects,
make the Project fully effective.
including, for instance, the concessioning of the Ressano
Garcia railway line from Maputo to Johannesburg.
WORKSHOPS AND The increased knowledge and capacity of the gov-
INTER-AGENCY COMMITTEE ernmental negotiating teams will lead to the quicker con-
clusion of future projects which, in itself, will attract
The problem of institutional lack of capacity cannot
further foreign direct investment into Mozambique.
be solved through a single transaction such as this Project,
Until the timelines for the completion of project
neither did the consortium look to tackle the problem per
finance transactions such as this Project are significantly
se. However, to try and overcome the hurdles resulting
reduced, however, the appetite of the investor market and
from this lack of capacity, a high-level taskforce (the Inter-
the commercial debt market likely will remain relatively
Agency Committee) was assembled comprising represen-
limited.
tatives of each stakeholder involved in the Project, including
CFM, the consortium members, MPDC, the Ministries
of Transport and Communication and Planning and To order reprints of this article, please contact Ajani Malik at
Finance, and the Central Bank of Mozambique. A number amalik@iijournals.com or 212-224-3205.
565

Case studies
Dabhol: A Case Study

of Restructuring
Infrastructure Projects
PIYUSH JOSHI
T
PIYUSH JOSHI he current worldwide economic THE INDIAN ELECTRICITY SECTOR
is an attorney in scenario has brought to focus the
Delhi, India. Before embarking on a discussion of the
necessity of restructuring a num-
piyush@law.com Dabhol Power Project, an overview of the legal
ber of infrastructure projects.
A few important aspects of restructur- framework governing independent power pro-
ing an infrastructure project financed on a non- ducers in India is helpful.
recourse or partial-recourse basis include: An independent power producer (IPP) in
India can sell electricity only to the electricity
studying the main problems facing the board of the state in which its power station is
project and potential solutions; situated. A state electricity board is an entity of
identifying the commercial interests of the relevant state government that undertakes
all the parties whose consent would be the generation, transmission, and distribution
necessary for enabling restructuring of of electricity within the geographical bound-
the project; aries of that state. Since 1994, many states have
studying the termination scenarios of the initiated reforms whereby they have split the
various project contracts; single state electricity board into multiple enti-
analyzing the possible revised structures ties with distinct functions of generation, trans-
from financial, political, and legal angles; mission, and distribution. In states where such
formulation of an adequate process and reforms have taken place and a single state elec-
framework for undertaking the process of tricity board no longer exists, an IPP can sell
restructuring; power only to the relevant state transmission
formulation of a suitable framework of utility that has been formed as a consequence
the restructured project; and of such restructuring.
negotiating and putting into place the If an IPP intends to sell electricity within
revised structure of the project. a state to an entity other than the relevant state
electricity utility (be it an electricity board or a
This article seeks to present some of the transmission utility), it has to obtain the per-
issues that arise in the context of restructur- mission of the government of the state in which
ing a project finance transaction. I will be using its power station is situated. With the introduc-
the Dabhol Power Project, one of the largest tion of a new law in 1999, in such circumstances,
independent power projects being imple- the IPP also will have to seek the approval of the
mented in India, to illustrate some of the issues electricity regulatory commission of the state
that have to be considered during the restruc- in which electricity is being sold with respect
turing of a project finance transaction. to the tariff at which such sale takes place.
566

Case studies
If an IPP intends to sell electricity to an entity sit- Phase I of the Project was financed and construc-
uated in a state other than the state in which its power station began in March 1995. Phase I commenced com-
tion is located or to entities in more than one state, it mercial operations in May 1999. Phase II of the Project
must seek the approval of the relevant agency of the Gov- achieved financial closure in May 1999 and construction
ernment of India. Furthermore, the approval of electric- began shortly thereafter, but it has not been completed.
ity regulatory commissions of the states where the sales The entire contractual framework necessary to
take place will also have to be taken with respect to the achieve financial closure of a project finance transaction
tariffs associated with those sales. was put into place for the Dabhol Power Project. The
The Indian legal framework, therefore, presently most critical of all the project contracts were the Power
does not allow an IPP to manage the risk relating to the Purchase Agreement (PPA) between MSEB and the
creditworthiness of the electricity utility of the state in Company, the engineering, procurement, and construc-
which its power station is located. An IPP bears the entire tion contracts for Phase I and Phase II (EPC Contracts),
risk relating to the creditworthiness of the state electric- the operation and maintenance agreements for all Phase
ity utility. To manage that risk, IPPs are looking for some I and Phase II power station, the regasification facility
form of state support in conjunction with their financ- and the marine facilities (O&M Agreements), the LNG
ing. The Indian legal framework also presents significant Supply and Purchase Agreements (the SPAs) and the time
challenges to the restructuring of a power project being charter party relating to the LNG tanker dedicated to
implemented by an IPP. the project to transport LNG to the project site (the
LNG TCP).
THE DABHOL POWER PROJECT: AN As pointed out earlier, MSEB had agreed under the
INTRODUCTION TO THE PRESENT SITUATION PPA to purchase the entire output of the Dabhol Power
Project. To support MSEBs payment obligations under
The Dabhol Power Project is comprised of the devel- the PPA, the Company and MSEB had established escrow
opment, construction, and operation of a power station and arrangements for the benefit of the Company utilizing rev-
an LNG regasification facility and associated port facilities enues from certain MSEB customers. The Maharashtra
(the Project). The power station is designed to be capable Government provided to the Company a guarantee (the
of operating on natural gas and liquid fuel (such as naph- GOM Guarantee) for MSEBs payment obligations under
tha). The Project is situated near the village of Dabhol in the PPA. This is an irrevocable and unconditional guarantee.
the State of Maharashtra, India, approximately 170 kilo- The Government of India also provided to the Company
meters south of the city of Mumbai. The Dabhol Power a limited counter-guarantee (the GOI Guarantee) cover-
Project is an independent power project that can sell power ing a portion of the same payment obligations.
only to the Maharashtra State Electricity Board (MSEB), the The credit risk with respect to MSEBs ability to
electricity public utility that is owned by the Government perform the payment obligations under the PPA were
of the State of Maharashtra. The Dabhol Power Company mitigated by: 1) a letter of credit that had to be opened
(the Company) and MSEB entered into the Power Pur- by MSEB under the PPA, 2) an escrow arrangement that
chase Agreement, pursuant to which MSEB undertook to would be triggered upon certain payment defaults by
purchase the entire output of the power station. MSEB, 3) the GOM Guarantee, and 4) GOI Guarantee.
The Project was being developed and constructed The Company was to purchase LNG pursuant to
in two phases. The first phase was comprised of a single 20-year LNG sale and purchase agreements with 1) Oman
power block and certain ancillary facilities (Phase I). The LNG and 2) Abu Dahbi Gas Liquifaction Company
second phase of the Project entailed the construction of (AdGas). These agreements were intended to provide suf-
two additional power blocks, the construction of an adja- ficient LNG to enable the Company to meet its obliga-
cent regasification facility, fuel jetty and breakwater, a tions under the PPA. An LNG tanker was commissioned
dredged channel and turning basin for the LNG tanker to be built specifically for the Project to transport LNG
(Phase II). Upon completion of Phase II, the Project is from Oman LNG and AdGas, pursuant to a time char-
envisaged to include three power blocks with each block ter agreement between the Company and Greenfield
consisting of a combined-cycle unit comprising two com- Shipping Company Limited.
bustion-turbine generators, two heat-recovery steam gen-
erators, and one steam-turbine generator.
28 DABHOL: A CASE STUDY OF RESTRUCTURING INFRASTRUCTURE PROJECTS SPRING 2002
567

Case studies
FINANCING DOCUMENTATION sion resulted in payment defaults by the Company under

the EPC Contracts, which were finally terminated by the
Various financing and security agreements were exe- respective contractors in June 2001. The construction of
cuted to provide for the financing of each aspect of Phase Phase II stopped in June 2001, when approximately 92%
I and Phase II of the Project. They are described as follows: of that phase had been constructed. Due to the lack of
The financing of the development and construction funds caused by the defaults committed by MSEB, GOM,
of Phase I was achieved with approximately $434.9 mil- and GOI, the Company continued to commit defaults
lion in equity contributions to the Company and $643.9 under all its project contracts and eventually its loan agree-
million debt from the Phase I lenders. Additionally, the ments. In addition to the EPC Contracts, most of the
shareholders were obligated to provide certain funds in
critical project contracts have been terminated. The O&M

completion support under certain circumstances. Agreements and the LNG TCP have been terminated
Development and construction of Phase II was and the LNG tanker that had been commissioned specif-
financed with approximately $453.9 million in equity ically for the Project has been withdrawn. The LNG SPAs
contribution commitments to the Company and $1,414.2 have not yet been terminated, but the Company has com-
million in debt from the Phase II lenders. Additionally, mitted a number of defaults under those agreements and
the shareholders were obligated to provide certain funds is incurring take-or-pay liabilities.
in completion support under certain circumstances. A At the time of writing this article (March 2002),
substantial portion of the Phase II loans came from cer- Phase I of the Project has not operated since May 2001
tain export credit agencies; they are secured by guaran- and Phase II lies incomplete. No work is being undertaken
tees from certain Indian financial institutions. in relation to the construction or operation of the
Financial closure for both Phase I and Phase II was Project. The majority shareholder of the Project, Enron
achieved only after a great deal of commitment from the Corporation, unexpectedly declared bankruptcy in
both the government of the state of Maharashtra (GOM) December 2001 and is presently under Chapter 11 pro-
and the Government of India (GOI) to the Dabhol Power ceedings in the United States.
Project. GOM provided the GOM Guarantee and exe- The infrastructure created at the project site lies
cuted a state support agreement. GOI provided the GOI unutilized and is deteriorating. The Project faces a num-
Guarantee. The Indian financial institutions that have ber of serious issues including willful default by the main
guaranteed the loans provided by the export credit agen- offtaker, the state-owned utility, defaults by the GOM
cies are entities of the Government of India. It was the and the GOI in their obligations under guarantees issued
best structure that could be achieved at that time. by them, and an unexpected bankruptcy of the main
However, ever since Phase I started commercial developer. The Project is in immediate need of extensive
operations, MSEB has not been complying with its pay- and a comprehensive restructuring, if the large invest-
ment obligations under the PPA. Initially payment of ments and loans invested into the Project are not to be
monthly invoices was delayed and later MSEB sought to written off.
raise various disputes on a number of aspects of the PPA
and continued to default on its payment obligations. From
THE ROAD TO RESTRUCTURING
January 2001 onwards, the Company regularly sought to
invoke the GOM and GOI Guarantees to ensure timely The actual challenge of any restructuring is not the
payment of the various outstanding invoices. Both GOM restructuring process itself but to get the parties onto the
and GOI repeatedly failed to honor their commitments road towards restructuring. The critical step in the pro-
under their respective guarantees. In May 2001, MSEB cess is moving all the necessary parties to make a decision
clearly stated that it has no intention to abide by the PPA on the need for restructuring and working out an agree-
and it unilaterally sought to rescind the PPA outside the ment relating to the various aspects of the restructured
framework provided in the agreement for settlement of project. In the case of the Dabhol Power Project, the need
disputes and termination. for restructuring was being discussed long before the proj-
In light of the various payment defaults by MSEB, ects problems escalated to their current level. By early
GOM, and GOI in relation to Phase I, the lenders to 2000, it had become apparent that MSEB by itself was
Phase II suspended disbursement of loans for construc- not in a position to sustain the monthly invoices of Phase
tion of Phase II sometime in March 2001. That suspen- I, let alone Phase II (the construction of which was, at that
568

Case studies
time, proceeding on schedule to enable its commission- posed greater hardships than restructuring the transac-
ing by July-August 2001). For over a year, the Company tion. A party that has a greater long-term interest in the
approached the GOM and GOI to make suitable policy project would support restructuring of a transaction if
changes that would enable independent power projects termination of certain contracts made it more problem-
to sell their electricity to any third party or to more than atic for future operation/restructuring of the project.
one state electricity board. The Company also discussed Generally, if a project has reached the stage that
this issue with the Project lenders. However, the Com- necessitates its restructuring, a number of project con-
pany did not succeed in making the relevant parties/agen- tracts already have been terminated or their termination
cies focus on the problem and the Project continued to is imminent in the absence of any adequate measures being
hurtle towards a major crisis. undertaken. At times, it even may be necessary to termi-
This also indicates one painful principle in restruc- nate the contract in its entirety to enable an adequate
turing projects, namely that there is no such thing as pre- restructuring of the terms and conditions and to enable
ventive restructuring. In complex financing transactions adequate protection of each partys rights, or even to
it is difficult to make parties undertake any corrective enable a more balanced negotiation of the revised terms
restructuring. Restructuring needs a crisis of corre- and conditions of the contract.
sponding magnitude. A suitable restructuring is a response Formulating termination provisions is an unenvi-
to a crisis and is possible only when the level of that cri- able task because, unlike the case with other provisions of
sis compels the parties to make concessions and under- a contract, the commercial aims and direction of the var-
take the restructuring of their existing rights. ious parties are generally either vague or not even defined.
If a termination clause is made too detailed, it might go
CRISIS MANAGEMENT AND RESPONSE against a party in a situation where that party causes the
termination or wants to terminate the contract. If a ter-
Since the process of restructuring large projects is one mination clause is made too standard, then the party may
of crisis management and response to crisis, the same prin- lose out in a situation where the counter-party termi-
ciples that are applicable to crisis management are appli- nates the contract.
cable to a restructuring process, some of which include: There are however, certain neutral principles that
should be reflected in a termination clause for the bene-
Identification of the crisis fit of parties in any situation. These include:
Identification of the cause of the crisis
Identification of the factors that continue to Procedure for Termination. The termination clause
sustain the crisis should provide for: 1) the events of default that
Identification of all the possible solutions would provide a party with the right to terminate
Identification of the parties essential interests the contract, 2) the agreed expiry date of the con-
and goals tractual relationship, 3) cure periods that would allow
Identification of common ground from the parties to rectify the event(s) of default that may
essential interests and aims of the parties have occurred, 4) vesting of the right to terminate
Elimination of possible solutions based on relevant the contract in the event the default is not cured, 5)
factors such as financial, commercial, and legal the procedure for delivery of termination notices,
Identification of possible ripple effects of the crisis and 6) the determination of the point of time when
Attempting to mitigate, to the extent possible, the the contract stands terminated.
ripple effects of the crisis. Consequences of Termination. The termination clause
should provide for the consequence of termination
TERMINATION SCENARIOS of the contract by a party. Termination is the
unwinding of a contractual relationship. The con-
Termination provisions of the contracts that consti- sequences of such a step should include: 1) a frame-
tute the framework of a structured finance transaction work for enabling the parties to unwind the
gain a great deal of importance in restructuring scenar- relationship in a structured manner, 2) a framework
ios. A party would be more inclined to support restruc- to enable determination of adequate compensation
turing of the transaction if termination of the contract to the other party on account of termination due
569

Case studies
to an event of default, and 3) adequate protection respect to the Project, when faced with MSEBs current
of the rights of parties that continue to accrue until situation, has taken the stand of simply not discharging its
the date of termination. obligations as MSEBs guarantor. This is clearly a politi-
Survival. The termination clause should clearly pro- cal decision by GOM and could be considered by some
vide for the survival of certain clauses that should to amount to an act of creeping expropriation. The entire
necessarily survive the termination of the entire con- financing of the Dabhol Power Project had been struc-
tract and continue to form binding contractual obli- tured on the basis of MSEBs obligations under the PPA
gations on the parties. The identification of such being guaranteed by the GOM and the guarantee obli-
clauses depends on the facts and circumstances of gations of GOM being counter-guaranteed to a certain
each case. Some contractual provisions that are gen- extent by GOI. GOM, by making a clear decision not to
erally identified for survival include: the termination discharge its guarantee obligations, effectively wiped out
clause itself, confidentiality obligations, and the dis- the very basis of the present structure of the Dabhol Power
pute resolution mechanism. Project. GOI has refused to discharge its obligations to
guarantee the performance by GOM of its obligations on
DABHOL POWER PROJECT the grounds that the disputes between MSEB, GOM, and
THE VARIOUS POSSIBILITIES the Company should first be resolvedgrounds that are
not provided for under the GOI guarantee.
The Roots of the Crisis The Dabhol Power Project thus suffers from a lack
of a purchaser for the electricity it has the capacity to gen-
The roots of the crisis facing the Dabhol Power erate and the collapse of the security structure that had
Project lie in the legal framework that governs it. Since formed the basis for structuring and financing the entire
the Dabhol Power Project is an IPP, the electricity gen- projectat a time when Phase I has been operational for
erated by it can be sold only to MSEB. The issues faced more than one year and the construction of Phase II has
by the Dabhol Power Project are a reflection of what ails almost been completed. The collapse of the security struc-
the Indian electricity sector: low tariff collection, high ture, which had formed the basis of the project financ-
subsidies, high transmission losses, poor transmission and ing, immediately led to the collapse of the financing
distribution infrastructure, and political unwillingness to arrangement, the EPC Contracts, the O&M agreements,
undertake measures necessary to reform the electricity the fuel supply agreements, and all the various contracts
distribution regime. that were necessary for the development of the Project.
MSEB presently does not have the capacity to either
offtake or pay for the total capacity of the Dabhol Power
Need for RestructuringInterests of Parties
Project. The inability of MSEB to offtake and pay for the
electricity generated by the Dabhol Power Project is more The collapse of the project finance structure occurred
a result of political than economic factors. The successive at a time when a large amount of resources already had
governments that have followed since the commencement been invested and there already were physical project assets
of the Dabhol Power Project in 1993 have reduced the to reflect these investments. Phase I of the Project had been
MSEB from being one of the best-run state electricity in operation for more than one year. Phase II had neared
boards to being a debt-riddled entity having very low tar- completion at the time when the construction was sus-
iff collection and very high transmission losses (read as pended due to the termination of the EPC Contracts.
theft). MSEB has had to bear the burden of extensive sub- The lenders to the Dabhol Power Project must
sides that were extended by successive governments to var- restructure the project if they are to prevent loss of the
ious groups of electricity consumers from farmers to specific loans extended and already drawn by the Project. The
industries. The demand for electricity in the state of Maha- original sponsors are keen to exit as the entire basis on
rashtra itself has not increased as forecasted due to low which they began development of the Project has now
growth in industries being established in the state. MSEB changed irreversibly. Enron, the majority shareholder
presently is completely incapable of discharging its obliga- of DPC, has filed for bankruptcy protection and would
tions to offtake electricity from the Dabhol Power Project. no longer be in a position to continue to develop the
The Government of Maharashtra, which had guar- Project even if it were interested in doing so.
anteed the performance by MSEB of its obligations with
570

Case studies
From this background of the present crisis facing ties for enabling the due delivery of electricity to such con-
the Project, it is clear that any feasible restructuring of sumers. It is possible to phase the operations of each power
the Project will have to address the following issues: block of the Project in light of the level of offtake that is
achieved by the Project after such measures are taken.
Offtake of electricity: a feasible structure to Allowing Multiple Uses of LNG Facility. The main
enable regular offtake of electricity will have assets of an infrastructure project and their potential util-
to be established. ity must be considered in any restructuring process. The
Change of equity participants: the existing share- immediate benefit of exploring alternative or multiple uses
holders of DPC will have to be replaced, particu- of project assets is that it reduces pressure on the tariff
larly Enron in light of its inability to continue charged by the Project. The Dabhol Power Project has two
development of the Project. distinct but interdependent facilities: the electricity gen-
Debt profile: the existing debt profile of the eration facility and the LNG handling facility. It is possi-
Project will have to be altered. ble to alter the Dabhol Power Project from a single power
project to an LNG regasification and storage project and
Certain Components of Possible Restructuring a power generation project. The power generation seg-
ment itself is comprised of three distinct but interdepen-
Restructuring of any project presents difficult options dent generating blocks, each having two turbines.
for all of the parties. Generally, the option that is finally The LNG facility should be allowed to handle LNG
selected is not the one that is best for all the parties but one for commercial purposes and not only for the Project.
that makes all the parties bear the burden of restructuring The Government of India would have to grant the rele-
in an appropriate manner, with none benefiting dispro- vant approval for this purpose. A pipeline also would have
portionately. It is usually more the lowest common denom- to be developed from the LNG facility to other locations
inator than the best possible scenario. If a party simply to enable the transportation of the LNG.
refuses to cooperate, no restructuring is possible, all the This may involve spinning off the LNG facility into
parties lose, and, more importantly, all the resources invested a separate corporate entity through a scheme of de-merger.
in the development of the Project are wasted. Negotiating An agreement for sharing certain infrastructure facilities
scenarios in a restructuring process should be based on the between the LNG facility and the power generation block
estimated threshold of each party to bear losses and a reflec- may have to form part of the scheme of de-merger that
tion of importance of the project to each party. is placed before the relevant court.*
Enabling Sale of Electricity. A feasible way to dis- Substitution of Equity Holders. The equity investors
tribute electricity generated by the Project will have to be of the Dabhol Power Project will have to be replaced by
explored. It is clear that MSEB, as the sole customer for equity investors that are interested and have the capability
the electricity generated by the Project, does not provide to implement a restructured project. In light of the option
for any feasible options for its future operations. It is imper- to spin off the LNG facility, it may be important to select
ative for any feasible restructuring of the Project that the a consortium of equity investors that have companies with
issue of the offtake of electricity from the Project be experience in developing, operating, and maintaining LNG
resolved. This is both a tariff and a payment issue. The facilities, as well as companies that have experience in devel-
Project will have to be permitted to sell electricity to par- oping power generation facilities. This is the process that
ties other than MSEB and even to parties outside the state has been commenced as the first phase of the restructuring
of Maharashtra. of the Project. The Indian lenders, led by the Industrial
This would require GOM to give the Company (or Development Bank of India (IDBI), a financial institution
other relevant entities) permission to sell the electricity controlled by the GOI, have invited expressions of interest
generated from the Project to parties other than MSEB. It from persons that meet certain financial and technical cri-
also will involve relevant statutory approvals from GOI and teria for participating in a due diligence process for the
other relevant state governments to enable the electricity eventual sale of the equity held by Enron, General Electric,
generated by the Project to be sold directly to consumers and Bechtel in the Company. As of the time of writing this
that are outside the state of Maharashtra. Suitable wheel- article (March 2002), seven companies had submitted
ing arrangements also will have to be made between expressions of interest in response to the invitation circu-
DPC/relevant entities and the various transmission utili- lated by IDBI. The success of this step towards the replace-
571

Case studies
ment of the existing offshore shareholders will depend upon for its purposes, the extent of which would be deter-
how the other steps required for the eventual restructuring mined by its investment in the Project.
of the Project are formulated, particularly the need to pro- The project company also would undertake com-
vide for a credible system for sale of electricity and allow- mercial operations of the Project. A mechanism would
ing the LNG facility to be used for the transportation and have to be put into place to regulate the revenues received
sale of LNG to other third-party consumers. by the project company through such commercial oper-
Assessing Viability of an Independent Operator ations, and each investor would be entitled to obtain a
Approach. There may be no single entity/consortium portion of the revenue generated by the Project in accor-
that would be in a position to take over the existing equity dance with the priority agreed to with the lenders. The
of the Dabhol Power Project. Since such a situation is investors also would receive part ownership in the revenue
possible, any attempts at restructuring the Project should stream generated by the Project.
also consider providing a solution to such a scenario. To The investors and the lenders would have to reach a
ensure the due implementation of the Project in the event specific structure for repayment of debt in such a scenario.
no single consortium is identified through the process for The debt could be still housed in the project company and
the substitution of Enron, GE, and Bechtel, it could be be paid by the commercial operations of the Project imple-
necessary to examine the viability of implementing the mented by the Company acting as an operator undertak-
Project in a format of an independent system operator. ing the activity on a not-for-profit basis. The revenues
In such a scenario, instead of selecting a single con- generated would go to the investors in accordance with
sortium to replace the existing offshore shareholders of the the arrangement reached with the lenders.
Company, various interested, but perhaps independent, The lenders and the investors would monitor the
parties could be allowed to invest/bid for a specific per- operations of the Project, which would be carried out by
centage of shares in the project company that would hold a separate professional team selected by the board of
the assets. The project company would be responsible for investors and approved by the lenders. In order to separate
the implementation and operation of the Project on a the asset holding function and the operator function it may
not-for-profit basis and would hold the revenues gener- be possible to establish a separate company that undertakes
ated by the Project in trust for the investors and lenders. the independent not-for-profit operations of the Project.
The project company and the investor would enter into Certain Measures by the Government. Any future
an investment agreement that would detail the rights and restructuring of the Project will require a few important
obligations of the investor and the project company. The measures to be taken by both GOI and GOM, including
investor also would have to enter into an agreement with granting certain concessions to the Project. GOI and
the lenders recognizing their rights and the project com- GOM will have to recognize that the assets that have
pany also would have to be a party to that agreement. already been developed by the Project constitute impor-
The project company would be responsible to a tant assets to the energy infrastructure of India and the State
board of directors representing all the investors in the of Maharashtra.
Project. The investors in the project company would The main concessions required by the Project can
get a part title to the project assets (depending upon the be divided into two categories: the first set of concessions
tax viability of obtaining such a right), the right to use are those required by the Indian energy sector as a whole
the specific project assets for which their respective invest- to revive private participation; the second set consists of
ments have been made, and a title to part of the revenue project-specific concessions.
generated by the Project. The right to use the project Measures that GOI and GOM would have to take
assets being contemplated by an investor can be explained in relation to the Indian energy sector as a whole would
by the following illustration: If there are two electricity include:
companies and two LNG companies that become the
ultimate investors, each electricity generator can be enabling independent power producers to sell elec-
allowed to use a specific amount of electricity generated tricity to, and receive revenues from, entities other
by the Project for its purposes, the extent of which would than the state electricity board regardless of their
be determined by its investment in the Project. Simi- geographical location;
larly, each LNG company that invested could be allowed
to use a specific amount of the LNG facilitys capacity
572

Case studies
enabling infrastructure facilities that are developed to enable the due operations of their respective assets. This
for a particular project to be used simultaneously could be achieved in the legal process of de-merger by
for other uses/business; which the assets were distributed. A shared-facilities agree-
establishing a framework to support and promote wheel- ment could be negotiated as part of the reconstruction
ing of electricity from a power project to consumers; plan that is presented to the relevant court that would
providing certain incentives to promote indepen- allow for the re-merger to take place.
dent power producers to assist in the development The total debt of the Project would have to be dis-
of infrastructure required for transmission of elec- tributed between the energy generation project company
tricity from their plants; and the gas project company after studying the total cap-
implementing reforms in the distribution and trans- ital costs of the respective facilities as compared to the total
mission of electricity; debt and equity put into the overall project. In relation to
granting certain additional tax concessions to projects, the electricity generation assets, it may be necessary to
which could be linked to time frames within which phase the operations of the various turbines in light of the
they are able to develop and commence the operation demand for electricity. In the event a single consortium of
of their facilities. investors is not identified, it may be necessary to examine
other structures for continuing the implementation of the
In addition to the measures that could be classified Project such as the format of an independent operator
as generally required by the Indian energy sector, there funded through various investors that each receive a part
are a number of measures GOI and GOM would be title to the project assets (depending upon the tax viabil-
required to take in relation to the Project such as: 1) ity of granting such a right), a right to use the project assets,
extending cooperation of various government-controlled and the title to a certain part of the revenues.
entities to enable the revival of operations of Phase I and
the implementation of the development of Phase II of ENDNOTE
the Project; 2) withdrawing certain disputes raised by gov-
ernment-controlled entities against the Company; 3) com- *Under Indian corporate law, in order to undertake the
pleting the construction of transmission lines required to reconstruction of a company (either through a merger or a de-
enable offtake of the electricity generated by Phase II; merger), a scheme of reconstruction first has to be formulated
and 4) enabling and supporting the use of the LNG facil- and approved by the lenders and the shareholders of the com-
pany. The scheme of reconstruction that is so approved then
ity as a distinct facility for handling, transportation, and
has to be placed before the court having jurisdiction over the
distribution of LNG to other consumers.
company undertaking the reconstruction. The court has to
approve the scheme of reconstruction and pass an order to that
CONCLUSION: A POSSIBLE OPTION effect. It is only upon the court passing the relevant order that
FOR THE DABHOL PROJECT the scheme of reconstruction comes into effect.
I would like to conclude the discussion on the Editors Note: The author is a lawyer based in India and has
restructuring of infrastructure projects by attempting to authored a book titled Law Relating to Infrastructure Projects, But-
indicate a possible option for restructuring of the Dab- terworths India, 2001. He can be contacted at piyush@law.com.
hol Power Project.
It is clear that GOI, GOM, and the Indian lenders
(the majority of which are entities controlled by GOI) To order reprints of this article please contact Ajani Malik at
will have to provide support for the restructured project. amalik@iijournals.com or 212-224-3205.
The Dabhol Project could be split into an electric-
ity generation project and an LNG facility project, with
the electricity generating assets continuing with the pre-
sent project company and the LNG facility assets being
hived off into a new gas project company. The two com-
panies would have to be bound to support each others
functioning on a non-commercial and mandatory basis
by allowing the sharing of certain infrastructure facilities
573

Case studies
Accessing Local Currency

Through Credit-Enhanced
Bond Structures in Africa
A Case Study of Safaricoms Medium-Term
Floating-Rate Secured Note Issue
CHRISTOPHER MARK JACKSON
T
CHRISTOPHER MARK his case study is based upon Citi- cies and B-Loan2 programs. Those risks asso-
JACKSON groups experience of arranging a ciated with the potential mismatch between
is a director and co-head
private placement and subsequent future local-currency income streams and the
of Media and Telecom-
munications at Global public listing of Kenyan shilling 4 up-front hard-currency cost of the network
Project Finance billion (US$50mm) of five-year amortizing equipment can be more difficult to transfer or
CEEMEA in London, notes for a Kenyan GSM 1 operator, 60% hedge. This is particularly true in Africa, where
England. owned by Telkom Kenya Limited and 40% by the process of raising long-term debt capital is
christopher.jackson@citi.com Vodafone Kenya Limited, with partial credit complicated by the limited development of
support provided by the Belgian government the local capital markets, where investors are
through OND (Office National du Ducroire), not always familiar with this type of credit sup-
the Belgian export credit agency. The purpose port and normally would not be attracted to
of the bond issue, which was executed in par- unstructured private-sector obligations.
allel with a 25 million offshore facility also Finance professionals are always seeking
backed by OND, was twofold: ways of removing or at least managing cur-
rency risk, which can be country specific or
to fund the purchase of equipment from regional in nature. For example, the CFA zone3
Siemens ATEA, the Belgian exporter in West and Central Africa provides a series
and subsidiary of Siemens AG, which of markets in which local currency can be
provided network equipment and related raised, facilitating cross-border local currency
services to Safaricom under a long-term transactions. Equipment vendors looking to
supply agreement and find financing solutions for their buyers tradi-
to fund the OND premium. tionally have found it difficult or have been
resistant to source local-currency funding and,
NEED FOR LOCAL CURRENCY as such, running a mismatched book has
SOLUTIONS become a way of life for many sponsors and
borrowers, with all the inherent risks. While
While many of the marketing, techno- daily volatility can affect weekly treasury man-
logical, and regulatory issues of start-up tele- agement activity, the issue for telecom project
com financings are common to both developed financings, because of its typically long tenor,
and emerging-market telecom transactions, is a sudden devaluation that can have long-
emerging-market operators and financiers face term effects. A one-off devaluation reflects a
a series of additional risks. If required, some of step change in the markets view of a currency
these risks, such as political risk, may be coun- and will result in both:
tered with the support of export credit agen-
26 ACCESSING LOCAL CURRENCY THROUGH CREDIT-ENHANCED BOND STRUCTURES IN AFRICA SUMMER 2002
574

Case studies
a significant downward adjustment in the purchas- EXHIBIT 1

ing power of the very people who are expected to Regulatory/Structural and Internal Credit
acquire these new goods and services and Constraints Affecting Investors in Telecom Facilities
an increase in the operators debt burden in local
currency terms. Regulatory/Structural Internal Credit
Constraints Constraints
The traditional option of using derivatives is often
Reserve requirements Familiarity with project
not possible in these countries. There may be regulatory,
finance structures
legal, credit, or liquidity constraints that do not permit Tenor limitations Familiarity with start-up
sophisticated hedging techniques to be used, in which
ventures
case alternatives need to be found. Capacity issues Appetite for telecom
Identifying the need for local-currency financing is, market risk

in itself, not as straightforward as may be expected. A bal- Single name lending limits
ance needs to be struck between limiting risk and ensur-
ing that the underlying business has sufficient hard
currency to pay for its network equipment. Without the definition willing to take some country risk. Thus, the
ability to service customers on an equal-coverage basis, need to source often scarce or expensive political risk
the business cannot hope to compete effectively and gen- insurance for the entire loan amount can be removed.
erate the necessary cash flow to pay back its debts. Fur- Depending on economic conditions, local liquidity may
thermore, although a managed exchange-rate regime like be strong, widening the potential investor base for a deal.
a crawling peg may exist when the financing is closed, Although innovation is important, it is not the first but
that linkage may fail at a crucial point in the businesss the last investor who completes an issue and has the final
development. While operators may undertake sensitivity word on whether or not its terms have found market
analyses to measure the impact of a devaluation, few start- acceptance. Additionally, with current market sentiment
ups with geared balance sheets can withstand significant for the telecommunications, media, and technology
shocks without needing to significantly reduce their cap- (TMT) sector, incremental liquidity in local capital mar-
ital expenditure programs or reschedule repayments over kets is becoming vital to telecom borrowers, where inter-
a longer time period. national banks cross-border and sector appetite is
becoming heavily constrained.
Is local currency funding all a bed of roses then?
Local-currency financing also can Certainly not. Local currency financings have their own
be a significant source of structural issues and costs that need to be carefully con-
sidered. The costs are fairly easy to identify, in that the bor-
additional liquidity as bond rower may have a potentially higher interest-rate base
demanded by the market to compensate for lending in a
investors or domestic banks, currency in which there is significant purchasing-power
whether they are local institutions risk. Thus, the short-term debt-service cost can increase
significantly at a time when the company is not free-cash-
or subsidiaries or joint ventures flow positive. Often finding a central EURIBOR equiv-
alent rate can be complex and the selection of a freely
of international financial groups, available and transparent reference rate becomes especially
are by definition willing to important.
When structuring telecom facilities, it is important
take some country risk. for the borrower to consider both regulatory/structural
and internal credit constraints affecting lenders and
Local-currency financing also can be a significant investors, as listed in Exhibit 1.
source of additional liquidity as bond investors or domes- Internal credit constraints can be resolved more eas-
tic banks, whether they are local institutions or subsidiaries ily as domestic lenders and investors often look for rep-
or joint ventures of international financial groups, are by utable lead arrangers or bookrunners and take comfort
575

Case studies
from those institutions acceptance of the terms, review- directly with bondholders, whose investment rationale may
ing their own criteria in light of that leadership. Advi- be very different from that of the agency. This is exempli-
sors and arrangers need to spend time taking the pulse of fied by agency concerns over the need for waiting periods
lender sentiment to ensure that they are reading the mar- on claims or the need for sufficient hard currency funds
ket accurately and the structure can be executed. This to ensure that the resiliation risk4 is minimized.
may mean providing split-tenor solutions, variable ticket
sizes, or additional forms of credit enhancement. Tenor
problems can arise, for example, as a result of regulatory CELC bonds provide access to an
asset and liability management issues. These may place alternative investor base, which
additional limitations on financial institutions that look
to run mismatched books with a predominance of long- significantly enhances financing

term assets and short-term liabilities.

Borrowers with international sponsors may be reluc- capacity, and they are drawn in
tant to source local funding when those sponsors do not one amount, removing the
have relationships and pull with local banks, as they
fear that they may become beholden to institutions that funding risk associated with a
are not as committed as their global relationship banks
during difficult times. That said, a domestic lender is less
long availability period.
likely to have a knee-jerk reaction to any short-term
domestic economic or political shocks, as it is better placed Why would a borrower be interested in such a bond
to assess the potential impact over the medium term and solution versus a bank deal? CELC bonds provide access
is more tangibly committed to the country or region. to an alternative investor base, which significantly
enhances financing capacity, and they are drawn in one
CELC BONDS amount, removing the funding risk associated with a long
availability period. This benefit also can be enhanced if
Credit-Enhanced Local Currency bonds (CELC there is asymmetric regulation between the bank and
bonds) are a potential solution to many of the issues bond markets, where issuers can take advantage of pric-
raised above in countries with partially or fully developed ing anomalies. The agencies are also willing to reduce
capital markets. Moreover, they can be a developmental their own premia by mitigating the convertibility and
tool in themselves for the domestic capital markets, and transferability risks of the bond solution. Finally, the value
this is particularly true in Africa. This developmental role to the issuer in terms of its profile following a successful
is also attractive to potential credit enhancers in that the public issue should not be underestimated, especially if
bonds allow agencies to meet one of their key objectives that issue can garner high-level in-country institutional
of being seen to facilitate alternative sources of funding. support, can be seen to develop the capital market for
A CELC bond has the following characteristics: everyone, and thus can provide international credibility
to a fledgling market.
Covered by a full or partial guarantee from one or As with any new structure, there are negatives. The
more export credit or multilateral agencies process of structuring such an issue and obtaining approvals
Issued in an exotic currency may be time consuming and the issue itself may be com-
Marketed primarily to local investors plex to understand and thus dissuade less sophisticated
Governed by local capital markets regulations investors from participating. Legal expenses can be sig-
Floating or fixed rate. nificant and the relevant domestic legal framework can
create challenges for documentation. Finally, just as the
The key feature that distinguishes a CELC bond from publicity of success is good, the impact of a highly pub-
other traditional bonds is the commercial risk mitigation lic failure could be seriously detrimental to the underly-
cover that third-party investors and agencies such as insuring business as people become concerned about the issuers
ance companies, multilaterals, and ECAs have not provided short-term liquidity or even ongoing viability.
in the past. This is for a variety of reasons, but predomi-
nantly because of a reluctance to coordinate and interface
576

Case studies
EXHIBIT 2
Irrevocable Guarantee Structure
Note
Guarantee
Bank Debenture / Charge over
Charge of Shares Escrow Accounts
Obligation
to pay
Note ECA
Trustee Facility
Security Agent Agent
Key: Lenders
Noteholders Euro 25
Proceeds of Shared Security
KSh 4 billion million
Proceeds of Security over Escrow Accounts
CASE STUDY oversubscribed. The Kenyan shilling proceeds were

deposited into a Ksh escrow account in Kenya, converted
Safaricom is one of two national cellular operators into euros within 60 days, and deposited into a euro escrow
in Kenya and had determined that it wished to maximize account in London. These funds were then available for
the local-currency element of its debt structure, but was drawdown in the usual fashion for ECA loans, namely
concerned over how much could be raised and on what against approved invoices.
terms. In January 2001, the company appointed Citibank The credit enhancement was more complicated, as
as its adviser to arrange project financing for the future the investors did not have a rating for the bond and were
development of its network. not necessarily comfortable with the wording of an export
After an extensive market review, Citibank deter- credit insurance policy. The solution was to provide an
mined that it would be possible to raise the largest and irrevocable guarantee from Citibank, NA, New York
longest-tenor bond for a non-sovereign issuer in Kenya, (termed the Note Guarantee Bank) for 75% of the Safari-
provided the bank was able to secure partial comprehen- com risk, which in turn was supported by OND on a
sive cover for the investors, with the balance being secured back-to-back basis. Thus Citibanks guarantee would
predominantly against the assets of the borrower. pay out 180 days after non-payment to match the timing
The key elements of the plan were twofold: of payments from OND to Citibank and the MTN hold-
ers rights would be transferred pro rata to Citibank fol-
mitigating the distribution risk for the issuer and lowing payments under its guarantee.
making investors comfortable with the form of credit The resulting structure is shown in Exhibit 2.
enhancement Key to the success of the transaction was the sup-
port and assistance of the three Kenyan regulators: the
The distribution issue was resolved through the pri- Capital Markets Authority, the Nairobi Stock Exchange,
vate placement mechanism, through which 85% of the and the Communications Commission of Kenya. By con-
issue was presold prior to retail launch and pre-commit- sulting with them early in the process and discussing the
ments were secured from five key institutions. The retail finance plan in detail, the bank was able to ensure con-
distribution then was completed through a group of stock- sents were obtained on time.
brokers and demand was sufficient for the bond to be
577

Case studies
List of roles for the overall financing

Title Party Contact Person Address
Global Co-ordinator and Citibank, N.A. Chris Jackson/ London, England

Advisor
Citibank International Plc John Ngumi Nairobi Kenya
Note Issue: Arranger,
New York, USA
Note Guarantee Bank,
Euro Escrow Bank and
Shilling Escrow Bank.

ECA Loan: Arranger

and ECA Facility Agent
Note Trustee Livingstone Registrars Daniel Ndonye Ring Road, Westlands,

Limited PO Box 30029,
Nairobi, Kenya
Registrar Chunga Associates Fiona Fox Rahimtulla Tower,

Upper Hill Road,
PO Box 41968,
Nairobi, Kenya
Security Agent Law Debenture Trust Susan Rose, 200 Aldersgate Street,
Corporation plc c/o Clifford Chance London, EC1A 4JJ, UK
Auditors to Safaricom PricewaterhouseCoopers Charles Muchene Rahimtulla Tower,

Upper Hill Road,
PO Box 41968,
Nairobi, Kenya
Issue & Paying Agent Chunga Associates Fiona Fox Rahimtulla Tower,
and Calculation Agent Upper Hill Road,
PO Box 41968,
Nairobi, Kenya
English Legal Advisor Clifford Chance Richard Ernest 200 Aldersgate Street,
Arranger/Citibank London, EC1A 4JJ, UK
English Legal Advisor Linklaters Stuart Thomas Mainzerlandstrasse 16,

Vodafone Frankfurt, Germany
Kenyan Legal Advisor Daly & Figgis Hamish Keith 8th Floor, Lonrho
to Safaricom House, Standard Street,
Nairobi
Kenyan Legal Advisor Kaplan & Stratton Oliver Fowler 7th Floor, Queensway
to Citibank House, Kaunda Street,
Nairobi, Kenya
578

Case studies
EXHIBIT 3 innovative and, by consultation with the regulators,

How the Financing Met the Borrowers Objectives resolved potential problems. The highly experienced legal
team ensured that the documentation was acceptable to
Objectives Deal Features all parties and the bond was issued at a time of high
liquidity and an absence of attractive medium-term invest-
Rapid Execution Financing made available in six ments. It was this coming together of key success factors
months so as not to delay the net that led to the popularity of the deal among all the par-
work rollout; extended credit ties who were involved.
terms were provided by Siemens But can it be repeated? While each market has its
ATEA in the interim. own characteristics, the basic structure evidences that
Local Currency Local currency availability maxi-

CELC bonds can bring significant benefits to emerging-
mized at 70% of the total financ-

ing as a natural hedge to the
markets borrowers in terms of all-in interest costs, bor-
future cash generation prospects rowing capacity, and currency hedging. An increasing
of the domestic subscriber base number of agencies is considering similar structures and
Non-Recourse Recourse to shareholders limited the bank is seeing heavy issuer demand to replicate what
to their pledge of shares in Project Finance magazine recognized as the African Tele-
Safaricom coms Deal of the Year in 2001.
Lowest Cost Term-loan margin minimized by
comprehensive OND cover and ENDNOTES
risk-mitigation impact of the
issuers local-currency hedging 1
Global System for Mobile Telecommunications.
OND premium on MTN issue 2
In an A/B loan structure, commercial banks lend along-
significantly reduced by exclusion side a multilateral agency such as the International Finance Cor-
of convertibility, transferability, poration. Participation of the multilateral does not provide a
and resiliation risks guarantee for the bank lenders, but it provides implicit support
Extensive Kenyan market read to and leverage with the borrower.
identify market clearing terms 3
In a recent article for this journal describing the Azito
Flexible Pre-agreed carveouts by the bond power plant in Cte dIvoire, John S. Strong described the CFA
investors franc zone as both a currency union and a monetary standard.
The CFA franc is convertible to French francs at a fixed nom-
inal exchange rate. France established the zone after World War
With its innovative credit enhancement, the bonds II to oversee monetary and fiscal policies in its African colonies,
and it continues to play a central role in its operation.
provided the investors (banks, insurance companies, pen- 4
Resiliation risk in this case is the risk that, for whatever
sion funds, and high-net-worth individuals) with a new
reason, the goods are not shipped to Kenya. Siemens was
asset class. By listing the bond, Safaricom was able to pro- indemnified against this pre-export risk as part of its export
vide much-needed liquidity and two market makers also credit insurance policy with OND.
were appointed. The issuer was able to secure a cost of
funds at a margin of 1% above the 91-day T-bill rate in a
market with few other long-term investment opportuni- Editors Note:
ties and relatively low bank deposit rates. The author served as global coordinator and advisor for the Safari-
The bond also met the borrowers objectives, as sum- com financing.
marized in Exhibit 3.
CONCLUSION To order reprints of this article please contact Ajani Malik at

amalik@iijournals.com or 212-224-3205.
The Safaricom CELC bond provided long-term,
local-currency financing for the issuer and established an
important benchmark in the Kenyan capital markets for
non-sovereign issuers, in terms of both the achieved tenor
and size of the issue. OND showed a willingness to be
579

Case studies
The Equate Project:

An Introduction to
Islamic Project Finance
BENJAMIN C. ESTY
M
BENJAMIN C. ESTY uslims, or followers of Islam, Co-financing is one solution. In a co-
is an associate comprise approximately 25% financed deal, the sponsors combine conven-
professor at Harvard
Business School.
of the worlds population, and tional Western finance with Islamic
Muslim countries control finance. Because Sharia prohibits interest-
approximately 10% of global GNP (see based financing, investors must use profit-
Exhibit 1). Because most of the countries based structures that involve asset ownership
with large Muslim populations are relatively in one form or another. Although there are
poor, as shown by their GNP per capital ratios, advantages to using Islamic finance, the asset
one of the biggest challenges facing Islamic ownership requirement generates several
countries in the next decade is financing potential complications in deal structuring
infrastructure development. By some esti- and project management. This article describes
mates, the potential market for private par- some of the permissible structures, the poten-
ticipation in infrastructure projects in the tial complications resulting from co-financing,
Middle East alone is $45 to $60 billion over and some of the generic solutions.
the next ten years. In fact, there are now
almost 300 infrastructure projects pending in
the Middle East not counting projects in The challenge is to develop
the oil, gas, and petrochemicals sectors.1 project finance structures
Although local companies will not be able to
finance all of these projects by themselves, that are not only consistent
they will participate as sponsors, sometimes by
choice and other times by regulation (i.e., with Sharia principles, but
governments often require domestic partici- also attractive to
pation and control of strategic resources).
Increasingly, the executives in charge of pro- international capital
jects in Islamic countries want to finance them
according to Islamic religious principles
providers.
(known as Sharia). At the same time, Islamic
investors are looking for long-term invest- But rather than simply describe the
ments that are religiously acceptable. The various structures and complications, I illus-
challenge, therefore, is to develop project trate them through a case study of the Equate
finance structures that are not only consistent Petrochemical Company, a $2 billion petro-
with Sharia principles, but also attractive to chemical plant in Kuwait that closed in
international capital providers. September 1996. The project is a joint ven-
WINTER 2000 THE JOURNAL OF PROJECT FINANCE 7
580

Case studies
EXHIBIT 1
Muslim Population Statistics 1996
Muslim Percent of
Population Countrys
Country (millions) Total Population
Indonesia 196 95
India 133 14
Pakistan 125 97
Bangladesh 104 85
Nigeria 77 75
Iran 65 99
Turkey 62 100
Egypt 59 94
Ethiopia 37 65
China 36 3
Morocco 29 99
Algeria 28 99
Sudan 26 85
Afghanistan 22 100
Iraq 20 97
Total for top 15 countries 1,019

Total Muslim Population 1,482
Total World Population 5,771
Muslim Percentage of Total 25.7%
Source: http://islamicweb.com/, authors estimates.
ture between Union Carbide Corporation and Petro- BACKGROUND ON ISLAMIC FINANCE2
chemical Industries Company (PIC), a subsidiary of
Kuwaits national oil company. The name Equate is based Islam is the worlds third monotheistic religion
on the concept of Ethylene Products from Kuwait and comes from the same Semitic heritage as Judaism
(Ethylene-Kuwait); the letters E and Q also stand for and Christianity. From the very beginning, Islam
Excellent Quality. The plant was financed with $800 acquired its characteristic ethos as a religion uniting both
million of equity and subordinated debt, $600 million of spiritual and temporal aspects of life, seeking to regu-
term debt from international banks with an 8.5-year late not only an individuals relationship with God, but
maturity, $400 million of term debt from regional banks also human relationships in a social setting. As a result,
with a 10.5-year maturity, and $200 million of Islamic Islamic law and secular institutions govern both indi-
funds in the form of an Ijara, or leasing, facility ($100 mil- vidual behavior and societal interactions in addition to
lion was allocated to each tranche of term debt). In this Islamic religious principles.
article, I describe not only the Ijara structure and the ratio- The Arabic term Islam, literally surrender, illus-
nale for its use, but also the two other most commonly trates the fundamental religious belief that followers must
used structures Istisna and Murabaha. After describ- surrender to the will of God, or Allah. The will of Allah
ing the general principles of Islamic finance, the project, is made known through the Quran, the sacred scripture
and its co-financed structure, I conclude with a brief which Allah revealed to his messenger, Mohammed.
update on the project since closing and a quick overview Mohammeds sayings and deeds, collectively known as the
of some other recent co-financed deals. Sunna, are codified in the Hadith. The Sunna provides an
8 THE EQUATE PROJECT: AN INTRODUCTION TO ISLAMIC PROJECT FINANCE WINTER 2000
581

Case studies
interpretation and explanation of the Quran. Together such as futures and options, which may be deemed ille-
these and other sources establish a set of guiding princi- gal due to their speculative nature.
ples for Muslims known as the Sharia (Sharia is derived Given the link between religious principles and
from the word meaning path.) Rather than a codified secular life, Islamic countries have developed financial
body of law, the Sharia is an ever-expanding interpreta- institutions that provide Sharia-consistent products and
tion of religious law. Only those believers whose lives con- services. Although the history of Islamic banking goes
form to Sharia will be granted entrance to heaven. back hundreds of years, it did not begin in its modern
form until the middle of the twentieth century. The first
Islamic financial institution, a small Egyptian institution
Because Sharia prohibits named Mit Ghamr Local Savings Bank, was formed in
interest-based financing, investors 1963. Early development was slow and did not acceler-
ate until the creation of the oil boom during the 1970s
must use profit-based structures created a larger segment of wealthy citizens looking for
ways to invest their savings in accordance with the Sharia.
that involve asset ownership in During this period, several Islamic financial institutions
one form or another. were created including the Islamic Development Bank in
Jeddah, Saudi Arabia in 1974, and the Dubai Islamic
Bank in 1975. Renewed interest in fundamental Islamic
Sharia has three main prohibitions that create dis- principles through the 1980s and 1990s further spurred the
tinctions between Islamic finance and conventional or demand for Islamic financial institutions.
Western finance.3 One of the most important features
of Islamic finance, and probably the only feature known
by most people, is the scriptural injunction against inter- Sharia has three main
est, or Riba. Interestingly, the Quran condemns Riba, but
provides little explanation of what the term actually means. prohibitions that create
In fact, the Arabic term Riba, a noun, means any payment distinctions between Islamic
in excess of the original principal, which can be inter-
preted as any form of interest payment. This prohibition finance and conventional or
is intended to prevent exploitation and to maximize social
benefits; it highlights Islams emphasis on social welfare over Western finance, against interest,
individual welfare. Instead of interest, profit is the just or Riba, against uncertainty,
return for someone who accepts the risks of ownership.
The emphasis on asset ownership biases Islamic finance or Gharar, and against gambling,
towards equity structures. Despite this orientation, project
finance, and hence this article, is largely about debt finance.
or Maisir.
Sharia also declares uncertainty, or Gharar, in
contracts as un-Islamic. Analogies, which are commonly By 1997, there were 176 Islamic financial institu-
used to explain Sharia principles, illustrate the importance tions, with $148 billion of assets, operating in over fifty
of certainty. Basically, you cannot sell what you do not countries. Although these institutions are often collectively
own or cannot describe in accurate detail. Thus, you can- referred to as Islamic banks, this term is somewhat of a
not sell fish in the sea prior to catching them because you misnomer because it includes commercial, investment, and
cannot describe them in sufficient detail (i.e., in terms of development banks. Of the total, there are approximately
type, size, and amount). The subtle difference here is that sixty Islamic banks holding $80 billion of assets. Exhibit
the former relies on the occurrence of an uncertain 2 shows the growth of Islamic financial institutions from
event for its fulfillment. Islamic law also declares gam- 1993 to 1997. While the compound growth rate of assets
bling, or Maisir, as unacceptable because it can lead to has been almost 30%, the market is expected to grow at
immorality (the compulsion to gamble) and other social 15% per year for the next several years. Exhibit 3 shows
evils such as poverty. This restriction has direct implica- the geographical distribution of these institutions as of
tions in the dealings of modern financial instruments 1997. As one might expect, the majority of the institu-
582

Case studies
EXHIBIT 2
Islamic Banking Market 1993-1997
4-year Compound
1993 1994 1995 1996 1997 Annual Growth Rate
Number of Banks 100 133 144 166 176 15.2%
Financial Statistics ($000)

Total Assets 53,815 154,567 166,053 137,132 147,685 28.7%
Total Capital 2,390 4,954 6,308 7,271 7,333 32.3%

Net Profits n/a 809 1,254 1,684 1,238 15.2%
Source: Directory of Islamic Banks and Financial Institutions 1997. The International Association of Islamic Banks, Jeddah.
EXHIBIT 3
Geographic Distribution of Islamic Banks 1997
Region Number of Percent of 1997 Industry

Banksa Assets Capital Net Profit
South Asiab 51 27% 12% 20%

Africa 35 1% 3% 2%
Southeast Asiac 31 2% 2% 4%
Middle East 26 56% 50% 20%
Gulf Cooperation Councild 21 14% 24% 49%
Europe and America 9 1% 8% 5%
Asiae 2 0% 0% 0%
Australia 1 0% 0% 0%
Total 176 100% 100% 100%
Source: Directory of Islamic Banks and Financial Institutions 1997. The International Association of
Islamic Banks, Jeddah.
aIncludes other Islamic financial institutions such as Islamic investment banks.
bSouth Asia includes Bangladesh, India, and Pakistan.
cSoutheast Asia includes Brunei, Indonesia, Malaysia, and the Philippines.
dThe Gulf Cooperation Council is a political, economic, social, and regional organization established in
1981 by UAE, Bahrain, Saudi Arabia, Oman, Qatar, and Kuwait.

eAsia includes Russia and Kazakhstan.
tions and the assets are in the Middle East. It is interest- sharing in financial risks and rewards. A second difference
ing to note that the largest institution as of 1997, the $22 is the fact that profit is not the sole purpose of an Islamic
billion Bank Melli Iran, was roughly equal to the fiftieth bank. These banks must ensure that funds are invested in
largest U.S. bank holding company at the time. accordance with religious principles. A Sharia advisory
Islamic banks differ from their Western counter- committee, comprised of Islamic jurists, oversees the
parts in two important ways. First, they conduct business operations of each institution. These committees, which
in an interest-free manner to avoid Riba. The relation- range in size from one to seven members, typically meet
ship between Islamic banks and their customers is not the quarterly to discuss specific products and transactions.4 It
standard one of creditor and debtor, but rather one of the is the committees job to determine what is permissible,
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Case studies
or halal, and what is unlawful, or haram. Like public Islamic Development Bank recently announced the cre-
accounting firms, they provide annual reports in which ation of a $1.5 billion Infrastructure Fund to finance pro-
they assess whether an institution has acted in compli- jects in member countries according to Islamic religious
ance with the rules and regulations of the Islamic Sharia. principles.8 Recognizing the growing demand for Islamic
Historically, different Sharia committees, or boards, equities, Dow Jones recently created the Islamic Market
have disagreed on the permissibility of various structures. Index (DJIM) which tracks 600 companies whose oper-
According to one lawyer: ations conform to Sharia principles. Major financial
institutions such as Citibank and HSBC Group, also
We have come up with a structure that has been recognizing the trend, have recently set up Islamic
approved by an Islamic institution and its Sharia finance divisions to serve this growing market segment.
board and we have tried using the same structure Another manifestation of the growing interest in Islamic
for another client and it is found to be completely finance is the increasing number of trade groups and
unacceptable.5 research organizations dedicated to collecting and dis-
seminating information about Islamic finance. One such
Recently, there has been an attempt to harmonize example is the Harvard Islamic Finance Information
Sharia standards and guidelines across institutions. One Program (HIFIP) which was founded in 1995.9 And
major step toward this goal was the creation of the finally, there have been several billion-dollar projects in
Bahrain-based Accounting and Auditing Organization recent years, including the Equate Petrochemicals Com-
for Islamic Financial Institutions (AAOIFI) in 1991. This pany and the Thuraya telecommunications project, that
organization has helped build consensus on a number of have utilized Islamic funds.
issues and narrowed the scope of disagreement on others.
THE EQUATE PROJECT10
Islamic banks differ from their PIC and Union Carbide officially formed Equate
Western counterparts in two in July 1995, to finance, construct, and operate a $2 bil-
lion petrochemical plant. The project was part of the
important ways: they conduct Kuwaiti governments economic strategy in the wake of
the Gulf War. Exhibit 4 shows the large decline in real
business in an interest-free GDP, oil production, population, and perceived credit
manner to avoid Riba and quality (the Institutional Investor country risk rating)
between 1990 and 1991, and the partial recovery by
profit is not their sole purpose. 1995. Following the War, the Kuwaiti government
wanted to develop stronger political and commercial ties
Despite its global growth, the development of an with coalition countries as a way to express gratitude and
Islamic financial sector has permeated countries in vary- ensure future domestic security. This desire to promote
ing degrees. In some countries with Islamic governments foreign investment changed Equate from a PIC-only
(e.g., Pakistan, Iran, and Sudan), the entire economic project into a joint venture with Union Carbide. But the
system has aligned with Islamic principles.6 More mod- project had other benefits. Kuwait wanted to limit its
erate governments (Bahrain, Brunei, Kuwait, Malaysia, dependence on oil production and refining, and it wanted
Turkey, and United Arab Emirates) embrace Islamic bank- to attract foreign capital given the deficits created by
ing though support of a dual banking system with con- government expenditures on reconstruction. Consistent
ventional banks. Other countries such as Egypt, Yemen, with the countrys economic strategies, PIC chose Union
Singapore, and possibly Indonesia, neither support nor Carbide, one of the worlds largest basic-chemicals com-
oppose Islamic banking. And finally, there are countries panies with joint ventures around the world, as the pro-
that actively discourage the creation of a separate Islamic- jects other sponsor because of its technology and access
banking sector (Saudi Arabia7 and Oman). to world petrochemical markets. From Union Carbides
As of the late 1990s, the growth and development perspective, it saw the Equate project as an opportunity
of Islamic finance is well underway. Several recent devel- to use its proprietary processing technologies and to
opments support this contention. For example, the source low-cost inputs.
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EXHIBIT 4
Kuwait Economic Indicators 1986-1995
Government Oil
Budget Surplus Production Institutional Investor
Real GDP (Deficit) (millions of Population Country
Year (KD billions) (KD billions) barrels per day) (millions) Credit Rating
1986 8.41 (651) 1.46 1.79 62.3

1987 8.08 (1,263) 1.39 1.87 58.3
1988 8.36 N/A 1.52 1.96 59.1

1989 8.99 (1,096) 1.79 2.05 60.2
1990 5.85 -- 2.04 2.14 60.8

1991 3.51 (745) 0.19 2.07 41.8
1992 6.14 (5,330) 1.06 1.42 47.4
1993 7.46 (1,783) 1.87 1.46 49.2
1994 7.76 (977) 2.07 1.62 53.3
1995 7.95 (656) 2.06 1.69 53.4
Sources: Economist Intelligence Unit Country Reports, International Monetary Fund, and Institutional Investor.
The project consists of three separate plants one PIC wanted to facilitate the involvement of a foreign
each for producing ethylene, polyethylene, and ethylene partner even though it could have financed the deal on its
glycol and is located in the Shuaiba Industrial Area own balance sheet neither PIC nor its parent KPC had
near Kuwait City. Exhibit 5 provides an overview of the any debt. Union Carbide, on the other hand, wanted to
project. The first plant, an ethylene cracker, processes use project finance to limit its Kuwaiti exposure, especially
ethane gas fuel from a nearby PIC plant into 650,000 met- given the Gulf War. The sponsors also reached early
ric tons per year (MTY) of ethylene, which then is used as agreement on the projects capital structure: 40% of the
the primary input for both the polyethylene and ethylene funding would come in the form of equity or subordinated
glycol plants. The polyethylene plant produces 450,000 debt (including subordinated debt, the project had a debt-
MTY of polyethylene, the most widely used plastic in the to-total-capital ratio of 85%). PIC and Union Carbide
world, utilizing Union Carbides UNIPOL process tech- each provided 45% of the equity. Boubyan Petrochemi-
nology. The ethylene glycol plant produces 340,000 MTY cal Company (Boubyan), a publicly traded company
of ethylene glycol, used in the production of polyester formed in June 1995 to give Kuwaiti citizens a chance to
fiber, automotive antifreeze, and engine coolants, using invest in the project, provided the remaining 10%. Exhibit
Union Carbides Meteor process technology. 6 describes the projects sources and uses of cash.
The sponsors hired Fluor Daniel to manage the
entire project and to construct necessary utilities and
related infrastructure. They began construction in August Both Union Carbide and PIC
1994, financed through a combination of equity and
debt from a $450 million bridge loan. By late 1995, wanted to use project finance,
they needed to replace the bridge loan with more per- but for different reasons.
manent financing.
ARRANGING THE A more difficult question was what kind of debt

PERMANENT FINANCING to use. The projects financial advisors, Chase Manhattan,
J.P. Morgan, and Chemical Bank, argued for bank debt
Union Carbide and PIC resolved two major issues with completion guarantees from the sponsors and export
regarding the permanent financing relatively quickly. Both credit agency (ECA) guarantees from organizations like
wanted to use project finance, but for different reasons. the United States Export-Import Bank (US Exim), Her-
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Case studies
EXHIBIT 5
Overview of the Equate Project
Kuwait Petroleum
Corporation (KPC)
100%
Petrochemical Industries
Union Carbide Corporation Boubyan Petrochemical Company (PIC)
Company 10%
10%
45% 45%
Equate Petrochemical
Company (Equate)
100%
100%
Ethylene Plant Ethane Plant

(650,000 MTY)
50.1% 49.9%
Ethylene Glycol Plant Polyethylene Plant

(340,000 MTY) (450,000 MTY)
Equate Marketing Company
Source: Based on published sources and company reports.

Notes: Dashed lines signify ownership; bold solid lines indicate product flow.
MTY is metric tons per year. A metric ton equals 1,000 kilograms (kg), or approximately 2,200 pounds (lb.).
mes, and SACE. In addition to term loans, PIC wanted sponsors. Structuring the deal Islamically (at least in part)
to use $100 to $500 million of Islamic funds, assuming would make it more socially acceptable to Kuwaiti citi-
it could be raised on competitive terms. On the one zens and investors.
hand, tapping the Islamic capital market would provide At the time, however, there were few precedents
an alternative source of funds, albeit a relatively small one for integrating Islamic and conventional funds in a single,
given the current size of the Islamic banking market. A project-financed deal. In fact, the first major co-financed
second, and more important reason for using Islamic transaction was the $1.8 billion Hub River power project
funds was, to quote a banker who worked on the project, in Pakistan. This project used a $92 million Istisna facil-
the deals optics. After all, this project was in an Islamic ity during the construction phase provided by Al-Rajhi
country with a government-owned entity as one of the Banking and Investment Corporation. An istisna is a
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Case studies
EXHIBIT 6
Sources and Uses of Capital
Amount Percent of Total

($ millions) (%)
Uses of Capital
Construction engineering, materials and equipment $1,500 75.9
Capitalized interest, closing/financing costs, and other costs 155 7.8
Licensed technology 200 10.1
Preliminary operating expenses 120 6.1

Total Uses of Capital $1,975 100.0
Sources of Capital
Petrochemical Industries Company (PIC):
Equity capital $ 129 6.5
Subordinated debt 220 11.1
Total PIC Contribution $ 349 17.7
Union Carbide Corporation:

Licensed technology and subordinated debt 220 11.1
Total Union Carbide Contribution $ 349 17.7
Boubyan Petrochemical Company:

Subordinated debt 48 2.4
Total Boubyan Contribution $ 77 3.9
Total shareholder funding $ 775 39.2
Term loan facilities

International banks $ 600
Regional banks 400
Islamic tranche 200
$1,200 60.8%
Total Sources of Capital $1,975 100.0
Source: Authors estimates based on published sources.
commissioned or pre-manufacture finance facility; see four years due to political factors. Nevertheless, Euromoney
below.11 When asked why they decided to use the Istisna, named it Deal of the Year in 1994, in part because it
a banker replied, The Islamic facility was available quick- proved the feasibility of co-financing as a financial struc-
ly . . . it was competitively priced and was responsive to ture. Based on this and other smaller deals, PIC wanted
the projects financing needs.12 Unfortunately, and some- to include a tranche of Islamic funds. It awarded a man-
what unfairly, this deal tarnished co-financing as a finan- date to arrange the funds to Kuwait Finance House
cial structure because the closing was delayed by more than (KFH), Kuwaits only Islamic Bank.
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Case studies
In structuring the Islamic tranche, KFH could For post-construction financing, the sponsors could
have chosen one of three main structures: Istisna, have used either a Murabaha (cost-plus financing) or an
Murabaha, or Ijara. While each had advantages and dis- Ijara (leasing) contract. Both structures require owner-
advantages depending on the application, KFHs job was ship of dedicated assets. Because construction was well
to select the most appropriate structure and to resolve any underway by the time the sponsors were looking for per-
complications resulting from the use of Islamic funds. In manent financing, there were assets available to ring
the words of an Islamic investment banker who worked fence for the Islamic tranche. In a Murabaha contract,
on placing the Islamic funds with investors: an Islamic bank purchases an asset and re-sells it for a
higher price at a later date hence the term cost-plus
The way to understand Islamic finance is to replace financing. While the parties negotiate the deferred sale
the word Islamic with the word structured. Like all price in advance, the Islamic bank typically collects the
structured finance deals, you have constraints that actual payment as a bullet at maturity or on an installment
must be overcome with creativity and innovation. basis depending on the contract. Murabahas are fixed
Here, the constraints are based on the principles of rate instruments, which is an advantage from a borrowers
Sharia. The question is how to structure the deal perspective. From an investors perspective, however, a
given these constraints. Murabaha contract is like investing in a risky, fixed-rate,
zero-coupon bond; they are exposed to ownership risk
between the time they buy and sell the asset. Dollar-
At the time, there were few denominated Murabaha contracts typically have maturi-
precedents for integrating Islamic ties ranging from one to three years while Kuwaiti
dinar-denominated contracts can have longer maturities as
and conventional funds in a long as investors are willing to assume interest-rate risk.
single, project-financed deal.
The most common structure for
The first approach would be to follow Hub River
and use an Istisna contract in which one party contracts
construction finance is known as
to manufacture an asset for another party according to a back-to-back Istisna, which
detailed time and product specifications. To avoid prohi-
bitions against Gharar (uncertainty), the assets involved had places a financial intermediary
to be describable in great detail. The most common struc- such as an
ture for construction finance is known as a back-to-
back Istisna, which placed a financial intermediary such Islamic bank in the middle
as an Islamic bank in the middle of the transaction. Under
the first Istisna (the sale contract), a customer agrees to of the transaction.
purchase an asset from the Islamic bank upon completion.
The purchaser can pay the bank in advance, at completion, Although short-maturity structures were indicative
or over time based on a set of pre-determined completion of lending conditions in Kuwait in 1996, they are still quite
milestones. Under the second Istisna (the hire to pro- common in most Islamic financial markets. In fact, at the
duce contract), the Islamic bank agrees to pay the man- time the deal was financed, 90% of the Kuwaiti Central
ufacturer to build the asset in question. As an intermediary, Banks bills and bonds had maturities of less than two years;
the Islamic bank accepts the manufacturers performance none had a maturity of more than three years.
risk and the buyers payment risk. The major advantage of Banks, too, were reluctant to make long-term
an Istisna facility is that it is a fixed-rate contract with the investments in part because there was no Islamic Central
profit margin set at signing. The major disadvantage with Bank (the Central Bank did not follow Sharia principles
an Istisna structure is that it is for construction financing, explicitly) and in part because they had few long-term lia-
not permanent financing and would expose the project to bilities to offset the assets. A quick look at KFHs asset-
refinancing risk. Thus, it was not appropriate in this case liability mix, as an example, illustrates several important
because the sponsors needed permanent financing. features of Islamic banks (see Exhibit 7). As of 1995, a large
588

Case studies
EXHIBIT 7 However, identifying specific assets with economic value

Asset/Liability Management in an Islamic Bank in a large, integrated project like Equate is not always easy.
(Kuwait Finance House) Unlike the Murabaha structure, the Ijara structure
is a variable-rate instrument that requires periodic, typi-
Total % of Assets % of Liabilities cally semi-annual, payments. According to the contract,
Assets Maturing Within Maturing Within the payment for the following period is determined at
Year ($ millions) One Year One Year each payment date. The standard contract sets the lease
profit rate based on a benchmark interest rate such as six-
1995 $4,682 52% 34%
month LIBOR (plus a fixed spread). As with a conven-
1994 $4,295 44% 58%
tional financial or capital lease, the project company treats
1993 $3,879 36% 70%

the leased assets as if it had purchased the asset itself. The
Source: Kuwait Finance House Annual Reports, 1993-1995. lease obligation appears on its balance sheet as a long-term
liability offset by a depreciating fixed asset. At the end of
the Ijara, the project company takes ownership of the
leased asset for a nominal charge. While the Ijara described
fraction of its assets and liabilities would mature within one here a fully amortizing lease with no residual value
year. Even the assets that matured after one year were really is the most common structure, there are other kinds of
not long-term assets as a western banker might think of leases (operating leases, leases with residual value, etc.).
them. Most had maturities of less than four years.13 That
said, not all the short-term liabilities were really short term
even though they were classified as such. They are more In a Murabaha contract, an Islamic
like rate insensitive core deposits. Second, KFH was able bank purchases an asset and
to reconfigure its maturity structure in a relatively short
amount of time. Between 1993 and 1995, the percentage re-sells it for a higher price at a
of liabilities maturing within one year decreased from 70%
to 34% as concerns over the Gulf War began to fade.
later date hence the term
Third, KFH had a potentially serious mismatch problem: cost-plus financing.
the fraction of short-term assets was growing while the
fraction of short-term liabilities was shrinking. While While all three structures Istisna, Murabaha,
these changes reduced its liquidity risk, they exacerbated and Ijara could have been used to finance Equate, the
its interest-rate risk. From this perspective, KFH should sponsors chose the Ijara structure as the best compromise
have been interested in booking long-term assets such as between what they wanted and what investors were will-
a long-term Murabaha or Ijara. The choice between the ing to provide. They selected several furnaces, boilers, and
two would depend on whether it had fixed- or variable- other related equipment as the basis of the lease.
rate liabilities. Its reluctance to book long-term assets The sponsors decision to use Islamic funds created
stemmed from a combination of not wanting to book a number of complications, particularly with regard to
fixed-rate assets (Murabahas) or extend long-term credit managing the project and structuring the intercreditor
given the countrys political, and economic fragility fol- agreement. For example, because the Islamic investors
lowing the Gulf War. would own the assets, they would bear ownership risk. In
The final option was to use an Ijara contract, or some cases, the ownership risk could be substantial. The
financial lease. In an Ijara facility, the Islamic bank pur- common example given by lenders was, What would
chases specific assets and then leases them to the project happen if you owned an airplane that crashed in a major
company for a period of time. To qualify for an Ijara con- city? For a petrochemical plant, there were equally seri-
tract, the assets had to be separable and have economic ous environmental and third-party risks. One way to
value unto themselves. Here, Islamic scholars use the minimize these risks was to place the assets in a special pur-
analogy of bicycle tires. You cannot lease finance the pose vehicle (SPV) with limited liability. Because such a
construction of bicycle tires using an Ijara contract because structure had not yet been tested in a major litigation, it
the tires are not useful by themselves. In contrast, you was unclear whether a court might pierce the corporate
could finance the construction of bicycles using an Ijara. veil and assert liability on the deals Islamic investors.
589

Case studies
A second issue involved the selection of assets for across the various kinds of debt and to deter delinquency.
the Islamic tranche. The sponsors had to be willing to Actual events of default introduced even more
relinquish asset ownership. In certain circumstances, this complicated issues. The standard procedure for resolving
decision was not easy. Some countries believed that nat- bankruptcies in the United States is to enforce an auto-
ural resources were strategic assets and were unwilling to matic stay. A judge then supervises a liquidation in the case
permit foreign ownership of those assets. If Kuwait of Chapter 7 or a reorganization in the case of Chapter 11.
imposed such a restriction, the pool of available investors In both cases, the goal is to maintain a common pool of
would shrink considerably. assets to ensure maximum liquidation or going-concern
value. For an integrated production facility like Equate, the
assets would be virtually worthless if they were liquidated
In an Ijara facility, the Islamic piecemeal. Because the Islamic investors would own spe-
bank purchases specific assets cific assets, they could claim those assets in a default situ-
ation. While they might come out whole, they could
and then leases them to destroy the projects going-concern value in the process.
the project company for This kind of preferential treatment violated the standard
pari passu treatment in most intercreditor agreements.
a period of time. Yet other structures that lumped the Islamic and conven-
tional lenders together as a single entity ran the risk of
A third issue involved the payment of insurance tainting the Islamic tranche. The standard solution was for
and maintenance expenses associated with the Islamically the Islamic investors to forego their rights in the event of
financed assets.14 The separation of asset ownership and use liquidation or default. To minimize priority issues outside
or control creates incentive problems in the same way that of default situations, the bankers had to ensure that the
drivers are less careful with rental cars than they are with drawdown and repayment of Islamic funds occurred simul-
their own cars a problem known as moral hazard. In fact, taneously with the flow of conventional funds.
even though the Islamic investors knew nothing about The complexity of co-financed deals makes them
running a petrochemical plant, they technically would be potentially more costly to structure and more unwieldy
responsible for maintaining the assets in working order to operate post-completion. One Islamic banker com-
and insuring them against loss. One way to solve this prob- plained, Using Islamic finance is like trying to do some-
lem, though it was not the solution here, is to sign a ser- thing with one hand tied behind your back. A lawyer
vice management contract that obligates the sponsors to pay from Clifford Chance, echoed a similar sentiment, If
insurance and maintenance expenses in a timely fashion. theres no [specific tax or balance sheet] need for Islamic
There were also complications associated with try- cash, then people wont hunt it down because of the
ing to integrate Islamic and conventional funds in a single, added complexity of structuring transactions.15
co-financed deal. Most of these issues had to be addressed
in the intercreditor agreement that specified entitlements PROJECT CLOSING AND COMPLETION
to cash flows as well as creditor rights in the event of
default. There were the simple problems such as which The sponsors closed financing on September 15,
law would govern the contracts Islamic religious law or 1996. Although they originally had envisioned using an
English law? Even if they chose English law to govern the Islamic tranche alongside ECA-guaranteed bank debt, they
transaction, would a commercial court recognize, under- abandoned the idea of using ECA-guaranteed debt after
stand, and respect Sharia principles? Another problem was more than a year of negotiations. One of the key sticking
how to deal with payment delays. Conventional lenders points was the ECAs demand for a sovereign guarantee,
could charge penalty interest, but the Islamic investors something the sponsors in general and PIC in particular
could not. Instead, they would have to donate the penalty objected to based on its belief that the project was strong
interest to charity or risk violating Sharia principles. In the enough to stand on its own. As a result, the sponsors
event the project experienced significant delays, this inabil- began considering alternative financial structures without
ity to collect penalty interest is very costly to Islamic ECA involvement, and eventually closed the deal without
investors. Nevertheless, liquidated damages are regularly ECA support. The final deal included two term loans, a
included in the Islamic tranches to ensure equal treatment $400 million regional bank tranche and a $600 million
590

Case studies
international bank tranche. Each tranche also included a The re-capitalization is being undertaken to
$100 million Islamic Ijara facility for a total of $1.2 billion strengthen the capital structure to improve its prof-
of term debt priced initially at 175 basis points (bp) over itability, which had been negatively affected by the
LIBOR. The International Investor (TII), a leading Islamic length, depth, and timing of the current trough in
investment bank located in Kuwait, and KFH placed $120 the petrochemicals market.20
and $80 million of the Islamic facility, respectively. While
KFH booked some of the Islamic tranche on its balance One measure of the projects success, though not
sheet, both KFW and TII placed funds with investors necessarily a reflection of the projects financial strategy
holding custodial accounts with them. overall, is Boubyans stock price. The public subscription
When the deal closed, it was heralded in the press or sale of stock took place at 100 fils (1000 fils equals one
for many reasons. It was the first project in Kuwait Kuwaiti Dinar, which equals approximately US$3.26 under
between local and international investors, the first heavy current exchange rates). Public trading began in June
industrial project financed in part by a public share offer- 1997 at a price of 400 fils, rose to as high as 480 fils, and
ing, and the first major project since the end of the Gulf then fell to 160 fils by September 1999.21 Compared to
War.16 The leading project finance journals commented: Equates 60% decline from the public offering, the Kuwaiti
market index fell 37%. One can attribute the markets
[Equate is]the most ambitious effort at blending decline, and a large fraction of Equates decline, to falling
Islamic and conventional financing.[it] not only oil and petrochemical prices over the past two years. Inter-
proves the viability of Islamic financing, it also estingly, neither the index nor Equate have re-gained
demonstrates that Islamic banks are capable of much ground since oil prices have shot up in late 1999.
arranging and funding large regional projects.17 Despite Equates recapitalization and Boubyans
poor post-issuance returns, KPC has announced plans to
The Equate deal may prove to be the turning construct a second olefins plant, a $1.2 billion aromatics
point for Islamic project finance it should plant, and a $50 million methanol plant by the year
provide a template for future Islamic-financed 2002.22 Whether these projects will proceed and whether
projects.18 they will be co-financed remains to be seen.
The Amir of Kuwait officially opened the plant on CONCLUSION

November 12, 1997. The following month, the sponsors
refinanced the project due to declining interest rates and With more than one billion Muslims living pri-
successful completion. The new terms extended repay- marily in regions with enormous infrastructure needs
ment on the international tranche from eight to ten years the Middle East, Asia, and Africa there is a growing
and cut the interest rate to 80 bp over LIBOR, but left need to understand Islamic culture, financial systems,
the Islamic facility in place though it, too, was repriced. and commercial practices. Toward that end, this case
In its first full year of operations ending June 1999, study is an attempt to explain the basic tenets of Islamic
Equate unexpectedly lost $210 million because of falling finance as they pertain to project finance and infrastruc-
crude prices and a subsequent downturn in the petro- ture development.
chemical market ethylene glycol and polyethylene The Equate project showed that co-financed struc-
prices fell 40% and 24%, respectively, in 1998.19 On the tures can work and created a template for future deals
positive side, sales volumes were close to projections. The across the Islamic world. In fact, there have been several
sponsors responded in August 1999 by injecting an addi- more co-financed deals since the Equate project closed in
tional $710 million into the company bringing total cap- 1996. The Kuala Lumpur Light Rail Transit 2 Project, a
ital up from $277 million to $987 million (KD 86 million $1.8 billion infrastructure project in Malaysia, closed in
to KD 306 million). The recapitalization reduced the October 1996. It included a four-year, fixed rate Istisna
leverage ratio to 44% based on the term loans only and facility for construction, which was converted into an
63% based on total debt (term loans plus subordinated eleven-year floating-rate Ijara facility.23 More recently,
debt). The sponsors provided the following rationale for Thuraya Space Telecommunications Company, a $1.1
the recapitalization: billion joint venture company formed to provide satellite
telecommunications services in the Middle East, closed in
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Case studies
July 1999 with a $100 million Islamic tranche as part of 4See Vogel and Hayes, p. 49.
5See
a $600 million debt package. Other smaller projects Khalili [1997].
6See Vogel and Hayes, p. 11.
such as the Shuaiba power plant in Saudi Arabia, the
7 The Saudi Arabian government believes that by
TAG and Mersin motorways in Turkey, and the Kuala
Lumpur International Airport in Malaysia have used declaring certain financial institutions as Islamic, they would
Islamic financing, but do not fall in the same league as the be implicitly branding other institutions as un-Islamic. For this
reason, it does not distinguish Islamic banks in the charter-
mega-projects like Equate and Thuraya.
ing process.
Although the number of co-financed mega-pro- 8The $1.5 billion IDB Infrastructure Fund L.P. will be
jects is increasing, the pace has been more of a trickle than managed by the Emerging Markets Partnership, an international
a flood. The question of how common co-financed deals
private equity firm headquartered in Washington, D.C.

or totally Islamic-financed deals will become is hotly (http://www.empwdc.com/).
debated among Islamic bankers. Iqbal Khan, Head of 9HIFIP can be reached at http://www.hifip.harvard.edu.
Global Islamic Finance at HSBC in London, commented: 10This information is based on the Harvard Business
School case study, The International Investor: Islamic Finance

We are clearly seeing new opportunities arising out and the Equate Project and the corresponding teaching note.
of Islamic financial institutions ability to origi- Both the case and the teaching note were prepared using pub-
nate, structure, and document the increasingly lic information only.
11Technically, the Hub River project used two istisnas.
complex transactions . . . (recent developments)
Because the closing was delayed, the Islamic Investment Cor-
give increasing relevance to Islamic finance in the
poration of the Gulf (IICG), the investment banking subsidiary
field of project finance.24
of Dar Al-Maal Al-Islami Group (DMI), provided a second
istisna to replace the first one.
Yet even proponents of Islamic structures have 12See Khalili [1997].
their doubts. A banker from Kuwait Finance House 13Aggarwal and Yousef [1999] provide additional evi-
commented: dence on the short-term nature of assets in Islamic banks.
14Sharia prohibits conventional insurance because insur-
Islamic finance capital markets are still in the devel- ance contracts are uncertain. An alternative is to use a mutual
opmental stage. There may be important domes- insurance structure, or takafol. Under takafol, participants pay
tic projects where local Islamic institutions may play a defined amount into a common pool. In the event of an
a major role but expecting this to happen on a con- insured event, the participants then donate compensation to the
sistent basis or a global or even regional level would damaged party.
15Newcomers Flock to the Market, Middle East Eco-
be difficult.25
nomic Digest, December 19, 1997, p. 7.
16Equate Kick Starts New Era in Kuwait Industry,
While it is too early to tell which view is right, an Middle East Economic Digest, December 5, 1997, p. 6.
improved understanding of Islamic finance in general and 17Infrastructure Finance, April 1997, p. 9.
Islamic project finance in particular will undoubtedly 18 Equate Signals Turning Point, Project & Trade
help the market develop. Finance, July 1996, p. 29.
19Equate Losses US $210 m, Project Finance Interna-
ENDNOTES tional, June 2, 1999, p. 5.

20Equate to Raise Capital to $987 Million, Middle East
The author thanks Mathew Mateo Millett and Fuaad Economic Digest, August 13, 1999, p. 24.
Qureshi for research assistance; Issam Al-Tawari, members of 21Prices are from Bloomberg under the ticker
The International Investor, and Iabal Khan of HSBC Group for symbol BBPC.
helpful comments; The Harvard Islamic Finance Information 22Kuwait to Build Second Olefins Plant, Deutsche
Program for data; and the Division of Research at the Harvard Press-Agentur, April 3, 1999.
Business School for financial support. 23Project Financing: Infrastructure Offers Opportu-
1See Canzi [1999].
nities to Combine Conventional and Islamic Finance, Middle
2Much of the background material on Islamic finance
East Executive Reports, July 1998, Vol. 21, #7, p. 9.
comes from Vogel and Hayes [1998]. See also An Introduc- 24Project Finance, October 1998, p. 40.
tion to Islamic Finance, Harvard Business School. 25See endnote 24.

3See Allen and Overy [1993].
592

Case studies
REFERENCES
Aggarwal, R.K., and T. Yousef. Islamic Banks and Investment

Financing. Journal of Money, Credit and Banking, 1999.
An Introduction to Islamic Finance. Harvard Business School,

Case study #200-002.
Canzi, German. You Cannot Afford to Wait. Project Finance,

July 1999, pp. 18, 20.
Esty, Benjamin C., and Mathew M. Millett. The International

Investor: Islamic Finance and the Equate Project. Harvard

Business School case #200-012, 1999.
Islamic Banking and Finance: Memorandum to Clients and

Professional Contacts of Clifford Chance. Clifford Chance,
London, October 1992.
Islamic Finance. Allen & Overy, Dubai, October 1993.
Khalili, Sara. Unlocking Islamic Finance. Infrastructure Finance,

April 1997, p. 9.
Vogel, Frank, and Samuel Hayes. Islamic Law and Finance: Reli-
gion, Risk, and Return. The Netherlands: Kluwer Law Inter-
national, 1998.
593

Case studies
Azito: Opening a New Era of

Power in Africa
JOHN S. STRONG
T
JOHN S. STRONG he commissioning of Phase I of that Cte dIvoire might become a net energy
is professor of finance the Azito Power Plant in Cte exporter in the near future.
and economics at the
School of Business
dIvoire in March 1999 marked a Since 1990, Cte dIvoire has under-
Administration at new era for power in Sub-Saharan taken a number of reforms to increase private
College of William & Africa. The project was the first major private investment and activity. Trade policies have
Mary in Williamsburg, infrastructure project in the region to receive been simplified with the elimination of many
VA, and consultant term finance from commercial banks.1 The import licenses and other nontariff barriers.
at the World Bank
project also brought a major extension of pri- Tariff rates have been reduced substantially and
Institute, Washington,
DC. vate participation in power, a new regulatory are now in the 10-35% range. Maritime activ-
structure, and innovative approaches to meet ities were fully liberalized in 1997, although
social and environmental goals. Despite its port charges remain high. Foreign direct invest-
complexity, the Azito project was completed ment has long been encouraged, with open
in a very short time,2 with financial close in access and no limits to repatriation of profits.
very difficult market conditions for emerging VAT procedures have been streamlined.
economies.3 Azito has been described as a Overall, much progress has been made,
blueprint dealone that is likely to be the despite resistance from monopoly businesses
model for future private infrastructure invest- and entrenched bureaucracies. However, the
ment in the region.4 new legal initiatives need to become estab-
lished, and the government (in many, but not
BACKGROUND ON CTE DIVOIRE all cases) has not shaken off its long history of
involvement in commercial decisions. The
Cte dIvoire, known as the Elephant strategic importance of the power sector makes
of Africa, is a country of approximately it a very important setting to evaluate the
323,000 square kilometers and a population of prospects for private-sector participation going
about 15 million. The country is a major pro- forward.
ducer of cocoa and coffee. Cte dIvoire has
considerable natural resources, including good THE MACROECONOMIC CONTEXT:
agricultural land and mineral, petroleum, and THE 1994 DEVALUATION AND
gas deposits. Exports have risen significantly ECONOMIC REFORM
since the early 1990s, in spite of an extremely
competitive world market. Development of As a member of the CFA franc zone,5
energy resources, which made the country Cte dIvoire experienced lower average infla-
self-sufficient as of 1998, holds the promise tion and faster growth during the 1970s and
38 AZITO: OPENING A NEW ERA OF POWER IN AFRICA FALL 2000
594

Case studies
early 1980s than other African countries of similar stand- 3. pursue an ambitious social agenda, especially in
ing. By the second half of the 1980s, the Ivoirian econ- education and health and in the reduction of
omy was hurt by real appreciation of the franc and by poverty.
sharp drops in the prices of key exports. Growth was
sharply curtailed, so that by the early 1990s a consensus PRIVATIZATION IN CTE DIVOIRE
was reached that devaluation was necessary.6 A 50% deval-
uation was announced in January 1994.7 The devaluation Throughout the 1970s and 1980s, state enterprises
was accompanied by other economic reforms,8 especially played a major role in the economy. Many of these enter-
a comprehensive privatization program and a new and prises did not perform well. This performance resulted in
much improved law to support it.9 an effort in the 1980s to reform the public enterprise sec-
Following the devaluation, a strong rise in exports tor by liquidating selected enterprises; by converting legal
and investment raised annual real GDP growth to the 6- status to corporate structures; by reforming management
7% range. Public finances improved considerably. Pri- practices; and by selected privatizations (especially between
vate-sector interest in investment returned, with net 1987 and 1989).14 There was extensive experimentation
foreign investment turning positive.10 The governments with mixed public/private enterprises (an important
privatization effort also gained momentum, so that pub- learning experience for the projects in the 1990s). These
lic ownership declined from about 50% of assets to about initial efforts, while somewhat disappointing, did make
18-20% by 1997. Cte dIvoire one of the pioneers in developing-country
The external debt situation remains difficult, but is enterprise reform.
being addressed. At the end of 1997, the net present
value (NPV) of Ivoirian public debt was about U.S.$13
billion. Of this, about 22% was held by multilaterals, 31% After poor performance of state
by Paris Club creditors, and 46% by London Club cred- enterprises, experiments with
itors.11 Cte dIvoire closed a commercial debt restruc-
turing agreement on March 31, 1998, in which all privatization made Cte dIvoire
outstanding commercial agreements were rescheduled at
a 75% NPV discount.12 A new Paris Club debt-relief one of the pioneers in developing-
agreement was signed on April 27, 1998, restructuring eli- country enterprise reform.
gible debt at an 80% NPV discount. The 1998 agreements
provide significant cash-flow relief to Cte dIvoire.
Even with commercial and bilateral debt relief, Nowhere was this initiative more clear than in the
however, the ratio of debt service to government revenues water sector. As early as 1971, the government had granted
is projected to remain above 27% through 2000. Because a concession to a private Ivoirian/French consortium
of this external debt burden, the International Develop- (SODECI) to provide water and sewerage in Abidjan
ment Association (IDA) and the IMF agreed to make under an affermage structure. (An affermage contract,
the country eligible for support under the HIPC Initia- based in French administrative law, involves a lease for
tive.13 Overall, IDAs contributions, and those of the other intrastructure, equipment, and operations. The lessee
creditors are expected to bring Cte dIvoires external takes some commercial risks, makes most operating deci-
debt ratios to sustainable levels by early 2001. sions, but does not control capital investment decisions or
In addition to external debt matters, the govern- financing. It is more extensive than a management con-
ments macroeconomic policy strategy for the medium tract but less comprehensive than a franchise or conces-
term aims to: sion.) By 1987, this concession had been extended to all
urban centers. As the government was facing financial dif-
1. deepen structural reforms that promote private- ficulties at the time, SODECI was given responsibility to
sector development and sustainable growth; operate and carry out investments for the sector.15
2. extend fiscal consolidation through a broadened The poor performance of many public enterprises,
tax base and reorienting public expenditure to the increasingly competitive international economic envi-
priority social sectors; ronment, and the successful experience with SODECI
convinced the government of the benefits of greater pri-
FALL 2000 THE JOURNAL OF PROJECT FINANCE 39
595

Case studies
vate participation in the economy. The government began continued to own the assets, direct new investments,
formulating a privatization program in 1990. This resulted monitor CIE activity, and manage the financial flows of
in Decree No. 90-161016 creating a special committee the sector. The government retained ultimate ownership
(Comit de Privatisation et de Restructuration du Secteur Para- of the gas fields. The power sector committed to a take-
public) to oversee the process, with a technical arm (Cel- or-pay contract with private gas producers; the govern-
lule Technique) in charge of implementation. The program ment guaranteed this contract. The government also
attempted to focus on the biggest enterprises, namely continued to set all tariffs. A waterfall agreement was
those in infrastructure and agro-industry, divestiture of established in which the revenues collected (net of VAT
which would have the biggest impact on the economy. and other taxes) were retained in the sector and allocated
to the interested parties as follows:
THE 1990 POWER CRISIS AND

THE CREATION OF CIE The first claim was CIEs remuneration, which
amounted to about 35% of total receipts;19
Before the enactment of the decree, however, the Following the CIE payment, residual revenues
government was faced with a deteriorating situation in the were to be allocated by the state in the following
electricity sector. Since 1952, nergie lectrique de Cte sequence:
dIvoire (EECI) had carried out generation, transmis- 1. Payment of fuel and energy costs on a pari
sion, and distribution of electricity. In the 1980s, EECI passu basis (about 40% of total receipts)
ran into extreme financial difficulties as a result of the 2. Other sector operating expenses
countrys deteriorating macroeconomic performance, 3. Debt service requirements
over-expansion, severe droughts, and financial misman- 4. Required investments by EECI (or to CIE for
agement. By 1990, annual losses were running at CFAF investments made on behalf of EECI, about 5%
1 billion per month; accumulated losses were CFAF 110 of revenues)
billion; and its accumulated debt totaled CFAF 90 billion 5. Rural electrification.
almost the same level as its operating revenues. This
financial crisis occurred despite EECI having some of the In return for an exclusive franchise over final con-
highest electricity tariffs in the world. Bad debts on the sumers of electricity in Cte dIvoire, CIEs affermage con-
public sector side made the condition worse: by 1990, tract with the government requires the company to operate
public sector entities owed EECI the equivalent of three and maintain generation, transmission, and distribution
years worth of electricity consumption. facilities in place in October 1990. CIE also must connect
Faced with what they perceived as a national emer- new customers to the distribution network. CIE also was
gency, the highest levels of government dealt with this sit- to undertake renewal expenditures and major overhauls
uation rapidly. President Houphouet-Boigny and his that were required in order to maintain operational per-
advisers held intense consultations with international formance of the system. CIE also undertook specific activ-
power firms and with French multinationals already oper- ities on behalf of the government, as defined in periodic
ating in Cote dIvoire. Based on these discussions, the gov- avenants (modifications) to the original lease contract.
ernment sought assistance from a French construction and These avenants quickly became a key aspect of the
engineering company, Bouygues.17 Negotiations took power sector in Cte dIvoire. EECI continued to have
place between May and October 1990. On October 20, difficulties fulfilling its investment responsibilities, so mod-
1990, a 15-year concession agreement was signed, estab- ifications were required. The first such avenant was signed
lishing a new privately held company, Compagnie Ivoirienne in 1993. It clarified investment responsibilities between the
dlectricit (CIE) to generate, transport, distribute, import, two operators, CIE and EECI, especially for mainte-
and export electricity. To add sector experience, lectricit nance and renewal works.20 Maintenance works were
de France (EdF) was brought in.18 Direction et Contrle divided into two categories:
des Grands Travaux (DCGTX), an established and pow-
erful agency with direct access to the president, oversaw Type A: Urgent maintenance works with a direct
the sector and managed the process of breaking up of impact on service quality. These were
EECI and creating CIE. given to CIE.
EECI still had an extremely powerful role, as it Type B: Less urgent and smaller-sized works,
596

Case studies
which were assigned to EECI. However, EECI The improved financial performance enabled the
was left with the task of undertaking extensions sector to generate enough residual revenues so that the
to the network, especially rural electrification. government was able to make a debt repayment for the
first time in 10 years.22 However, public-sector customers
As a result of this arrangement, CIE became respon- continued to be slow payers. By law, CIE was not per-
sible for about 75% of ongoing investment. mitted to cut power supply for nonpayment by govern-
Despite the political risks that the government took ment bodies. To deal with this problem, CIE withheld
in creating CIE, a turnaround was accomplished very payment of the residual revenue for unpaid state bills; it
quickly. CIE was successful in improving billing, collec- also withheld municipal taxes in compensation for delays
tions, and the overall financial management of the former in payment for public lighting. As a result, public-sector
national electricity company. Within the first two years of recovery improved considerably.23 However, the fact that
operation, CIE recorded a net profit, compared to annual these public-sector payments could bypass the waterfall
losses every year of the past decade by EECI.21 Financial arrangement meant that a restructuring of the concession
performance of CIE is summarized in Exhibit 1. agreement would be required if additional private par-
Turnover, profits, and margins have increased steadily, ticipation was to occur.
while leverage has remained relatively stable. The num-
ber of customers increased by 50%, to more than 650,000
EXTENDING PRIVATE PARTICIPATION:
in 1998. Commercial losses are estimated at about 3.3%
CIPREL AND INDEPENDENT POWER
of low-voltage bills and 0.7% of medium-voltage bills. The
PRODUCTION
recovery rate of private clients was in excess of 99%.
Encouraged by the success of the CIE concession,
the government sought further private participation in
EXHIBIT 1
the power sector. A major project had been proposed in
CIE Financial Performance, 1993-1997 (billions of CFAF)
the early 1990s to develop a gas field and
1993/94 1994/95 1995/96 1996/97 1997/98 construct electric-generation facilities.
(15 mos.)a However, cabinet changes, the death of
President Houphouet-Boigny in 1993, and
Profit and Loss:
the devaluation in January 1994 caused the
Revenues 102.7 137.4 143.2 197.0 168.0
Of which: project to be delayed and then split into
Energy Sales 98.6 125.7 129.8 172.0 146.0 two components.
The power-generation element was
Profit 0.8 1.5 2.5 4.1 4.4 granted in 1994 as a build-own-operate-
transfer (BOOT) concession contract
Profit Margin (%) 0.7 1.1 1.8 2.1 2.6 between the government and a French-
owned consortium, CIPREL (Compagnie
Balance Sheetb
Total Current Assets 98.7 112.5 95.8 112.0 127.0 Ivoirienne du Production dlectricit). This was
Total Fixed Assets 15.3 17.4 21.1 24.0 28.8 the first independent power project (IPP) in
Sub-Saharan Africa. The government granted
Short-term Liabilities 88.1 98.5 86.2 102.2 112.2 the CIPREL contract on a sole-source basis
Long-Term Liabilities 9.7 10.2 10.9 7.9 24.9 because it found private interest to be quite
Equity 17.6 21.2 19.8 22.6 19.4 low and preferred not to open an interna-
tional tender process. It dealt instead with
Ratios
Rate of Return
operators who had been involved in the sec-
on Capital (%) 2.9 4.8 8.1 13.4 9.9 tor since 1990.
CIPREL is a private company, in which
Source: CIE Annual Accounts, as reported by World Bank/NERA, Cote dIvoire: Power,
p. 19, supplemented and updated by Patrick Achi, Ministry of Energy, Cote dIvoire. 75% of the equity is held by VALENER, a
a Fifteen months due to change in accounting system. holding company incorporated in Cte
b Accounts reported here only show major items, so statement does not pre- dIvoire. The remaining 25% of the equity is
cisely balance. held by the Agence Franaise de Developpement
597

Case studies
(AFD), the International Finance Corporation (IFC), of the facility is contracted out to CIE.25 The state
PROPARCO, and the West African Development Bank (through FNEE) is committed to buy electricity of 1,419
(BOAD). VALENER in turn is 65% owned by SAUR (a GWh per year.26 CIPREL is obligated to supply at least
Bouygues subsidiary) and 35% by lectricit de France that amount, with penalties payable to the state for any
(EdF). shortfalls.27 Tariffs during the first phase were set at CFAF
The CIPREL project is located in Vridi (a suburb 15 kWh.28 Once the second phase was in operation, the
of Abidjan). CIPREL was built in two phases. The first price was reduced to CFAF 11.61/kWh, for quantities up
phase (100 MW) of the project was commissioned in to 1,410 GWh; above this amount, the tariff was set at
March 1995. This investment was financed with 25% CFAF 8/kWh.
equity and 75% debt. Debt was provided by the IFC, AFD, The CIPREL concession contains an indexation
and BOAD. Phase II (110 MW) was commissioned in formula by which the CFAF/kWh price adjusts for infla-
June 1997, and was financed entirely by the State of Cte tion and for changes in the VAT rate, customs duties, and
dIvoire, out of an IDA loan. According to CIPREL, excise taxes. While there is no explicit allowance for
external financing accelerated the building of the first plant changes in the exchange rate, the consortium believes the
to meet demand, while public financing reduced the government would agree to renegotiate the contract in the
interest rate for the second phase, which did not face the event of a devaluation. CIPRELs financial performance
same demand-induced pressures to bring it on-line.24 No between 1994 and 1997 is summarized in Exhibit 2. The
commercial banks were involved in the financing of either lower profit margins reflect the decline in the tariff paid
phase of the project. by the government once the second phase was
CIPREL sells its energy to the state under a 19-year commissioned.
take-or-pay power purchase agreement (PPA). Operation
THE REGULATORY AND
INSTITUTIONAL FRAMEWORK
EXHIBIT 2
CIPREL Financial Performance, 1994-1997 (billions of CFAF) A. The 1985-1996 Period
1994/95 1995/96 1996/97 The 1985 Electricity Law established

Output (GWh) 418 722 1235 the legal and regulatory framework for the
power sector. It established a state monopoly
Profit and Loss: over transmission and distribution but not
Revenues 4,893 13,179 19,513 over generation. Prior to the formation of
Of which: CIE in 1990, government oversight of EECI
Energy Sales 4,891 11,566 18,342 was to be undertaken by a unit of the Ministry
Profit 3,118 5,691 8,061 of Economic Infrastructure. Also, a Commis-
Profit Margin (%) 63.7 43.2 41.3 saire du Gouvernment was given economic,
technical, and financial control over the CIE
Balance Sheet
contract, but this post was not appointed until
Total Current Assets 7,021 8,665 10,030
1997. Finally, Le Bureau National dtudes
Total Fixed Assets 33,100 37,032 50,608
Techniques et de Developpement (BNETD) was
Short-term Liabilities 3,279 3,335 974 given responsibility for the control and exe-
Medium- and Long-Term Liabilities 24,991 29,946 45,959 cution of BOOT projects in the sector.29
Equity 11,851 12,146 13,705 With the introduction of the CIE con-
cession in 1990, this institutional framework
Ratios soon ran into difficulties. EECI failed to com-
Rate of Return on Capital 8 13 14 ply with its objectives for financial and man-
agerial reasons. While most of EECIs staff
Gearing (%) 68 71 77 had been transferred to CIE, a number of
Source: CIPREL Annual Accounts, as reported by World Bank/NERA, Cte senior EECI managers and directors were
dIvoire: Power, p. 20. not. This created much tension and conflict
598

Case studies
of interest. Finally, EECI was widely blamedjustifiably In place of these overlapping organizations, sector
or notfor problems in the sector, so that any confidence oversight is now implemented by three new socits dtat:
in its capability was irredeemably lost. As a result, EECIs
responsibilities were gradually shifted to other organiza- 1. Creation of a state holding company, Socit de
tions created to address these shortcomings. Gestion du Patrimoine du Secteur de llectricit
In 1994, following the signing of the CIPREL con- (SOGEPE), which will be in charge of manag-
tract, the government established by decree a new system ing state assets and overseeing financial flows;
to manage power-sector funds, known as Le Fonds National 2. An independent operator, Socit dOperation
de lnergie (FNEE, the National Energy Fund). FNEE Ivoirienne dlectricit (SOPIE), which initially has
was created to undertake investment planning and to the responsibility to monitor all new public works
improve financial controls that had deteriorated under in the sector (e.g., transmission lines and rural
EECIs stewardship. FNEE became responsible for electrification). SOPIE has taken over many of
approval of all expenses related to asset rehabilitation, the roles formerly played by BNETD, and is the
investments, rural electrification, and debt service. In largest of the new agencies in terms of staff.
practice, though, it has served as a clearinghouse rather Once the CIE concession ends in 2005, the gov-
than a financial-policy organization. ernment hopes that SOPIE will be in charge of
In 1995, the Groupe Projet nergie Cte dIvoire- buying, selling, and transporting electricity on the
Banque Mondiale (GPE) was established in response to a call network. However, many complex transition
from international lenders to deal with a single govern- issues remain unsettled.
ment organization for a loan from the IDA.30 GPE quickly 3. An autonomous regulatory body, Autorit
took the lead in the design, implementation, and moni- Nationale de Regulation de llectricit (ANARE),
toring of the CIPREL contract. Subsequently, GPEs in charge of existing concessions, dispute resolu-
activity extended beyond CIPREL, as it came to oversee tion, and protecting consumers interests.
investment and financing of power stations and transmis-
sion lines. This institutional and regulatory structure is similar
In March 1995, a special coordinating committee to many developed countries with its emphasis on sectoral
(GSPER) was created to manage rural electrification unbundling, private participation, and an independent reg-
Additional responsibilities for managing large investment ulatory authority.
projects were transferred from EECI to BNETD. Finally,
the Commissaire du Gouvernement was appointed in July THE IVOIRIAN POWER SECTOR IN 1998
1997 and played a major role in the designand subse-
quent revisionof the institutional framework. All in A. Demand
all, the result was a myriad of ad hoc structures put in place
as a response to specific problems or opportunities, yet Since the 1994 devaluation, demand for electricity
with no clear overall sectoral or regulatory framework. in the Cte dIvoire has been growing at an annual rate
of 12%, about twice the rate of real GDP growth.31 Before
B. Regulatory Reforms in 1996-1998 the Azito project, additional capacity was needed to meet
forecast demand. In addition, the government was keenly
By 1996, international lenders and the government aware that it urgently needed to augment its thermal
realized that sectoral oversight was not working. The generating capacity to attenuate the effect of repeated
World Bank commissioned a study to recommend droughts on its hydro capacity.
reforms. In late 1998, the government decided to pro-
ceed with many of the recommendations. The goals B. Supply
were to improve regulatory oversight and strengthen
financial and technical management of the states assets. The supply of power has improved in recent years.
Specifically, the government agreed to dismantle EECI, As of November 1998, the operating capacity includes 470
GPE (responsible for the concession program), FNEE MW of thermal plant and 620 MW of hydro plant. The
(responsible for management of financial flows), and transmission system comprises about 1,700 km of 225kV
GSPER (rural electrification). lines and approximately 2,400 km of 90kV lines. The gov-
599

Case studies
ernment is an active supporter of further interconnection 700 in 1995 to 200 in 1998. The number of outages on
and (eventually) a West African Power Pool. The coun- the medium-voltage network has fallen by half between
trys power system has been interconnected with Ghana 1992 and 1997, while the number of outages lasting more
since 1984 (and, through it, to Togo and Benin). A link than two hours fell from 4,200 in 1992 to just over 2,000
to Burkina Faso was under construction in 1999. Until in 1997.
1993-1994, Cte dIvoire was a net importer of electric-
ity from Ghana. Since that time, the country has been a F. Productivity
net exporter, with sales to Ghana, Togo, and Benin reach-
ing a peak of 950 GWh in 1997 (representing 27% of total The total number of CIE employees is about the
sales).32 Exports are not set through long-term contracts; same as it was in 1990, reflecting substantial improvements
rather, they are largely dependent on levels of rainfall in in productivity despite growing system capacity and
neighboring countries.33 This exported electricity is priced demand. For example, the ratio of MWh sold per
in U.S. dollars. Prices have ranged between U.S. 5.1-5.8 employee rose from 570 in 1990 to just over 1,000 in
cents per kWh.34 1998. This ratio compares favorably with neighboring
countries and is well above the World Bank median of 600
C. Access MWh per employee.
The system supplies over half a million customers, G. Tariff Policy

with about two-thirds in urban areas. Access in Cte
dIvoire compares favorably with its neighbors. Even so, The government is formally committed to adjust tar-
only 25% of the population had access to electricity by iffs to maintain financial equilibrium in the sector.37 Elec-
1999. Many rural communities are still not linked to the tricity tariffs are determined by the Council of Ministers.
national grid. A levy on the electricity tariff (CFAF In theory, tariff adjustments are to be made annually, but
1/kWh) is dedicated to rural electrification. Since 1995, in practice they have been made on an ad hoc basis,
about 100 villages per year have been electrified. Finan- depending on events.
cial limitations have precluded a more extensive program.35 Tariffs have fallen significantly in real terms since
1990 and by about 30% since 1993. Following the 1990
D. Transmission and Distribution concession contract with CIE, average consumer tariffs
were reduced by 10%. In the wake of the 1994 devalua-
The transmission and distribution network in 1998 tion, average customer tariffs rose from CFAF 47/kWh
consisted of approximately 12,275 km of low-voltage to CFAF 57/kWh. However, these rates were reduced by
lines, 9,022 km of medium-voltage lines, and 4,233 km 10% in 1996, following a political decision to offset a
of high-voltage lines. CIEs efforts in improving trans- simultaneous increase in water rates.
mission performance have been less successful than many In 1998, the weighted average tariff was about CFAF
of its other initiatives. The transmission network had not 52.5/kWh (about US 8.75 cents per kWh), including
grown significantly in recent years, except for marginal taxes. A recent amendment to the schedule affecting the
increases in the low-voltage network. Technical losses poorest customers has raised the weighted average rate as
on the system have been reduced only slightly, from of early 1999 to about CFAF 55.5/kWh. These rates are
16.5% in 1992 to 14% in 1998.36 There remains consid- about mid-range for the region. A number of issues
erable scope for reinforcing and extending the distribu- regarding specific pricing and preference issues were
tion network, and for reducing transmission losses either beginning to be discussed in 1998-1999.
from theft or from electro-mechanical losses.
THE AZITO PROJECT
E. Quality and Reliability
Given the perceived successes of the CIE and
Quality and reliability has improved dramatically. CIPREL concessions, Cte dIvoire sought to further
Average outage time per year has fallen from just under develop private participation in power by seeking a new
50 hours in 1990 to about 12 hours in 1998. The num- type of concession. It was hoped that Azito would increase
ber of outages on the high-voltage network has fallen from the number of producers of electricity. Unlike CIE and
600

Case studies
CIPREL, though, this new concession was to be compet- 1), for 24 years, including fuel price. Lot 2 was to be
itively bid and was to involve private commercial financing. awarded to the lowest bidder for Lot 1.
Azito was designed to have a number of economic, The Azito project was introduced to private investors
social, and environmental benefits. By reducing public at an international investment forum in 1995. The pro-
investment expenditure in power, more funds would be cess was led by BNETD. The governments timetable
available for the governments ambitious initiatives in was very ambitious, since it was thought that any delay
education, poverty reduction, and social services. Azito from the proposed January 1999 start date would lead to
also would expand power supplies and thus extend access significant power shortages in the country. The preselec-
to rural areas, and produce global environmental benefits tion/qualification process was initiated in May 1996; six
(since natural gas is a clean-burning fuel). consortia were preselected. Particularly noteworthy in
the prequalification process was the governments decision

A. Main Features of the Project not to include the owners of the CIPREL consortium in
the group of six.
The Azito project was designed as a competitively The international competitive bidding process was
tendered concession from the government. The govern- launched on November 16, 1996. Of the six preselected
ment would provide gas fuel supplies and buy Azito consortia, four submitted bids: AES, Enron, Tractebel, and
power through a contract based on capacity plus energy ABB. The ABB consortium, known as CINERGY, sub-
payments.38 Strictly speaking, the contract is not a typi- mitted the lowest bid. After additional negotiations, the
cal take-or-pay structure, in that the government saves eventual CINERGY bid that emerged was CFAF
the energy payment if it chooses to take no power.39 The 11.94/kWh for the first 10 years, decreasing to CFAF
project also includes a transmission line under a turnkey 6/kWh by the 16th year, excluding the cost of gas. While
construction contract.40 Construction would take place a precise comparison is difficult, the Azito and CIPREL
under a fixed-price, date-certain engineer/procure/con- tariffs are in the same range.43 Azitos price of energy is
struct (EPC) contract, along with subsequent operations quite low compared to recent international prices for
and maintenance by the project sponsors. IPPs, especially in Africa.
The procurement for the Azito project was carried Following the awarding of the project, a series of
out in two lots. Lot 1 covered the power plant; Lot 2 cov- delays ensued over specific terms in the concession agree-
ered the associated transmission system. Lot 1, covering ment. Matters were further complicated by the request of
the power plant, consists of three phases. Phase I is an CIPREL to build a third project. Conflicts also arose
open-cycle, gas-turbine unit of 150 MW slated for com- within the government between EECI and FNEE, on the
missioning in January 1999. Phase II is an open-cycle, gas- one hand, and BNETD on the other, over financing and
turbine unit of 150 MW scheduled for commissioning by control. While any project financing requires sorting
January 2000. Phase III consists of the conversion of the through conflicts and negotiations, the Azito project was
first two phases into a combined cycle and adding 150 characterized by a great deal of drama, tension, and pres-
MW capacity through a heat-recovery boiler. However, sure on all parties.
after more detailed demand analysis was undertaken, Finally, a concession contract was signed on Septem-
Phase III was not included in the project financing. 41 ber 5, 1998. Following the award, a number of critical
Lot 2 covers the transport of Azito energy to the and somewhat controversialchanges were made. The
existing transmission network. The government is under- most important of these was that lectricit de France
taking reinforcement of the transmission system to (EdF) joined the CINERGY consortium at a later stage
improve system security and to enable transmission of the of the negotiation process. CINERGY is a special pur-
power that is scheduled to be produced in Phase II.42 pose company registered in Cte dIvoire for implemen-
tation of Azito.44 Three sponsors thus own it:
B. Bidding for the Concession
ABB Energy Ventures (ABB-EV), a subsidiary of
The two lots were bid together, with the condition Asea Brown Boveri (37.74%)
that Lot 2 was to be financed by the government. The cri- lectricit de France (EdF), the French national
terion for the concession was the levelized lifetime cost utility (36.26%)
per kWh to be delivered by the Azito power plant (Lot Industrial Promotion Services (Cte dIvoire), a
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Case studies
unit of the Aga Khan Fund for Economic EXHIBIT 3

Development (26%) Azito Project Structure (amounts in U.S.$ millions)
This change was expected to improve coordination USES:

between CIE and Azito, since EdF is a participant in EPC 110.86
both. It also brought ABB a partner with substantial Owners EPC Contingency 7.50
experience in Cte dIvoire. EdF thus has an interest in Land for Power Stations 0.03
the generators (CIPREL and CINERGY) as well as Initial Spares 2.11
transmission, distribution, and export through CIE. Insurance 2.10
These affiliations created some concern on the part of Transmission Line 31.85
Resettlement Indemnification 1.00

multilateral organizations and for some government offi-
Reimbursable Development Costs 18.20

cials, although the late participation limited the poten-
O&M Mobilization 2.58
tial conflicts as far as the concession award was concerned. Initial Working Capital 2.19
The transmission line also introduced additional Buffer Stock 7.50
issues and delays. One of the key difficulties noted by Interest and Fees during Construction 22.24
IFC and others after the bid award was that the trans- Debt Reserve 14.75
mission line crossed heavily populated areas. This led the
Total Uses 222.94
government to rethink the routing of the line to mini-
mize relocations. Also, the concession bid had specified SOURCES:
that the government would finance the transmission
Sponsors Equity 43.89
line. But the government was unable to identify a source
of financing. After some intense discussions, the gov- Senior Debt 140.50
ernment turned to the financiers to include the trans- IFC A Loan 32.31
mission line as part of the project scope. IFC B Loan 30.20
CDC & Others 47.77
This change in project scope led to additional
Commercial Lenders (IDA Guarantee Facility) 30.20
delays in arranging the financing.45 Faced with another
extended delay and concerned about power shortages Subordinated Debt 20.07
anticipated in early 1999, the government then asked Fixed 10.03
ABB to implement the project on an accelerated basis. Convertible 10.03
After some tough negotiations, ABB initiated con- Cash from Operations 18.47
struction on the basis of bridge financing secured on its
Total Sources 222.94
own balance sheet, as well as assurance that the World
Bank would participate through the IDA Partial Risk
Guarantee.46
will onlend the financing for the transmission component
to the government. This loan is to be repaid on an annu-
C. Project Financial Plan
ity basis over 12 years. Total senior debt for the project has
Exhibit 3 summarizes the Azito Project and the been limited to a level that would provide a minimal
financing structure. The total project cost was estimated debt-service coverage ratio of 1.4 and an average cover-
at approximately U.S.$223 million for the power plants age ratio of 1.55 during the life of the project.
and transmission combined. The financing structure was
approximately 70% senior debt, 10% subordinated debt, MAJOR ISSUES FACED IN THE AZITO PROJECT
and 20% sponsor equity. The shareholders also were
required to make available up to U.S.$17 million as con- A. The Legal Framework for Concessions
tingency finance. The financing plan also includes U.S.$18
million of internally generated funds from the operation Cte dIvoires law relating to private infrastructure
of Phase I of the project. was based on French administrative law at the time of
The financing plan was structured for both the independence rather than contract law. The lack a formal
power and the transmission components. CINERGY BOT legal structure created problems the financing. For
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Case studies
example, there were issues concerning the applicability of be based on a three-year projection and will take into
international arbitration and about using assets as collat- account the financial impact of the proposed new entrant.
eral for debt. Given this legacy, arranging private financ- Should this ratio not be met, payments to the new entrant
ing was extremely difficult. will be subordinated to existing power and gas entities.
This financial-performance requirement creates strong
B. Tariff Framework incentives for the government to maintain cost-recover-
ing electricity prices to users, and to tie future investments
Resolution of legal issues related to concessions to demand growth. Thus, the negotiations established
took place in the context of structuring revenues. The new structural conditions that will make future conces-
original concession agreement with CIE was unclear as sions easier to implement.
to how cash flows available to pay CINERGY and other

private-sector participants would be prioritized. As a C. Tariff Modifications

result, the involved parties worked very hard to in effect
re-craft certain aspects of the original CIE concession from The tariff structure was modified to improve the
1990. These revisions took effect as Avenant 4. financial viability of the sector. In particular, eligibility
Avenant 4 dealt with at least two major issues. First, conditions for the subsidized low-voltage tarif modere
how would sectoral cash flows be allocated to the differ- domestique were changed, to target the tariff more closely
ent private-sector participants? (For example, where does to low-income consumers.49 The increased yield from this
the company supplying gas to Azito stand relative to tariff modification was estimated at about CFAF 5.8 bil-
Azito?) A waterfall hierarchy needed to take into lion, equivalent to about 5% of total billed energy.
account the new Azito project, but also had to be flexi- This reduction in eligibility for cheap power was a
ble enough to incorporate other projects in the future as difficult political decision for the government. However,
necessary. The mechanism that was settled upon was an it served as an early test of the governments political will
innovative priority ranking that treated IPPs and gas sup- and the commitment to implement pricing decisions that
pliers on an equivalent basis, rather than the latest project were necessary to maintain sectoral financial covenants.
being last in line47 for payment. It also gave clear pri- These actions served to enhance the credibility of the gov-
ority to private-sector participants in the sectoran ernment in upholding its commitments.
important potential precedent for future private project
finance in Cte dIvoire. As funds from the sector will not D. Regulatory Institutions and Oversight
be transferred to the government until the above payments
are made, the project is insulated from the payment risk The multitude of overlapping agencies and powers
of the government. This provided a great deal of security that emerged since 1990 created a great deal of regulatory
to the private sector that had previously been unavailable uncertainty. The negotiations over Azito continually
or uncertain. raised these concerns. Already aware of the need for
The second major issue involves dilution of Azito restructuring and recognizing the regulatory problems, the
project cash flows as a result of subsequent project government began to construct the new three-part reg-
approvals. If IPPs were to participate on an equal stand- ulatory structure discussed above. Thus, while the regu-
ing, what was there to prevent the government from latory reforms came only at the end of the Azito
inviting in additional projects that could dilute the prior negotiations, the willingness to restructure the sector
participants claims and possibly reduce returns to unac- helped make Azito happen. In turn, the new regulatory
ceptable levels? In its agreement concluded with lenders, system was justified in part by the structure of Azito.
the government pledges not to allow any new entrants to
the energy sector (either power producers or fuel suppli- E. Lender and Sponsor Relationships
ers) unless certain sectoral financial conditions are met.48
These conditions require the government to demonstrate The government and the IFC had gained experi-
that a sectoral ratio of 1.3 (total sector revenues less CIE ence and a certain comfort level with respect to private
fees divided by payments to fuel suppliers and IPPs) will participation in power in Cte dIvoire, as they both
be maintained. This is the equivalent of a minimum cov- had been involved in the CIPREL concession. But Azito
erage ratio for the power sector. The financial ratio will was different in its aim to bring private commercial
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Case studies
finance into the sector. To do so, ABB brought in Socit ernment under a long-term, comprehensive power pur-
Gnrale (SG) to arrange financing. SG also served as chase agreement.54
bridge lender to ABB during Azito construction. Early
on, in its discussions with IFC with respect to loan par- G. Resettlement Issues
ticipation, SG sought and received status as Joint Arranger
of the project financing. This Joint Arranger mandate The Azito transmission component (as initially pro-
allowed SG and IFC to pool resources and to bring composed) created a major delay-and-completion risk prob-
plementary skills to the project. The active involvement lem, as its proposed path would have required the
of SG in the upstream phase provided critical input to the resettlement of approximately 15,000 persons. Moreover,
government and the World Bank on what would be the World Bank and the IFC could not accept such a large
required to make the project bankable: phasing of the pro- social impact. To prevent delays, resettlement issues related
ject; limited tariff increase; covenants on maintaining to the transmission line were legally separated in the pro-
tariffs; cash-flow capture structures; and control of invest- ject agreementsa technique in project finance known
ment structures. At the syndication stage, SG played a key as ring-fencing.
role in selling the deal in financial markets. It also kept BNETD, as the lead government agency in the
the relationship between financial institutions together task, did a remarkable job in managing the resettlement
during disagreements. issue. BNETD engineers worked closely with IFC tech-
nical staff and with ABB to reroute the transmission line.
F. Commercial Risks/Guarantee Issues The result was a dramatic reduction in resettlement
requirements, affecting only 700 familiesmany of those
Construction and operating risks are mitigated by a only temporarily.55 Organizational arrangements for the
fixed-price, date-certain EPC contract and by an all-in resettlement plan include a Steering Committee from
operating and maintenance contract. The sector waterfall BNETD and the Ministry of Environment; a Project
arrangements enabled lenders to become comfortable Management Unit; and CARITAS, the Catholic non-
with commercial risks to some extent. governmental organization that handles the consultation
The inclusion of the transmission line introduced process and conflict resolution. In addition, a group of reli-
additional political risk from the lenders viewpoint, as gious leaders has been appointed to settle disputes and
they were concerned that the government might not ful- grievances.
fill its commitments to the project.50 As a result, the IDA
Partial Risk Guarantee (PRG) was introduced.51 The H. Gas Supply Risks
addition of the IDA guarantee was critical for Azito.
Because the project was occurring in the aftermath of the The adequacy of fuel supplies was investigated by the
Asian crisis in emerging markets, Azito would probably gas producers, Apache and UMIC (United Meridian
not have been able to mobilize commercial finance International Corporation, a U.S. energy producer that
without the PRG.52 Although the PRG covers only since then has changed its name to Ocean Energy), and
15% of total project cost, it played a key catalytic role in by outside experts. All parties felt that available gas was suf-
the financing. This is due to the syndicate structure in ficient to meet the demand of the Azito Phase I and
which lenders participate on a pro rata basis with units of Phase II plants. Beyond Azito, however, the amount of
the IDA Guaranteed Loan linked with units of the IFC domestic gas supplies will need to be evaluated if new gas-
B Loan. It also allowed the project maturity to be fired plants are considered.
stretched to 12 years.53
Under the Indemnity Agreement, IDA reserves its I. Risks to the Government of Cte dIvoire
right to demand immediate payment from the govern-
ment for any amounts paid to lenders should the Guar- The sponsors and lenders of Azito bear most of the
antee be triggered. About 50% of the funding from risk of construction and operation of the plants. They in
commercial banks is covered by the PRG. Consequently, turn pass on some of these risks to their subcontractors,
there is a clear financial disincentive for the government lenders, insurers, suppliers, etc. The government retains
to cause a call on the Guarantee. This introduction of an important commercial role and also bears important
guarantees shifts commercial (demand) risk to the gov- risks in Azito. In particular, it bears the risks associated
604

Case studies
with the price and availability of fuel and with the value extended (financing, transmission, competitive
of the power supplied by the Azito plants. tendering). While the regulatory institutions
The government sets the retail tariff for electricity. had faced many problems, credible reforms were
It has made a commitment that tariffs are to be set at a level being discussed. There was a clear commitment
to ensure the financial viability of the sector. Thus, some toward a transparent, unbundled, and more com-
risks may be passed on to final consumers through prices. petitive power industry.
However, because these changes are not automatic, and 3. Legal framework and regulatory reform.
because there are political and economic limits on the The basic structure of administrative law in Cte
extent to which tariff revenue can be increased, the gov- dIvoire meant that specific concession-contract
ernment does bear commercial risk. laws did not exist, and thus needed to be devel-
oped in parallel with the project itself. Both

CRITICAL SUCCESS FACTORS IN THE AZITO the government and the project participants
PROJECTWHAT MADE IT POSSIBLE? decided early on that the project could serve as
the basis for the design of a new legal framework
The Azito project has become a model for future and regulatory system. The innovations were
infrastructure projects in the region. Project participants developed jointly and were ratified by appro-
attribute the success of Azito to the economic setting, the priate political and administrative authorities in
participants, and the project structure itself. a timely fashion.
A. Economic and Sectoral Performance B. Commitment of All Parties to the Project
1. Macroeconomic performance. 1. The government came into the Azito project

Cte dIvoires economic policies and growth knowing what it wanted both in the specifics of
since the 1994 devaluation gave confidence in the private participation and how these aims fit with
prospects for private investment in the power larger social goals such as rural electrification.
sector. Government initiatives in debt restruc- The experience in sector reform helped the gov-
turing also improved the outlook for public finan- ernment commit to a strategy for Azito.
cial performance. 2. The government put together a strong team with
2. Demonstrated need and prior experience with pri- good technical, financial, and managerial skills,
vate participation in the power sector. who also were proficient in negotiation. The
There was clearly demonstrated demand for a team, drawn from a variety of public sector orga-
power project the size and scope of Azito (Phase nizations, put aside parochial views and adopted
I and II). Sector reform had done well in the eight a clear decision orientation to get things done.
years since the start of the CIE concession. The The ministers involved in the project were avail-
poor operational and financial performance of able to make commitments and to take political
EECI was replaced by sustained improvements in risks to make Azito happen.
reliability and efficiency. Economic viability had 3. The IDA Partial Risk Guarantee (PRG) was crit-
been reestablished through sound end-user tariffs ical in mitigating noncommercial risks and thus
and balanced sector cash flows among partici- enabling the financing package. Despite the pos-
pants. The government, Socit Gnrale, and itive macroeconomic trends of Cte dIvoire
the IFC were able to demonstrate to financial since the 1994 devaluation, the credibility of the
markets that the Ivoirian power sector was finan- country had not yet been established in interna-
cially balanced and well-managed. tional commercial financial markets. At the same
The nature and extent of private partic- time, the emerging markets crisis made it almost
ipation had been advanced by the CIPREL con- impossible to mobilize medium or long-term
cession. Overall, prior concessions are working. commercial debt. The IDA Partial Risk Guar-
This experience made all parties comfortable antee helped to catalyze private finance to
with the basic structure of Azito and the new reforming sectors in a frontier country through
ways in which private participation was being limited mitigation of political risks. The PRG
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Case studies
covered public sector undertakings in the project customer of the project required detailed project
that are within the governments control. The design and a variety of associated sectoral reforms.
PRG was indicative of a new role for the World 3. Potential conflicts of interest for ABB and EdF
Bank Groupthat of helping establish a track were addressed through a structure of penalties,
record for the country in international com- damages and bonuses related to performance.
mercial debt markets. Sponsor support extended beyond standard prac-
4. The Joint-Arranger Mandate between IFC and tice, including bridge loans and the beginning of
Socit Gnrale was instrumental in designing a construction before financial close.
financing structure that facilitated commercial
funding. The joint mandate allowed problems to
QUESTIONS FOR THE FUTURE

be addressed early, while retaining the lenders
commitment to the project when it might have A number of unresolved issues remain that will
been easier for them to walk away. IFC and World shape future private participation in the power sector and
Bank staff worked to accommodate the concerns other infrastructure activities in Cte dIvoire. These
of commercial lenders, while Socit Gnrale issues include:
came to recognize that the multilateral institu-
tions face constraints and objectives related to 1. The scope and timing of Phase III of the Azito
their development mission. This commitment project. While this investment is not currently
resulted in a fruitful and, for the most part, friendly needed to meet domestic demand, it is seen by
working relationship. The PRG, though, might some officials as an opportunity to increase elec-
have worked even better had IDA been brought tricity exports to the region. The question of
into the project earlier.56 Such partnerships do Phase III as an export project or as one to sustain
not come easily in the World Bank Group (WBG) economic development within Cte dIvoire is an
culture, and faced some internal resistance. How- important one. For commercial lenders to par-
ever, in the case of Azito the WBG enhanced its ticipate in an export project, though, they would
impact through more equal partnerships with likely request a long-term, take-or-pay contract
financial institutions. Overall, multilateral agencies, with a creditworthy entity.
often known for being bureaucratic and indepen- 2. Covenants with respect to the price of electric-
dent, worked well together, bringing a variety of ity may be difficult to enforce. Recent history
instruments such as technical assistance, guarantees, (1996) showed a willingness to cut electricity
and financing that were essential to the project. tariffs to offset a water price increase. There
5. The Sponsors (ABB-EV, local expert IPS, and also is some concern that electricity prices could
EdF) brought technical skills, a strong record of be an election issue. Existing coverage margins
project work and Ivoirian experience, risk-bear- are thin enough that tariff decreases could cause
ing capacity through their subsidiary and insur- cash flows to fall below the minimum 1.2 cov-
ance relationships, and a clear sense of what they erage ratio, so that remedies would have to be
needed to make the project work. implemented.
3. The CIPREL and Azito concessions impose gov-
C. Innovations in Project Structure ernment guarantees of the supply of fuel and the
purchase of electricity. This introduces the poten-
1. The development of a new sector cash-flow tial for disputes over the adequacy of gas reserves
waterfall agreement was the major structural and the long-term availability of fuel. The pub-
innovation. The approval of Avenant 4 modified lic management of the gas sector is critical to
existing arrangements, and established a new sys- future power projects. Development programs
tem for power concessions. It also established and oversight will require improved coordination
clear risk-bearing features with incentives for between the Ministry of Hydrocarbons and the
sustainable, sound management of the sector. Ministry of Energy.
2. Risk allocation and incentives were balanced 4. The effectiveness in practice of the new regulatory
carefully. The government roles as supplier and structure remains uncertain. The constraint under
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Case studies
which future power projects may be undertaken zone after World War II to oversee monetary and fiscal poli-
makes it more difficult to introduce additional cies in its African colonies, and it continues to play a central role
competition in the market. While Azitos contract in its operation. Member countries use a common currency
terms are attractive in current conditions, they with multilateral discussions on policy issues.
6The fixed exchange rate ruled out adjustment through
lock in Cte dIvoire for an extended term.
a nominal devaluation.
5. Azito is a major test of the credibility of the gov- 7The magnitude of the devaluation signaled that it was a
ernment and its compliance with contractual once-and-for-all measure. Thus, the benefits could be gained
obligations to the sponsors and lenders. Moreover, with undermining the future credibility of the fixed exchange
given the linkages between government perfor- rate.
mance and IDAs Partial Risk Guarantee, Azito
8An IMF Structural Adjustment Facility, several World
also is a test of IDAs leverage with respect to Bank structural adjustment credits, and funds from other mul-
monitoring of the sector and the project, to tilateral and bilateral donors supported these reforms.
ensure that its guarantee is not triggered by gov- 9Law No. 94-338.
10Prior to the devaluation, inward FDI was outweighed

ernment noncompliance. Commercial bankers
perceive the PRG program as more than sim- by outward flows of dividends.
11The London Club is the informal name for private
ple extended political risk cover that could be
provided by any export credit agency. The PRG creditors, while the Paris Club is the informal name for official
(government) lenders.
is seen as a World Bank promise to monitor the 12The amount restructured was U.S.$6.8 billion, includ-
Azito project and to encourage the government ing principal, interest, arrears, and penalties.
of Cte dIvoire to meet its commitments, espe- 13IDA debt relief is U.S.$91 million in NPV terms. The
cially with respect to end-user tariffs and gas IDAs role in this project was to provide a policy-based guar-
reserves. If successful, Azito will help establish a antee that the distribution and transmission functions, still run
successful financing track record for the country, by the government, would hold to the institutional reforms that
as well as open the doors for future private infras- were put in place. The IFC was not willing to put money into
tructure investment. the project unless sector reform was guaranteed by the IDA.
Standard World Bank guarantees usually deal with the Ministry
of Finance or the Ministry of the Economy; it was not com-
ENDNOTES
pletely clear in this case that such a guarantee would apply to
The case is drawn from Azito project documents and a state enterprise.
14Enabling laws were passed in 1980 and 1983.
from interviews with project participants. It draws heavily
15The government retained overall responsibility for sec-
from the joint World Bank/NERA report on the Power Sec-
tor in Cte dIvoire; the IDA Project Appraisal Document for tor planning and policy.
16Enacted on December 28, 1990. See Comite de Pri-
the Azito Project, dated November 17, 1998; and a presenta-
tion by Saleem Karimjee of the IFC on June 10, 1999. Exten- vatisation, Journees Portes Ouvertes sur la Privatisation en Cote
sive comments and assistance were provided by Patrick Achi, dIvoire, January 29-31, 1997, p. 12.
17Bouygues also was a major participant in SODECI.
Kouame Valentin, Pierre Bouvrey, Saleem Karimjee, Michel
18The equity shares in the new enterprise were as follows:
Wormser, Bertrand Delaborde, Farida Mazhar, Marie Francoise
Marie-Nelly, Francois Nankobogo, Tim Irwin, and Antonio Societe Internationale des Services Publics 51% (of which a
Estache. Bouygues subsidiary, SAUR, owned 65% and EdF 35%); the
1Societe Generale (SocGen) and the IFC jointly arranged, government 20%; other Ivoirians 24%; employees 5%. Some
and SocGen underwrote, a U.S.$60 million package that was of the private sector stake was purchased on behalf of the gov-
then syndicated to seven other European banks. ernment, which did not have sufficient capital at the time.
2Seventeen months from project award to commission- Although not formally codified, the government pledged to buy
ing of Phase I. these shares (over time) at fair value from the investors.
19CIEs remuneration was originally fixed at CFAF 17 per
3The structuring of Azito took place in the aftermath of
the Asian economic crisis. kWh of energy sold, up to 2092 GWh annually. It was increased
4See Azito: A Benchmark for Africa, Project Finance, to CFAF 21/kWh after the 1994 devaluation. For units sold in
March 1999, p. 15. excess of 2092 GWh per year, CIE receives CFAF 10.5/kWh.
5The CFA franc zone is both a currency union and a This compares with a weighted average retail tariff in Novem-
monetary standard. The CFA franc is convertible to French ber 1998 of CFAF 55.5/kWh (approximately U.S. cents
francs at a fixed nominal exchange rate. France established the 9.5/kWh).
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Case studies
20The avenant also established contractual penalties for practice, an 8% rate of return on assets has been used as a con-
nonperformance. ceptual basis for reviewing tariffs. As will be see below, the Azito
21There remains some dispute over when profits began project also imposed financial equilibrium requirements on
and how profitable CIE was, because of accounting and valu- the sector itself. In practice, an 8% rate of return on assets has
ation issues. In any case, both financial and operating perfor- been used as a conceptual basis for reviewing tariffs.
mance improved markedly. 38The government commits to pay a fee for the capital
22World Bank, Privatization in Cte dIvoire, Progress investment as well as for the power produced. This mechanism
Report, 1996, as cited by L. Jones, Y. Jammal, and N. Gokgur, shifts the risk of a power plant being underutilized to the gov-
Impact of Privatization in Cte dIvoire, Draft Final Report, ernment.
mimeo, November 1, 1998, p. I-14. 39This savings is not part of the CIPREL concession,
23Overall collection rates now exceed 80%. which is a more traditional take-or-pay structure.
24The original concession agreement set an October 1995 40Originally, the proposal was only for generating facil-
start date, but delays in securing public funds led to the com- ities, as the government was to finance the transmission line.
missioning in June 1997. However, financial constraints led the government to bundle
25CIPREL remains in charge of major investments and the two together. This served to change the original project
general oversight. CIPREL and CIE negotiate a dispatch sched- concept partway through the process, and also decreased the
ule that is updated weekly. Given the terms of its take-or-pay potential returns.
agreement, CIPREL is invariably dispatched as base load. 41The concession contract covers all three phases. Phase
26This is equivalent to a 77% load factor. III is to be triggered by demand growth. If Phase III is not
27Penalties apply to differences between programmed underway by 2003, the tariff profile may be revised.
and actual deliveries, and range between 8% and 38% of the 42This work was begun in June 1999.
price, depending on the amount of the shortfall. 43The two tariffs are not directly comparable, since their
28These tariffs exclude the cost of gas. calculations were based on different assumptions about load fac-
29BNETD assumed many of the roles of the former tors and other rates and indices. In addition, CIPREL benefited
DCGTX. Sector oversight makes a distinction between the man- from an IDA loan to the government that was on-lent to
ager of the sector and the ultimate owner. The maitre doeuvre of CIPREL on favorable terms, which affected tariff levels.
a project is the organization that plans the work to be done, 44The sponsors will provide engineering, technical, and
invites tenders, oversees and certifies work as completed, and management expertise, as well as necessary local knowledge.
authorizes payment. In Cte dIvoire, this role is almost always ABB-EV was to take primary project management responsibility
delegated to BNETD. This role is distinguished from that of until project acceptance. After that time, Electricite de France
the maitre douvrage, who is the ultimate owner of the works is responsible for operations and maintenance for a term of 15
in this case the state years.
30Given its internal problems, along with all the organi- 45Some government officials felt that they had been
zational changes, shifting responsibilities, and overlapping and assured that such financing was available; when it was not
contested jurisdictions, EECI was unable to fulfill this role. immediately forthcoming, a new set of tough negotiations
31Electricity demand had grown about 10% annually in the ensued as the transmission line was included. However, while
1960s and 1970s. Along with economic problems, demand a proposed financing plan was part of the bid documents, such
growth in the 1980s and early 1990s had fallen to about 2.5% financings are not finalized until after bid awards. IFC and the
per year prior to the 1994 devaluation. World Bank cannot commit until after Board approval, while
32Ghana is heavily dependent on hydroelectric generation. commercial banks can only commit after completing due dili-
33These countries rely heavily on hydroelectric power. gence and finalization of the concession documentation.
34A new contract was signed in 1999 with Ghana, agree- 46This bridge facility was repaid at Financial Closure in
ing to sell power through 2002 at a price of 4.8 cents per kilo- December 1998.
watt-hour. 47This amendment to the CIE concession contract was
35The program is complicated because some rural com- established by a Government Decree issued on July 15, 1998.
munities require significant extensions of the network, while The amendment stated how all parties would be paid and pre-
others require more limited expansion. scribed equal standing through a new waterfall agreement.
36While this performance compares favorably to the It requires CIE to make payments directly to CINERGY,
region, it does less well in comparison with Zaire or Zambia, CIPREL, and the fuel suppliers.
with losses of 12% and 9%, respectively. 48This requirement depends on a sound financial report-
37The financial equilibrium criteria under the IDA ing system being in place. The government committed to the
covenants include standards for operating ratio, debt service cov- system by contracting with Ernst and Young to produce a
erage ratio, internal financing ratio, and return on net assets. In manual of procedure that defines various financial flow cate-
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Case studies
gories and sets out in detail the ways in which the various par-
ties should receive payment. Ernst and Young had served as
auditor of CIE and CINERGY, so had much prior knowledge
of the sector. The manual of procedure was reviewed and
subsequently revised based on inputs from the interested par-
ties. This effort was an essential prerequisite to monitoring the
cash flows that go into the waterfall.
49Previously, this tariff was available only to those con-
sumers with a 5-ampere fuse. This was found to lead to exces-

sive annual consumption. The eligibility condition was therefore
changed to a maximum consumption of 80kWh for a two-

month period, with penalties applied if this level was exceeded.
50Cte dIvoire had previously defaulted on its external
and internal obligations, and while recent macroeconomic per-

formance had been good, credibility of the country had not yet
been established in financial markets.
51 See World Bank Project Finance and Guarantees
Department, Sub-Saharan Africa Benefits from the First IDA

Guarantee for Azito, Project Finance and Guarantees, June 1999;
J. Ukabiala, IDA Makes First Private Loan Guarantee, Africa
Recovery, April 1999, p. 3.
52See W. Hall, IDA Loan Guarantee for Abidjan Power
Plant, Financial Times, January 8, 1999.

53IDA Partial Risk Guarantee was of a shorter period (12
years) than usual, which leaves some residual risk from the pro-
ject and Ivoirian perspective. Since this was the first IDA Par-
tial Risk Guarantee, it was seen a particularly important in
helping countries encourage private finance. The use of IDA
guarantees rather than direct credits were expected to have an
important demonstration effect for private sector participation
not just in Cte dIvoire, but also in the entire region.
54The degree to which this contingent liability reduces
Cte dIvoires public debt capacity is open to debate.

55These 700 families are the largest part of 3,200 persons
affected by the final design of the project. The families include

owners and tenants living under the transmission lines. A fur-
ther impact is on the village of Azito, which will receive com-
pensation (in the form of a social fund) for the loss of 12
hectares of communal land to the plant site. A third group of
affected people is a fishing community of 15 houses that had
to be relocated due to the location of the gas feeder line.
56 Because Socit Generale was established as Joint
Arranger prior to IDA being brought into the project, IDA

could not competitively bid the guarantee. Also, under its arti-
cles, IDA requires a counter guarantee from the government.
In other situations, bringing IDA in earlier may lower costs or
reduce delays.
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Case studies
Case Studies of Project Finance

in Latin America
WALLACE C. HENDERSON
I
WALLACE C. n May 1998, Credit Suisse First Parks expansion project achieved a number
HENDERSON is a Boston lead a $110 million Rule of milestones. The transaction was the first
managing director at
Credit Suisse First
144A bond offering to finance an investment-grade project bond offering
Boston in New York. expansion for Phoenix Park Gas Pro- from the Caribbean and is likely to pave
cessors Limited, a natural gas processing the way for future project bond offerings
plant in Trinidad. Citicorp Securities was from the region. The combination of
co-lead manager. The plant purifies natu- strong ratings and an excellent credit story
ral gas for industrial users and exports the enabled Phoenix Park to raise funds at rates
natural gas liquids (NGLs) removed. far below those achieved by Caribbean as
Trinidad has abundant natural gas and has well as most Latin American projects to
attracted power, methanol, fertilizer, and date. Finally, the absence of a completion
other downstream industries to use that guarantee from any of Phoenix Parks
gas. Those industrial users prefer to use gas shareholders, although highly unusual for
without NGLs. Phoenix Park acts as a oil and gas projects, was readily accepted by
straddle plant, performing a needed both the rating agencies and investors based
function for both the sellers and the users on the companys outstanding operational
of natural gas. All revenues are in dollars, record and perceived ability to complete
deposited in offshore accounts controlled the expansion on time and on budget.
by the collateral agent on behalf of the
lenders. FINANCING SUMMARY
The principal sponsors are the
National Gas Company of Trinidad and $110 million of Rule 144A/Regula-
Conoco, Inc. The gas processing technol- tion S bonds with a fifteen-year maturity
ogy is commercially proven and widely (April 2013) were offered with a coupon of
used. Because of these factors, Standard & 7.267% to yield 165 basis points over ten-
Poors gave a BBB rating to the project, year U.S. Treasuries. Amortization begins
above its BB+ foreign currency sovereign in 2000 and the average life of the bonds is
rating for Trinidad and Tobago. Similarly, 9.81 years.
Moodys rated the project Baa, above its
Ba1 rating for Trinidad. The financing DESCRIPTION OF PROJECT
was a particular challenge because of con-
cern about all emerging markets as the Phoenix Park Gas Processors Limit-
Asian financial crisis continued to unfold. ed was organized in 1989 under the laws of
The successful financing of Phoenix the Republic of Trinidad and Tobago. The
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Case studies
company owns and operates a cryogenic natural gas According to the Petroleum Economist, the countrys
processing plant and related facilities including a total proven reserves of non-associated (not from oil
fractionator, product storage tanks, and a marine fields) natural gas were estimated in early 1997 to be
loading dock. The fractionator separates propane, 16.1 trillion cubic feet, providing a reserve life of
butane, and natural gasoline. The three products are twenty-eight years at projected production levels.
known together as natural gas liquids (NGLs). NGC is the sole supplier of non-associated natural
Propane and butane are known together as liquified gas in Trinidad. It sells all of its natural gas to petro-
petroleum gas (LPG). The plant is located in the chemical, power generation, and other industrial
Point Lisas Industrial Estate, a secure and isolated consumers, which it has attracted to Trinidad by
industrial zone on the west coast of Trinidad. long-term, competitively priced energy-supply
Phoenix Park currently is 51% owned by the arrangements. Those customers generally prefer to
National Gas Company of Trinidad and Tobago use natural gas that does not contain significant
(NGC), which in turn is owned by the Government amounts of NGLs.
of Trinidad; 39% owned by Conoco, Inc.; and 10% Phoenix Park operates as a straddle plant,
owned by Pan West Engineers and Constructors, Inc. receiving natural gas from NGC, removing and sell-
NGC was established by the government in 1975 to ing NGLs, and returning lean residue gas to NGC
purchase, transport, and sell natural gas. It is Trinidad for sale to industrial consumers. Industrial users pre-
and Tobagos sole aggregator, controlling distribution fer lean gas because it is less costly to process. The
and sale of natural gas. With revenues of US$2.2 bil- natural gas is owned by NGC throughout the process.
lion and profits of US$355 million, it accounted for Phoenix Park processes the natural gas stream,
about 6% of the countrys GNP in 1997. Conoco is a removing NGLs which are fractionated into propane,
major multinational energy company active in more butane, and natural gasoline. It pays a fee to NGC for
than forty countries with both upstream (exploration the energy content of the NGLs and exports them to
and production) and downstream (refining and mar- customers in the Caribbean and North America.
keting) operations. Revenues in 1997 were US$26 Phoenix Park also purchases gas from Petrotrin and
billion. In that year, the companys exploration and Textrin, two other local entities (the Soldado Gas
production operations produced 453,000 barrels of Suppliers) and has agreed to purchase the entire NGL
petroleum liquids and 1.2 billion cubic feet of gas stream from Atlantic LNG, which is discussed below.
daily. Its natural gas division sold 3.6 billion cubic feet The Soledado gas is associated gas that comes from
of natural gas and produced 116,000 barrels of NGLs the Soledado oil field, off the southwest cost of
daily. Conocos refining and marketing operations Trinidad. It has three times the liquid content as the
include interests in nine refineries processing approxi- NGC gas. It has lower pressure than the NGC gas
mately 780,000 barrels per day and 7,900 retail mar- and must pass through a compressor station before
keting outlets. E.I. du Pont de Nemours & Co. processing.
(DuPont) acquired Conoco in 1979 and spun off 30% The Phoenix Park plant was financed original-
of its shares in a 1998 IPO. Pan West operated for ly with $28.5 million equity from the partners and a
eleven years as a privately-owned engineering and $80.0 million bond financing underwritten by
construction firm specializing in gas processing and Citibank. Multinational U.S. companies invested in
treatment facilities. It developed a proprietary process the bonds with Section 936 funds, representing prof-
for separating NGLs from natural gas that is used by its from Puerto Rican operations that remained on
Conoco in a New Mexico plant as well as Phoenix deposit in Puerto Rico because they could not yet be
Park. Pan West recently exited the engineering and repatriated tax-free to the U.S. Section 936 of the
construction business but continues to hold an inter- Internal Revenue Code allowed such funds to be used
est in Phoenix Park for financing of projects in the Caribbean basin at
below-market rates through the Caribbean Basin
REASON FOR PROJECT Financing Authority (CARIFA). Phoenix Park was
AND SPONSORS NEEDS the first project financed that way. The bondholders
were protected by a credit-enhancement letter of
Trinidad has abundant reserves of natural gas. credit from Banque Paribas.
26 CASE STUDIES OF PROJECT FINANCE IN LATIN AMERICA WINTER 1999
611

Case studies
Construction Begins in 1989 and natural gasoline sales 30% of Phoenix Parks rev-
enues. The company shipped 56% of its LPG to the
The plant was completed on schedule and eastern Caribbean, 17% to Central and South Ameri-
within budget in 1991 and has been operating prof- ca, and 27% to North America. Shipments to
itably since then. The plants on-stream factor has Caribbean customers generally are premium priced
been above 98%. It has a zero demurrage record of because they are in relatively small amounts. By the
over 800 cargoes. There have been no safety-related year 2000, there will be additional competition from
lost workdays in over six years. Phoenix Park is the Venezuelan LPG supplies, but Phoenix Park manage-
only non-majority-owned affiliate to receive ment believes that it will retain its Caribbean cus-
DuPonts marketing excellence award. Through tomers because of a reputation for quality and reliabil-
operating cash flows, the company has funded three ity as well as a willingness to ship in small parcels. The
enhancements to the plant, an expansion of storage companys natural gasoline is sold primarily in the
and export facilities, an increase in processing capac- North American low-octane and petrochemical feed-
ity, and a compression facility to increase the pres- stock markets.
sure of the Soldado gas. Because the new debt can Under an offtake safety net product market-
be serviced largely by cash flow from existing oper- ing agreement, Conoco is committed to purchase all
ations, no completion guarantees were required of the companys NGL products that cannot be sold
from the sponsors. elsewhere. The need to sell under this agreement
An overview of the planned expansion is would be considered the worst-case scenario for
shown in Exhibit 1. Phoenix Park. To date, there have been no sales under
the product marketing agreement because sales to
OVERVIEW OF PLANNED EXPANSION third parties and arms-length sales to Conoco have
brought higher prices.
The 1998 expansion project includes con- Conoco has served as the general technical advi-
struction of an additional gas processing plant, sor to the project. All of the major engineering, pro-
expansion of fractionation facilities, expansion of curement, and construction (EPC) contracts were
product storage capacity, and construction of an awarded in a competitive bidding process. Black and
additional marine export terminal. The expansion Veatch Pritchard, Inc., and Tarmac Construction
was justified principally by an increase in NGCs (Caribbean) Limited were awarded a contract for the
commitments to supply downstream industrial cus- engineering and construction of the new gas plant and
tomers with residue gas. A 1996 study by the the expansion of the fractionation and storage facilities.
Petroleum Economist estimated that demand for natu- Brown & Root-Murphy, LLC was awarded a contract
ral gas in Trinidad would increase 46% by the year for construction, and TI Energy Services, Inc. a contract
2000 and an additional 19% by 2005. The expansion for engineering, the pipeline between Phoenix Park and
also was designed to increase the plants volume of the Atlantic LNG plant.
NGL production by 125%, strengthening its posi-
tion as Trinidads predominant producer and ANALYSIS OF PROJECT RISKS
exporter of NGL products and the largest supplier of AND ECONOMIC VIABILITY
those products in the Caribbean. To further those
goals, Phoenix Park signed an agreement to pur- The offering circular for the bonds cites the fol-
chase the entire NGL stream from the recently com- lowing risks:
pleted Atlantic LNG plant in Port Fortin on the
southwest coast of Trinidad. Atlantic LNG is a joint Operating and technical risk: the risk of breakdown,
venture among subsidiaries of Amoco, British Gas, failure, or underperformance of the existing or
Repsol (Spain), Cabot (US), and NGC. Phoenix expanded facilities; the risk of problems in the appli-
Park will construct a 34-mile pipeline to transport cation of gas processing, fractionation, storage, or
the NGLs from Point Fortin to its expanded frac- transportation technology. While this type of risk
tionation facilities. exists in any industrial plant, Conoco has worldwide
In 1997, LPG sales were approximately 70% operating expertise using a commercially proven
612

Case studies
EXHIBIT 1
Overview of Planned Expansion
technology. gas suppliers to deliver natural gas to Phoenix Park

Adequacy of insurance: the risk that insurance will will be impaired.
not be adequate to compensate for plant replace- Marketing risk: the risk related to selling all products
ment or lost operating time in the event of an under short-term sales contracts at current prices.
explosion, natural disaster, or other calamity. Other than the product marketing agreement with
Reliance on projections and underlying Conoco, the company has no long-term offtake
assumptions: the risk that the plants actual contracts.
financial performance will be worse than in Limited recourse: risk of reliance on Phoenix
projections prepared by the company, the inde- Parks existing and expanded facilities as the sole
pendent engineer, and the marketing consultant source of debt repayment without recourse to its
because of factors such as commodity prices, parent companies.
discussed next. Conflicts of interest and related-party transactions:
Commodity price risk: the risk that prices for risk that shareholders will take advantage of their
propane, butane, and natural gasoline will drop so position to provide unfavorable terms or breach
far over a sustained period that cash flow will not contracts with the company.
be sufficient to meet debt service obligations. Currency risk: risk that a rise in inflation that is not
Gas supply risk: the risk that natural gas reserves offset by a corresponding devaluation of the Trinidad
will be less than estimated or that the ability of the and Tobago dollar could increase the companys
613

Case studies
EXHIBIT 2 the principal amount of the bonds and the share-

holder funds contributed, totalling $158 million,
Sources and Uses of Funds (US$ millions)
would be sufficient to complete the expansion pro-
Sources ject and that the companys operating cost estimate
was realistic. In the marketing consultants report, the
Senior debt obligations (bond offering) 110.0 firm estimated that NGL prices would grow at com-
Shareholder funds (cash flow from operations) 48.2 pound rates of about 2.5% through 2015, that the
company would be able to sell all of the output of the
Total sources 158.2 expanded facilities, with sales concentrated in small-
quantity, premium-priced Caribbean markets. The
Uses company will gain market share in long-haul mar-

kets, particular for natural gasoline, over time. Latin

Gas processing plant and fractionating
America is currently a net importer of LPG but will
fractionating facilities 100.2
become a net exporter around 2005.
Storage capacity and
Export facilities 37.0 STRUCTURE OF FINANCING
Pipelines 17.8 The company estimated that total expansion pro-

ject costs, including financing costs would be approxi-
Other 3.2
mately US$158.2 million. It financed US$48.2 million
of that amount with internally generated funds and
Total uses 158.2
US$110 million with the proceeds of a bond offering.
The sources and uses of expansion project funds are
summarized in Exhibit 2.
operating expenses in U.S.-dollar terms. The bonds have an average life of 9.81 years and
mature in 2013. Interest of 7.267% is payable quarterly,
Purvin & Gertz, a leading international con- beginning in October 1998. Quarterly principal repay-
sulting and engineering firm, was retained to pro- ments ranging from 0.8125% to 3.1875% of the original
vide both the independent engineers report and the principal amount begin in April 2000.
marketing consultants report. In the independent At the time of the financing in May 1998,
engineers report, the firm stated its opinion that: 1) Phoenix Park had $30 million outstanding under the
the design, construction, and operation of the CARIFA loan, secured by a Citibank standby letter of
expansion project were in accordance with standard credit, and US$7.1 million of shareholder loans out-
industry practices; 2) the project should be capable standing. The CARIFA loan indebtedness ranks pari
of processing the specified quantity and quality of passu with the 1998 bond offering. The shareholder
natural gas and NGLs; and 3) the background of the loans are subordinated to the senior loans.
sponsors justifies the expectation of successful pro- Exhibit 3 shows the capitalization of the compa-
ject completion. The firm noted that natural gas ny as of March 31, 1998 and as adjusted to reflect the
demand has grown steadily in Trinidad, and demand bond offering.
for natural gas as both fuel and feedstock for petro- The bonds were issued through a special pur-
chemical and power projects will drive continued pose company created to facilitate the financing. Pay-
exploration and production. In its technical design ment of the bonds is unconditionally guaranteed by
and construction review, the firm described Phoenix Phoenix Park Gas Processors Limited and secured by
Parks cryogenic gas processing technology as com- the companys property and its rights and benefits
mercially proven. Construction cost estimates were under project agreements, sales agreements, and
prepared by experienced EPC contractors in accor- insurance policies. Under an intercreditor agreement,
dance with accepted estimating practices and meth- creditors claims related to the bonds and the CARI-
ods. In the financial review, the firm estimated that FA loan are secured on a pari passu basis. Bonds may
614

Case studies
EXHIBIT 3 eral agent for benefit of the senior lenders,

Company Capitalization on March 31, 1998 (US$ millions) has established a construction account, master
account, debt service reserve account, dollar
Long-Term Debt Actual As Adjusted operating account, loss proceeds account,
delayed completion account, sinking fund
CARIFA loan 30.0 30.0 account, and local currency accounts. Pro-
Shareholder loan 7.1 7.1 ceeds of the bond offering were deposited in
Bond offering 110.0 the construction account and made available
for expansion project costs. An amount equal
Total long-term debt 37.1 147.1 to the next two quarterly interest and princi-
pal payments will be maintained in a debt ser-

Shareholders equity
vice reserve account or provided through a
Share capital 21.7 21.7 debt service reserve letter of credit. Receipts
Retained earnings 78.9 78.9 from export sales and interest income are
deposited into the master account and then
Total shareholders equity 100.6 100.6 disbursed according in the following order of
priority: transfer to the dollar operating
Long-Term Debt as a account for normal operating expenses, trans-
Percentage of Capitalization 26.9 59.4 fer to local currency accounts for local cur-
rency expenses, scheduled interest and prin-
cipal payments, replenishment of the debt
service reserve account, repayment to the
be redeemed or purchased for the outstanding prin- debt service reserve letter of credit provider, capital
cipal amount plus accrued but unpaid interest with- expenditures not made from the construction
out the holders consent. The bonds are subject to account, and finally, subordinated debt payments and
mandatory redemption if the company does not dividends.
complete the plant expansion within fifteen months
of the scheduled completion date and if the compa- CREDIT ANALYSIS FROM
ny does not rebuild, repair, or restore its facilities INVESTORS AND LENDERS PERSPECTIVE
after receipt of insurance of expropriation proceeds
in excess of US$1 million. Under certain conditions, Exhibit 4 summarizes Phoenix Parks financial
the company may incur up to $25 million additional performance from 1993 through 1997. The company
senior debt that will rank pari passu with the bonds has used cash flow from operations to reduce outstand-
and the CARIFA loan. Customary affirmative and ings on the CARIFA loan from $80 million in 1991 to
negative covenants pertain to maintenance of assets, $30 million in 1998. Exhibit 5 summarizes the base-case
licenses, permits, approvals, and insurance; comple- projection for revenues, EBITDA and debt service until
tion of the expansion project; and limitations on maturity of the bonds in 2013.
indebtedness, liens, guarantees, and the use of the
bond proceeds. Events of default include bankruptcy CREDIT RATING
proceedings against the issuer, Conoco, or NGC,
default under any of the outstanding financing doc- As of September 1998, Standard & Poors
uments, abandonment of the existing or expanded assigned a BBB rating to the Phoenix Park Funding
facilities, expropriation or nationalization, and false bonds with a stable outlook. The agencys rating
representations and warranties. reflected the following risks: production sold through
All revenues of the company and the proceeds short-term contracts, creating continuous commodi-
of the bond offering are to be deposited in offshore ty price risk; future competition from planned new
accounts and applied in accordance with the deposit projects in Latin America; unrated entities such as
and disbursement agreement. Under that agree- NGC and Atlantic LNG providing all production
ment, the depository agent, as agent for the collat- inputs; construction contracts with multiple contrac-
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Case studies
EXHIBIT 4
Financial Summary
1993 1994 1995 1996 1997
Revenue 50.1 49.2 59.6 92.7 75.4

EBITDA 26.1 26.7 33.4 55.9 40.8
Long-term debt 86.8 90.0 87.1 37.1 37.1
Shareholders equity 38.3 53.3 67.1 92.7 97.3
tors; and the companys ability to incur $20 million Venezuela. Formerly a British colony, Trinidad
additional debt ranking pari passu with the bonds. became an independent state in 1962 and a republic in
Offsetting those risks, the agency cited the follow- 1976. The country has had a stable democracy since
ing strengths: low break-even prices required for a independence. It has a population of 1.3 million and a
1.0 debt service coverage ratio; the strategic service literacy rate of 96%, the highest rate in the western
Phoenix Park provides as the sole natural gas pro- hemisphere. Trinidad has exported oil and natural gas
cessing facility for industrial users responsible for a without interruption for over twenty years. In the
rising share of Trinidads export earnings; NGCs decade prior to 1982, the oil sectors was the founda-
nearly exclusive right to distribute natural gas from tion for economic growth and prosperity. The coun-
a reserve that should last twenty-eight years at cur- try was able to build its monetary reserves and estab-
rent reserve levels; dollar-denominated sales con- lish both a modern infrastructure and social safety net.
tracts with payments made directly to offshore From 1982 to 1991, declining prices and demand
trustee; Conocos long-term agreement to provide caused Trinidads oil revenue to drop and monetary
management, operating, technical, marketing, reserves dropped accordingly. Since 1992, both the
financial, purchasing, and maintenance services; a energy and non-energy sector of Trinidads economy
conservative ratio debt to project capitalization; have grown steadily. As of October 1998, Trinidads
good operational and financial performance since external debt was rated BB+ by Standard & Poors and
1993; experienced sponsors with host-country Ba1 by Moodys.
sponsor participation; a collateral package that The macroeconomic comparison in Exhibit 6
includes the existing and expanded facilities; and the shows that Trinidad and Tobago compares favorably to
ability to repay debt under worst case scenarios. its Latin American neighbors.
Standard & Poors justified rating Phoenix Park
above the BB+/positive sovereign rating it assigned MACROECONOMIC COMPARISON
to Trinidad and Tobago based on the following fac-
tors: a low probability of exchange restrictions Standard & Poors notes that there is a broad
because of a fundamental shift in government policy consensus in Trinidad in favor of a market-oriented
in the early 1990s; Phoenix Parks crucial role in economic framework, as implemented by three recent
supporting the growth of the petrochemical indus- elected governments of alternating political parties.
try, which is fundamental to the countrys growth, Structural reforms have reduced the size of the gov-
diversification, and export strategy; and the disin- ernment sector and sound fiscal and monetary policies
centive and limited benefit for the government in have reduced the government debt burden to 46% of
interfering with the flow of export proceeds. GDP and inflation to 3.5%. High levels of
recent foreign investment are helping the countrys
COUNTRY RISK balance of payments and increasing its growth poten-
tial by broadening its energy-based industries. Offset-
Trinidad and Tobago is a 1,980-square-mile, ting these strengths are intermittent pressure on the
two-island republic located just off the coast of Trinidad and Tobago dollar and on foreign currency
616

Case studies
EXHIBIT 5
Base-Case Projection for Revenues, EBITDA, and Debt Service
1998 2003 2008 2013
Revenues 43.7 136.7 152.7 46.3

EBITDA 25.1 70.9 78.0 23.6
Debt service
Interest 6.8 7.6 4.8
Principal 5.0 5.5 10.2 2.2
Total 11.8 13.1 15.0 2.2

Partialyear
After-tax minimum debt service coverage ratio 2.13
After-tax average debt service coverage ratio 3.79.
reserves, which amount to just over two months in pressure, and quality of the gas to be delivered by
imports. This reflects limited growth in the non- NGC, the volume of gas to be processed by Phoenix
energy sector, which partly explains unemployment Park, Phoenix Parks payment to NGC for NGLs,
of 14% and non-performing bank loans of 9.5%. and respective obligations of the Phoenix Park and
NGC for the construction, operation, and mainte-
MOST IMPORTANT PROJECT CONTRACTS nance of pipelines. Phoenix Parks payments are
based on the energy content of the liquids extract-
A summary of the contractual relationships is ed.
shown in Exhibit 7. NGL Sales Agreement: This agreement governs
The contractual relationships are defined as the sale and transport of NGLs from the Atlantic
follows: LNG plant to Phoenix Park, including Atlantic
Joint Venture Agreement: Under this agreement, LNGs obligation to supply NGLs recovered from
NGC, Conoco, and Pan West formed the com- its first liquification train to Phoenix Park, quali-
pany under the laws of Trinidad and Tobago in ty specifications, and the price paid to Atlantic
1989. The agreement is governed by the laws of LNG by Phoenix Park.
Trinidad. Disputes are referred to a single arbitra- Product Marketing Agreement: This agreement,
tor in Trinidad under the rules of the London mentioned above, defines Conocos obligation to
Court of International Arbitration. buy NGLs if Phoenix Park is unable to sell them.
Memorandum of Association (MOA) and Articles Conoco pays Phoenix Park the current Mont
of Association (AOA): These are the charter docu- Belvieu, Texas (Gulf Coast) price less transportation
ments of the company that collectively govern the and marketing costs incurred by Conoco and a mar-
relationship between the company and its share- keting fee.
holders and provide procedures for management of Soldado Supply Agreement: This agreement, signed
the company. The MOA is equivalent to a certifi- in 1995, obligates Petrotrin and Textrin, the
cate of incorporation for a Delaware company, and Soledado suppliers, to supply Phoenix Park with a
the AOA to its by-laws. defined amount of wet gas for processing and obli-
Gas Processing Agreements: The existing gas pro- gates Phoenix Park redeliver residue gas to those
cessing agreement, signed in 1989, and the new gas suppliers. It defines the respective obligations for
processing agreement, define NGCs obligations to maintenance of pipelines and a formula price for
supply gas and Phoenix Parks processing rights and Phoenix Parks purchase of NGLs. Petrotrin is the
obligations. The agreements define the amount, residue gas offtaker. The amounts payable to
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Case studies
EXHIBIT 6
Trinidad and Tobago in Macroeconomic Comparison to Its Latin American Neighbors
Trinidad and Tobago Uruguay Chile Venezuela Argentina Mexico Brazil
GDP (US$ billion) $5.73 $19.8 $74.2 $80.2 $303.2 $276.0 $758.7
Population (million) 1.3 3.1 14.4 22.1 34.8 96.5 160
GDP per Capita (US$) $4,500 $6,394 $5,153 $3,630 $8,712 $2,859 $4,742
Inflation Rate (%) 4.5 28.3 6.6 103.0 0.2 30.0 9.3
External Debt (US$ billion) 1.9 10.9 23.1 32.7 112.3 124.4 177.2
External Debt as % of
Exports of Goods and Services 42.8 242.3 160.2 124.3 336.7 110.0 286.8
External Debt as % of GDP 32.4 55.0 31.1 40.7 37.0 45.0 23.4
External Debt Ratings BB+/positive/Ba1 BBB-/Baa3 A-/Baa1 B+/Ba2 BB/Ba3 BB/Ba2 BB-/B1
Estimated.
Source: U.N., Economic Commission for Latin America and the Caribbean; IMF, International Financial Statistics; World Bank, World Debt
Tables; 1996 data.
Petrotrin are computed based on Phoenix Parks in emerging markets. The companys strong credit fun-
pool prices. damentals and sponsorship enabled Phoenix Park to
access this increasingly prevalent form of financing on
CONCLUSION terms better than achievable from any other market.
Notwithstanding recent market volatility, the success of
The capital markets can be a very attractive the transaction should pave the way for similar transac-
source of long-term, low-cost project financing, even tions from the Caribbean.
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EXHIBIT 7
Contractual Relationships
Conoco Pan West NGC
Technical 41% 10% 49%

Services
Agreement
Joint
Product
Marketing Venture
Agreement Agreement
Soledado Soledado PHOENIX Gas

Gas Processing
Supply PARK Agreement
Suppliers Agreement
NGL Sales Product

Atlantic Sales
LNG Agreement
Agreements
Customers
(including
Conoco)
619

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TermoEmcali
THOMAS E. LAKE AND HENRY A. DAVIS
T
THOMAS E. LAKE ermoEmcali is a build-own-trans- teen-year maturity were issued under Rule
is a vice president at fer, combined-cycle, gas-fired 144A, underwritten by Bear Stearns.
Dresdner Kleinwort
Benson in New York.
power generation facility in Cali, Project credit facilities underwritten
Colombia. The project financing, by a group of commercial banks led by Dres-
HENRY A. DAVIS completed in early 1997, still represents the dner Kleinwort Benson were as follows:
is managing editor at state-of-the-art in Latin American power
the Journal of Project project financing, although such a financing $13.2 million, five-year debt service
Finance.
would be difficult to complete in todays reserve letter of credit with a fee of 2.5%
credit market environment. per year and a margin over LIBOR of
The TermoEmcali project had quite a 2.75% per year.
number of distinctive features, including the $12.0 million working capital facility
following: maturing no later than seven years from
financial closing with a commitment fee
Infrastructure project generating local- of 0.5% per year and a margin over
currency revenues financed out of the LIBOR of 1.875% per year.
box with bonds. $15.5 million, five-year project contract
First power project in Colombia letters of credit with a fee of 2% per year
financed through Rule 144A private a margin over LIBOR of 2.625% per year
placement. and a commitment fee of 0.5% per year.
Longest-term bond issued to date for
Colombian borrower. APPLICABLE SPREAD
Bond issue backed by commercial loan
commitment. If the credit rating for the project
No state guarantees or state-owned off- changes, there is a provision for the spread over
takers. Libor of the project credit facilities, defined as
Obligations of private off-takers guaran- the applicable spread, to change accordingly.
teed by pledge of receivables .
Debt-service reserve and working capi- DESCRIPTION OF PROJECT
tal account.
In 1994, International Generating
DESCRIPTION OF FINANCING Company Ltd. (InterGen) began develop-
ment of a 233.8 megawatt (MW) natural
Senior secured notes in a principal gas-fired power plant located approximately
amount of US$165 million with a seven- ten kilometers outside of Cali, Colombia.
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Construction began in January 1997. Commercial megawatt Samalayuca II plant in Mexico, the 725
operations are scheduled to begin in January 1999. megawatt Rocksavage plant in the UK, and the 440
Affiliates of InterGen, as the majority partners, megawatt Quezon plant in the Philippines; in 1997
along with two Colombian partners, Emcali and Cor- Mayakon in Mexico; and in 1998, Meichou-wen in
fiPacifico, formed TermoEmcali for the purpose of China and Crayton in the U.K.
developing, owning, and operating the project. It is a 2. Emcali, with a 43% interest in the project, is the
build-own-transfer (BOT) project. At the end of the third largest utility in Colombia. Established in
twenty-year PPA, Emcali will assume full ownership 1955, it is municipally owned. Emcali is the exclu-
without payment of additional consideration. Total sive distributor of electricity and the exclusive
project loans are $209.8 million, of which 79% was provider of water, sewer, and telephone services to
financed through the issuance of senior secured notes the city of Cali, Colombia. Prior to the TermoEm-
pursuant to Rule 144A and Regulation S of the Secu- cali project, Emcali had no electric generating facil-
rities Act of 1933. ities. Its year end 1996 financial statements reflected
The plant consists of a single Westinghouse revenues of US$461 million, net income of US$54
model 501F advanced combustion turbine generator million, assets of US$2,486 million, and equity of
nominally rated at 155 MW which exhausts to an US$1,447 million. Debt was 24.7% of total capital
unfired Distral natural circulation heat recovery steam and EBITDA (earnings before interest, income
generator. Steam is produced in the heat recovery steam taxes, depreciation, and amortization) covered inter-
generator and delivered to a Westinghouse steam tur- est expenses 1.6 times. As of year end 1996, Emcali
bine generator nominally rated at 84 MW. had a BBB+ local and BBB- international credit rat-
In the past, Emcali has purchased all of its power ing from Standard & Poors and BBB local and inter-
from the Bolsa, the national grid. The TermoEmcali national ratings from Duff & Phelps.
project assists in meeting the growing demand for elec- In 1996, electric distribution accounted for 58% of
tricity in the Cali area. It also enhances the security of Emcalis revenues. Of total electricity sales in 1996,
the national power supply and reduces the strain on the 32% were to industrial customers, 31% to residential
Colombian national power system. customers, 22% to commercial customers, and 15%
Natural gas will be supplied to the project to other customers. The total number of Emcalis cus-
through the TransGas natural gas pipeline, which trans- tomers increased from 357,000 in 1992 to 420,000 in
ports gas to the Cauca Valley. As a result, the project 1996. Peak electricity demand in 1996 was 651 MW.
provides a low-cost and secure supply of thermal power Emcali reorganized in 1997, creating a holding
to meet Emcalis existing and forecasted demand. The company and four operating subsidiaries for power
project pipeline route is shown in Exhibit 1. generation, power distribution, water and sewer, and
telephone. The PPA and TermoEmcali ownership
SPONSORS INTERESTS were transferred to the power generation subsidiary,
but PPA obligations continued to be covered by
The background of the sponsors, their owner- joint and several guarantees of the holding company
ship interests in the project, and their reasons for par- and the four operating subsidiaries.
ticipating in the project are as follows: 3. CorfiPacifico is one of seventeen private Colombian
financieras that provide commercial and invest-
1. InterGen is jointly owned by Bechtel, the largest ment banking services. It holds a 3% interest in the
private construction company in the U.S, and project as a portfolio investment.
Shell. Its primary business is to develop power
plants overseas. InterGen won the project in a LEGAL AND FINANCIAL STRUCTURE
competitive bidding process. It is responsible for
development, operation, and financing of the pro-
ject. In 1996, InterGen arranged for the financing Ownership Structure
of more greenfield power plants, measured in total
megawatts, than any other developer. Other Inter- TermoEmcali is a Colombian mixed-economy
Gen projects financed in 1996 include the 690 sociedad en comadita por acciones formed to develop, con-
38 TERMOEMCALI WINTER 1999
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Case studies
EXHIBIT 1
TermoEmcali Pipeline Route
struct, and own the power plant. As shown in Exhibit 2, TermoEmcali Holdings, Ltd. (Termo Hold), Mayflower
it is owned by Empresas Municipales de Cali E.I.C.E. Holding, Inc, and Corporacin Financiera del Pacifico
(Emcali), Cauca Valley Holdings Ltd. (Cauca Holdings), (CFP). BEnICO and BTH are Bechtel subsidiaries and
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EXHIBIT 2
TermoEmcali Project Ownership Structure
InterGen
100%
Cauca Valley TermoEmcali Corporacion Financiera

Emcali Holdings Ltd. Holdings Ltd.
Mayflower Holding
de Pacifico S.A.
(Cauca Holdings) (Termo Hold) Inc. (CFP)
90% 84.39% 5.26% (Non-Voting)

(To be acquired)
3.1479% 10.35%
43%
InterGen Colombia
Caligen Limitada
Leasing Ltd.
(Caligen)
(Leaseco)
25.4691%
3%
25.383% 100%
(Managing
Shareholder)
TermoEmcali
Funding Corp.
(Funding Corp.)
TermoEmcali I
(Managing
S.C.A. E.S.P.
Shareholder)
(TermoEmcali)
InterGen affiliates. InterGen Colombia Leasing Ltd. proceeds from issuance of the notes to Leaseco, which
(Leaseco), a Cayman Islands company, is owned and will use those proceeds to acquire equipment for lease to
controlled by BEnICO and BTH. It, in turn, is a part the project company. This arrangement will allow the
owner of the project company. Mayflower Holding Inc., project company to take advantage of tax deductions for
owned by an individual who also owns shares in CFP, lease payments. The project company thus will own
will acquire a non-voting interest in Leaseco. some assets and have a leasehold interest in others.
Financing Structure PROJECT ECONOMICS
The project financing structure is shown in

Exhibit 3. TermoEmcali Funding Corporation, wholly Colombian Power Industry
owned by Leaseco, is established for the sole purpose of
issuing the notes. It is a special-purpose corporation Prior to completion of the TermoEmcali project,
operating under the laws of the State of Delaware in the Colombia had 10,500 MW of installed power generating
U.S. TermoEmcali Funding will lend a portion of the capacity, of which 75% was hydroelectric and 25% was
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EXHIBIT 3
TermoEmcali Project Financing Structure
Noteholders
Notes
Repayment
Supplier Funding Corp. of Company Contractor
Loans
Participation
in Company
Loans
Payments Repayment of Financial Payments Under

Under Leaseco Loans Institution Construction
Offshore Equipment Contract
Leaseco
Contract
Loans
Company Loans
Leaseco Rent The Company
Lease of
Equipment
PPA Tariff
Payments
Facility
Emcali
Pursuant to the Leaseco Guarantee, Leaseco will guarantee the obligations of Funding Corp. under the Financing Documents.
thermal. Heavy dependence on hydroelectric power led provide anchor demand for the pipelines.
to unreliable service and sharp swings in electricity
prices. Frequent brownouts and blackouts encouraged Projects Importance to Emcali
the development of a fossil fuel generation plan to take
advantage of Colombias abundant natural gas resources. When completed, TermoEmcali will account for
The cornerstone of this plan has been construction of a 25% of Emcalis expected customer load. It lowers
gas pipeline transportation system to bring gas to the Emcalis costs. The projected project price averages 4.6
larger cities. Gas-fired power plants such as TermoEmcali cents per kilowatt hour compared to Emcalis average
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Case studies
cost of 5 cents per kilowatt hour in 1996. The project Offtake Risk
establishes a degree of certainty in Emcalis power costs,
which in the past have been subject to change with The PPA with Emcali provides fixed capacity
each new two-year contract. As a result, Emcali will be payments designed to cover all fixed operating costs,
able to offer long-term contracts to its customers. including debt service, and energy payments that pass
through virtually all actual fuel supply, transportation,
ANALYSIS OF RISKS and other variable costs. Emcali, rated BBB- by Standard
& Poors, provides additional support in the form of a
letter of credit and fiducia, described below, to cover
Construction Risk short-term payment disruptions. The project is of strong
strategic importance to Emcali, providing it with low-

As with any major construction undertaking, cost power, reduced transmission costs, and diversifica-
many factors such as material shortages, labor disputes, tion away from hydroelectric power. Emcalis obligations
bad weather, failure to obtain necessary permits, and under the PPA remain in effect if Emcali reorganizes, as
unforeseen engineering, environmental or geological is planned, and if it is privatized.
problems, could cause a cost overrun or a delay in pro-
ject completion. Except in the case of certain defined Fuel Supply/Transportation Risk
force majeure events, the contractor is required to pay
schedule and performance liquidated damages totaling Ecopetrol is a national fuel company with a BBB-
40% of the contract price if the project is not complet- credit rating, obligated to provide fuel and firm trans-
ed on or before the guaranteed completion date (twen- portation capacity under long-term contracts. Emcalis
ty-two months from the full notice to proceed under capacity-payment obligations to the project continue in
the construction contract and twenty-four months the event fuel is unavailable so long as the project remains
from the financing date under the PPA) and if the plant available. Emcali is obligated to pay for substitute fuel if it
does not satisfy the performance tests, including 233.8 is used. C.C. Pace, in the independent fuel consultants
MW capacity, by 365 days after the completion date. report, estimates that there will be adequate transportation
Emcali can terminate the PPA if construction is not and more than an adequate supply of natural gas for the
complete within twenty-four months of the financing projects requirements during the term of the debt.
date and if plant capacity at the time of commercial
operation is less than 196 MW. In addition, the com- Technical Risk
pany has taken out delay-in-completion insurance and
set aside an owners contingency of $10 million in its The project will use a 155 MW Westinghouse
construction budget to cover budget overruns, force 501F gas turbine. (The Westinghouse turbine business is
majeure events, and other events that could delay com- now part of Siemens.) At the end of 1996, there were
pletion of the facility. twenty-eight similar turbines in operation. In 1996,
Over the past ten years, Bechtel has constructed according to Westinghouse, average availability for its tur-
twenty-five combined-cycle plants similar to the Ter- bines installed in 1992 was 94%, slightly above the 91%
moEmcali project. In its history as an EPC contractor availability in the projects base-case scenario. Westing-
for combined-cycle plants, Bechtel neither has incurred house has four other turbines installed in Colombia.
delay penalties nor performance damages through the
date of the financing. Bechtel has a strong financial Operating Risk
incentive to complete the project within the twenty-
two-month construction timetable and is further moti- As with any new project of this size and nature,
vated by an obligation to pay up to 40% liquidated operation of the facility could be affected by many factors
damages to cover delay penalties owed to Emcali under including start-up problems, equipment breakdowns, fail-
the PPA, a holdback letter of credit equal to 10% of the ure to operate at design specifications, changes in law, fail-
contract price, and unlimited liability to achieve ure to obtain necessary permits, terrorism, labor disputes,
mechanical completion. and other catastrophic events such as fires, explosions,
625

Case studies
earthquakes, or droughts. by Emcali prior to its restructuring. This agreement was

The monthly capacity payments by Emcali are intended to prevent the restructuring from having a neg-
based on the facilitys available capacity and on an ative impact on Emcalis creditworthiness.
equivalent availability factor (EAF) that is equal to the
facilitys available capacity for any period divided by Exchange Rate Risk
the facilitys capacity on the day commercial operations
begin. If the EAF of the facility is less than 60% in any Emcalis PPA payments in pesos are indexed to US
month, capacity payments from Emcali will be reduced dollars, thereby mitigating the lenders exchange rate risk.
to zero; if the EAF is less than 60% for any consecutive
six-month period, the PPA can be terminated. Emcali Dispatch Risk
will not make capacity payments during most force

majeure events that prevent the facility from operating. The structure of the capacity and energy pay-
Stewart and Stevenson, owned by General Elec- ments under the PPA largely insulates the project from
tric (GE) is the largest third-party operator of power variations in dispatch.
facilities in the world. It presently operates thirty-six
plants with total capacity of 3,500 megawatts, including Bolsa Risk to Emcali Credit
four plants in Colombia. Stewart & Stevensons fleet
availability over the last four years has averaged over As the Bolsa is a bid-based system, a power short-
94% with no single plant below 92% availability. The age could cause a substantial increase in Emcalis power
O&M agreement provides incentives for Stewart & costs and a consequent reduction in cash flow. The pro-
Stevenson to operate the plant as efficiently and cost ject locks in the price for a portion of Emcalis power
effectively as possible. The PPA requires the project needs. Emcalis business diversity further mitigates the
company to contribute annually to a maintenance effects of a power price increase.
reserve for periodic equipment overhauls and to main-
tain business interruption insurance equal to eighteen Country Risk
months of expenses.
No political risk coverage is provided for the pro-
Environmental and Permit Risk ject financing as Colombia has a long democratic tradi-
tion of stable government and economic reforms reflect-
TermoEmcali has received the necessary permits ed in its long-term investment-grade credit ratings from
from the Colombian government and is in compliance Duff & Phelps (BBB), Moodys (Baa3), and S&P (BBB).
with the World Bank environmental standards. Costs Colombia has a long track record in which contracts are
associated with future changes in Colombian environ- honored and parties can be sued. The country never has
mental and tax laws, as well as other changes in Colom- defaulted or rescheduled its government debt. Although
bian law that affect the projects net economic return, left-wing guerilla violence presents a safety problem,
are pass-throughs under the PPA. there has been no significant instance of expropriation,
currency inconvertibility, or contract abrogation by the
Restructuring Risk central government. Trade liberalization and privatiza-
tion and deregulation of key sectors such as energy, elec-
As mentioned earlier, in December 1996, the tricity, other utilities, and banking helped attract foreign
City Council of Cali adopted an agreement that requires direct investment, which has averged 3% of GDP over
Emcali to restructure its business by establishing separate the last five years. During this period, numerous projects
power, water, sewage, and telephone subsidiaries under have been financed successfully in international bank and
a holding company. To accommodate this reorganiza- capital markets. Among them are CentraGas, El Dorado,
tion, Emcali signed an agreement with the senior OCENSA, Termopaipa IV, TransGas, and Termobarran-
secured lenders that requires each subsidiary to be joint- quilla. Nonetheless, Columbias spending has risen from
ly and individually liable for Emcalis obligations under 11% to 18% of GDP since 1990, resulting in a fiscal
the PPA and also provide a priority interest in a portion deficit of 3.3% of GDP. The newly elected president,
of its operating revenues to the same extent as provided Andrs Pastrana, has tried to take a fresh approach to an
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Case studies
intractible civil war problem by personally negotiating unregulated customers under contracts. At the end of
with both the left-wing guerillas and the right-wing twenty years, the projects ownership will be transferred
paramilitaries, both financed by the drug trade. The to Emcali without additional consideration.
problem will be difficult to solve until drug activity has The PPA for Emcali was one of the last of such
been either controlled or eliminated. agreements signed in Colombia. The original agreement
was modified several times to accommodate the markets
INDEPENDENT ENGINEERS REPORT move toward the relatively unregulated, free-auction
Bolsa system.
In the independent engineers report, Stone & Lake considers the PPA conservative and typical
Webster concluded that the facility would be able to of PPAs in various countries signed at this time. Emcali
achieve and maintain operating standards specified in the is obligated to purchase electricity from the plant subject
PPA, that projected operating results are a reasonable to certain performance requirements.
forecast of the projects economics, and that projected In addition to having the protection provided by
debt service coverage ratios are insensitive to reasonable the PPA, the commercial lending banks wanted to know
changes in technical assumptions. The independent how TermoEmcali would add value to Emcali as a utili-
engineer considered liquidated damages to be adequate, ty. They commissioned a dispatch study to determine
but also to give the contractor an incentive to achieve how competitive TermoEmcali would be compared to
the guaranteed completion date. Stone & Webster noted other power sources. The study concluded that Ter-
that the power plant site is easily accessible and located moemcali would reduce the dependence of the Colom-
next to a substation of the gas pipeline. Its riverside loca- bian power system on hydrology and thereby reduce the
tion simplifies construction. Stone & Webster will pro- volatility of power prices.
vide an ongoing review throughout the project life.
EPC CONTRACTS
GAS CONSULTANTS REPORT
The project company entered into fixed-price,
In the gas consultants report, C.C. Pace con- turn-key construction contracts totaling $124.1 million
cludes that the gas supply and transportation contracts with two Bechtel affiliates, Bechtel Overseas Corporation
provide sufficient volume to meet the projects require- (the Onshore Contractor) and Bechtel International Cor-
ments and that Ecopetrols gas reserves are more than poration (the Offshore Supplier). The EPC contracts are
adequate to meet the projects requirements. The firm split between the Onshore Contractor and the Offshore
notes that the diesel fuel storage capacity and local oil Contractor to take advantage of a provision in Colombian
terminal facilities provide sufficient access to back-up tax law that allows imported equipment to be leased, and
fuel supplies and that the PPA insulates the project from therefore allows tax-deductions for lease payments to the
fuel-related supply, transportation, and price risk. Offshore Contractor. The performance obligations and
liabilities of both contract parties are guaranteed by Bech-
PROJECT CONTRACTS tel Power Corporation. Following a three-month interim
notice-to-proceed period that commenced on December
The project contract structure is shown in 24, 1996, the contractors were given a full notice to pro-
Exhibit 4. Emcali will purchase power from the facility ceed on March 31, 1997. They committed to complete
under a twenty-year dispatchable PPA with fixed the project in twenty-two months. The contractors have
capacity payments and variable energy payments. The an unlimited obligation to achieve mechanical comple-
capacity payments are designed to cover all fixed oper- tion, which entails installing all components and systems
ating costs, including debt service and return on invest- required by the EPC contract and preparing the plant to
ment. The energy payments pass through actual fuel- begin performance testing. Liquidated damages totaling
supply and transportation costs and other variable oper- up to 40% of the EPC price are payable for schedule
ating expenses. TermoEmcalis tariffs are dollar indexed. delays and performance deficiencies, which are defined in
Under the PPA, tariffs are protected against a change in the EPC contract in terms of net electrical output and
law. Emcali will sell power into the Bolsa when dis- heat rate. Similarly, bonuses may be earned if schedule and
patched by the national dispatch center and directly to performance goals are exceeded.
627

Case studies
EXHIBIT 4
Project Contract Structure
Contract Structure
60% of W/C
Repayment after 3 years The Banks Funding Corp.
Note Proceeds/ Issues 144A notes
Repayments
U.S. Collateral Agent

DSR LOC
Contract LOC
Repayment of W/C Facility Note Proceeds/

<60% 40% Equity Bridge SPC Bechtel Repayment
Deposit of excess amount
Equity/Div.
Equity Div. Lease Payment
Emcali Tariff TermoEmcali CortPacifico Leaseco

(Equity/Div)
Electricity Lease
Onshore EPC
Turbines Purchase Price

Gas Purchase Price Bechtel Overseas O+M Service
Fee
Gas
Ecopetrol Stewart & Bechtel International

gas supply Stevenson using
gas transport Westinghouse
equipment
GAS SUPPLY AGREEMENT the Colombian state-owned oil and gas company. The
project initially will be charged on an annual take-or-
The project executed a sixteen-year firm gas pay basis for 10,000 MMBtu per day, which is equal to
supply agreement with Ecopetrol, starting January 1, 25% of the firm quantity available to the project. The
1999, for up to 42,000 MMBtu per day. Ecopetrol is project has an option to convert all or a portion of the
628

Case studies
remaining 31,000 MMBtu per day to a take-or-pay targets, expenses exceeding the operating budget. It is the
basis if and to the extent Ecopetrol provides notice that largest third-party O&M operator of power facilities in the
a new or existing customer requests a quantity of guar- world. The companys 1996 revenues were $1.3 billion.
anteed gas that exceeds Ecopetrols available supply.
STRUCTURE OF FINANCING
GAS TRANSPORTATION AGREEMENT
Financing for the project was provided by a $165MM
The project executed a ten-year natural gas Rule 144A/Regulation S debt issue lead managed by Bear
transportation agreement with Ecopetrol. The contract Stearns and co-managed by certain institutions including
provides for the firm transportation and delivery of up Dresdner Kleinwort Benson North America LLC, the U.S.-
to 42,000 Mcf per day to the project. Initially, 10,000 based securities affiliate of Dresdner Bank AG.
Mcf per day is subject to a fixed charge regardless of The final maturity of the notes is 2014, 17-3/4
usage. The project has an option to convert all or a por- years from issuance. Average life is 12-3/4 years. The
tion of the remaining 31,500 Mcf per day to a fixed- notes have a twelve-year non-call with a declining call
charge basis to maintain a firm capacity if and to the premium thereafter.
extent Ecopetrol provides notice that a third party seeks It is common for a power project to be financed
that capacity on a firm basis. The natural gas pipeline to with bank loans through the construction period and
supply gas to the project, part of the TransGas system, then taken out with a bond financing. The Termoemcali
is on land adjacent to the project. As a back-up, Ter- project financing was relatively aggressive with a bond
moEmcali will store a five-day supply of diesel fuel. financing out of the box.
Ecopetrol is the state-owned company engaged in
gas supply and transportation and oil production, refining, Alternate Standby Facility
distribution, and marketing. As of year end 1995,
Ecopetrol has sales of US$3.4 billion, net income of To ensure long-term financing for the project,
US$172 billion, and assets of $5.6 billion. It controlled gas Dresdner Kleinwort Benson committed to underwrite a
reserves of 7,665 billion cubic feet, a thirty-year supply. $156 million alternate standby facility to be used if the
The natural gas pipeline is part of the TransGas 144A note issue was unsuccessful or delayed because of
natural gas pipeline system that was expected to com- poor market conditions. Although a bank term loan in
mence service during the second quarter of 1997. place of the 144A note issue was conceivable, the terms
TermoEmcali and Emcali have agreed to share the and conditions for such a loan would have been more
cost of any penalties imposed by Ecopetrol for trans- restrictive and therefore provided an incentive to refi-
portation imbalances on a 50/50 basis unless willful gross nance the facility as soon as possible.
negligence of misconduct can be proven by either party.
In the unlikely event of gas service interruption, Project Contract Letter of Credit Facility
backup fuel oil will be supplied to operate the project
via a) an onsite storage tank equal to five days of pro- The fuel performance letter of credit supports
ject fuel needs, b) a requirement under the gas supply certain payment obligations under the gas supply agree-
contract that Ecopetrol make fuel oil available to the ment and the fuel transportation performance letter of
project during periods of gas unavailability, and c) a credit supports certain payment obligations under the gas
contract with Texaco Oil Company to provide a back- transportation agreement. Both are in an amount of
up oil supply from its nearby oil terminal. US$5.5 million, issued on the financial closing date, and
expiring in five years. Ecopetrol required that the fuel
OPERATIONS AND performance and fuel supply letters of credit be issued by
MAINTENANCE CONTRACT a Colombian bank. A back-to-back letter of credit was
created in which the lending-syndicate banks issued a
Stewart & Stevenson will operate the facility letter of credit in favor of Citibank in Colombia, which
under a six-year contract that provides for cost reim- in turn issued a letter of credit in favor of Ecopetrol,
bursement and a fixed fee with an escalator. Fees are sub- priced at the applicable margin.
ject to adjustment for shortfalls in availability, heat rate The US$8.5 million PPA construction period let-
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Case studies
ter of credit, issued on the financial closing date, con- were necessary. The bank letter-of-credit facility provid-
verts to a $US10 million PPA operating period letter of ed a credit enhancement partly to replace the govern-
credit when commercial operations begin. ment guarantee or power-purchase commitment com-
The project contract LOCs support some of the mon in previous power project financings.
projects payment and performance obligations under The US$13.2 million debt service letter of cred-
the PPA. Drawings under the project contract letters of it facility, equal to six months principal and interest pay-
credit will mature no later than seven years from finan- ments, supports temporary shortfalls in debt service pay-
cial closing. The facility is expected to be renewed and ments to the 144A note holders. Drawings are available
extended annually on an evergreen basis for addi- the earlier of the commercial operation date, the guar-
tional one-year periods. anteed completion date under the EPC contract, or a
date certain, which is defined as thirty-four months plus

Working Capital Facility allowable force majeure delays. Principal payments are
subordinated to the other senior loans. The debt service
A US$12 million working capital facility is avail- reserve lenders have a right to step up or upgrade their
able to support the projects working capital needs on principal repayment status to be pari passu with all
the earlier of the commercial operation date or the date senior secured indebtedness if loans under the facility are
the project is obligated to make its first payment to pur- not paid on time or if the project debt is accelerated.
chase gas. Each working capital loan has a 180-day Fees and interest on the facility rank pari passu and share
maturity, but is required to be repaid only up to the collateral with senior debt.
limit beyond which deposits with the Colombian cen- Sources and uses of funds in connection with
tral bank are required, as explained later. The remain- development, construction, financing, and commence-
der is deposited as cash collateral for the loans. ment of commercial operation of the project were esti-
Shortly before the project financing was closed, mated to be are shown Exhibit 5.
Colombian regulations were changed, in effect, to pro-
hibit the repayment of more than 40% of a loan amount Security Package
during the first three years the loan is outstanding. Under
the new regulations, a borrower who pays more than Senior lenders are secured by a lien on and secu-
40% is required to make a non-interest-bearing deposit rity interest in the collateral, as defined, subject to the
with the central bank. To accommodate repayments of priority of payment on the working capital facility loans.
more than 40%, the lending banks created the available The collateral consists of real and personal property
pledged funds account, a deposit account held by the owned by TermoEmcali and Leaseco, including equip-
U.S. collateral agent. Loan repayments above the 40 % ment, receivables, insurance, and other tangible and
limit are held in the available pledged funds account until intangible assets; all of TermoEmcalis and Leasecos
they can be repaid without a required central bank rights, title, and interest in the project contracts; equity
deposit. Deposits in this account are protected from obligations of the project sponsors; all revenues of the
claims by 144A note holders or any other senior secured borrower; all accounts established under the collateral
parties. They continue to accrue interest at the applica- agency agreement; and all permits and other approvals of
ble borrowing rate even though they are cash collateral- the project.
ized. For subsequent working capital needs, funds are
drawn first from the available pledged funds account to Emcali Support Package
the extent available, and then new loans are extended
under the working capital facility. Recent changes in In addition to the security package, Emcalis obli-
Colombian law required this structure to be amended. gations under the PPA are supported by a letter of cred-
it and a fiducia. Emcali plans to install the fiducia some-
Debt Service Reserve Letter time after closing. Until the fiducia is in place, the letter
of Credit Facility of closing (LOC) is oversized. In the US$424 million
Termobarranquilla power project, closed in November
In previous Colombian power projects such as 1995, the obligations of Corporacin Elctrica de la
Termobarranquilla, state guarantees or undertakings Costa Atlntica (CORELCA) to pay for power were
630

Case studies
EXHIBIT 5 ty and energy payments to the project. Should

Emcali fail to maintain the requisite amount of
Sources and Uses of Funds
collateral in the fiducia, it will be required to pay
Sources US$ (in millions) an escalating premium that will be added to the
capacity payment. If Emcali defaults in its PPA
Sponsor equity 44.8 payment obligation, the fiduciaria (trustee) has the
144A Note issue 165.0 right to utilize daily collections in the designated
Total sources of funds 209.8 collection accounts to satisfy Emcalis obligations
to TermoEmcali. Until a default occurs, Ter-
Uses moEmcali has no right to use funds from the fidu-
cia to satisfy Emcalis obligations. The fiducia no

EPC Price (net) 123.3

longer will be required if Emcalis international
Interconnection/meter 0.8
Land purchase 2.0 credit rating is upgraded to triple B, which likely
Development budget 15.0 would occur only if the Republic of Colombias
Legal fees during development 7.6 sovereign credit rating were upgraded.
Financing and legal fees 5.7
Quorum engineering fees 1.4 HOW THE FINANCING
Owners construction administration 2.5 WAS ARRANGED
Independent engineering during construction 0.2
Start-up costs 5.6 Bear Stearns was engaged by InterGen
Insurance during construction 2.9 before the banks were. InterGen wanted to do a
Taxes and duties during construction 6.8 bond financing out of the box, but recognized
Environmental management 0.2
that this was an ambitious undertaking, and
Interest during construction (net) 25.0
therefore developed a back-up plan in case the
Contingency 10.0
Pre NTP 0.8 bond markets turned unfavorable. This require-
ment led to the idea of an alternate standby facil-
Total uses of funds 209.8 ity to serve as an insurance policy. InterGen ten-
dered the standby letter of credit facility and the
debt service working capital reserve facility to the
banks for bids. Dresdner Kleinwort Benson
guaranteed by Financiera Energetica Nacional S.A. arranged the standby facility, receiving approval from
(FEN), an official Colombian government financial their respective credit committees to underwrite a syn-
institution used to finance the electicity sector, as part dicated loan for the full amount, but did not actually
of part of an emergency programme to increase gener- underwrite the facility because it was not needed.
ating capacity. The letter of credit and the fiducia were Note that bonds can offer longer-term, lower
used in place of a government guarantee in the Ter- financing cost and, to a certain extent, more flexibility to
moEmcali project. a borrower. However, except in unusual circumstances,
The letter of credit, equal to four months of a bank commitment is more reliable in the event that
capacity payments during operations, will be issued by a credit markets change. A sponsor complying with a con-
creditworthy Colombian bank. A back-to-back letter of struction deadline under a PPA does not have the flexi-
credit will be issued in favor of the lenders by an inter- bility to wait until the credit markets improve to do a
national bank with at least a single-A credit rating. The bond financing. The plan for a bond financing backed by
fiducia is a trust that grants TermoEmcali a priority an alternate standby facility provided InterGen with the
interest in a portion of Emcalis operating cash collec- advantages of both. A bond financing, in some ways,
tions in case Emcali defaults in its payment obligations may allow sponsors more flexibility than a bank financ-
under the PPA. Emcalis customers pay their bills at des- ing because bonds are sold to a diverse group of institu-
ignated banks. The fiducia covers collection accounts at tional investors who are not in a position to follow a pro-
those banks to the extent necessary to provide Ter- ject closely on a month-to-month basis and make judg-
moEmcali access to two times average monthly capaci- mental decisions such as temporary forgiveness of
631

Case studies
covenant defaults. On the other hand, disclosure issues that provides for a bond financing or a commercial loan
sometimes make bond financings seem less flexible. In depending on market conditions. Once the universal
the case of environmental liabilities and other unusual bank receives the mandate, it knows that it will be com-
risks and issues, commercial bankers can be more flex- pensated in one way or the other for its analysis, due
ible than investment bankers. Commercial bankers gen- diligence, and other work. In the past, the problem with
erally are willing to discuss unusual situations and this approach has been that few financial institutions
decide whether or not they are acceptable. But for have had really good capabilities on both the commer-
investment bankers, unusual situations may create diffi- cial and investment banking side. But that is beginning
cult disclosure issues. The due diligence process to change as large commercial banks staff up their invest-
requires that unusual risks be disclosed in a prospectus. ment banking groups and buy or merge with investment
Too much disclosure may exaggerate risks, raise pric- banking firms.
ing, and scare off institutional investors. The bonds were oversubscribed. Lake sees several
For a short time before the bond financing, factors that made the bonds attractive to institutional
there was a possibility that the credit facility would be investors: Investors were looking for attractive alternative
used. The bank group agreed on a term sheet with investment opportunities. The TermoEmcali bonds were
InterGen. Lake notes that the banks would have had to investment grade, but also with a good spread. The engi-
move quickly to draft all the required documentation neering and contract structure of the project was sound.
and line up all the participating banks, but essentially Emcali was a relatively strong credit. Colombia had an
they were ready to carry out the syndication. investment-grade credit rating and, despite recent problems
Pricing the alternate standby facility presented a with drugs, terrorism, and political corruption, one of the
challenge to the banks because InterGen did not want strongest, best managed economies in Latin America.
to pay excessively for a facility that was just a back-up
in case the other facility did not work. On the other CREDIT ANALYSIS
hand, Dresdner Kleinwort Benson needed enough
compensation to justify their analysis and preparation in Debt service coverage is projected to be 1.62
the event the syndicated loan was required. times average and 1.54 times minimum. The base case
The banks agreed on a term sheet with InterGen assumes a 17-3/4-year bond tenor (12.61-year average
that provided for a deadline and fees in the event the life) and a 318 basis point spread over U.S. treasuries
standby facility was used. The banks would be given equating to an all-in fixed rate of 10.8%. The PPA large-
sixty-five days to close the loan once the facility was ly insulates the project from interest rate risk since the
activated. As soon as InterGen notified the banks that it capacity payment is adjusted to compensate for interest
wanted to use the facility, it would pay the first part of rate fluctuations within a range of 9.5% to 12%. With
an up-front fee. Additional installments of the up-front the sale of the 144A notes, Emcali effectively locked in
fee would be paid at three-month intervals at increas- the pass-through cost of interest. The Colombian peso
ing rates. Presumably, the standby facility would be devaluation and inflation rates are assumed to be 15%
activated if there was a problem, and the longer the and 19% respectively (see Exhibit 6).
standby facility was utilized, the greater the banks risk
would be. This justified a fee that escalated over time. Credit Rating
We observe that there is inherent tension
between an investment banking firm responsible for a At the time the bonds were issued, TermoEmcali
bond underwriting and a commercial bank group was rated BBB by Duff & Phelps and BBB- by Standard
offering a related standby facility. A client may decide & Poors. The S&P rating for the Republic of Colombia
not to do a bond issue because of market conditions or at that time was BBB-. Lake observes that the rating for
for other reasons. But later, if the client once again a domestic infrastructure project such as Termoemcali,
decides to do the bond issue, it may not be obligated to with revenues collected in local currency, seldom pierces
give the mandate to the same investment banking firm. the sovereign ceiling. The rating was based on the stabil-
Therefore, the investment banking firm risks doing a ity of cash flow to be derived from the power plants sale
lot of work for minimal fees. Alternatively, the client of capacity and energy to Emcali, a corporation rated
may choose a universal bank to underwrite a facility BBB- by S&P. The agency stated that the rating was
632

Case studies
EXHIBIT 6 January 1999, just one

Sensitivity Analysis month behind schedule.
The project was over bud-
Sensitivity Case Average DSCR Minimum DSCR get but had not exceeded
project contingencies.
Base case 1.62 1.54
0% dispatch 1.64 1.52 LESSONS LEARNED
1-year delay in commercial operation date 1.63 1.54
2% reduction in capacity 1.58 1.50 First, an infrastruc-
2% reduction in available capacity 1.58 1.50 ture project such as a
1% increase in average heat rate degradation 1.61 1.53

power plant that generates
10% increase in operating costs 1.60 1.52

local-currency revenues in
10 days per year on fuel oil 1.65 1.56
a developing country can
be financed out of the box
with bonds under the
highly reliant on Emcalis ability and willingness to right circumstances. In this case, the sponsors were of
honor its obligations. In September 1997, S&P con- top quality, Colombia had an investment-grade credit
cluded that construction risk detracts from the credit rating, and the alternate standby facility and debt ser-
quality of the transaction. Although the bondholders vice reserve were additional financing tools to bridge
were protected by liquidated damages of 40% of the timing problems.
EPC contract amount, a $10 million contingency built Second, it is more efficient to provide a bond issue
into the contract budget, and $5.8 million delay in and a standby facility out of the same financial institution.
opening insurance, the agency believed that the twenty- Third, debt-service reserve facilities require care-
four-month construction time frame under the PPA ful risk analysis. Issues include: 1) whether drawdowns
could be tight if force majeure events or other schedul- under such facilities are subordinated to amounts origi-
ing problems occur. But it also noted the additional 12 nally drawn down under a bond indenture or term-loan
month cushion that can be obtained through payments agreement, and 2) whether the pricing of those draw-
for a schedule extension. S&P concluded that as long as downs should be comparable to subordinated debt or
the plant was constructed properly and achieved start-up senior debt, or somewhere in between. Lake notes that in
that Stewart & Stevenson should be able to operate and the subordination waterfall interest payments and fees
maintain the plant with little difficulty, and therefore rank pari passu with senior debt. If a payment under a
that operating risks associated with the project are neg- debt service reserve facility is delayed, the lenders have
ligible. It concluded that fuel risk, borne primarily by the right to raise the status of those overdue obligations
Emcali, is minimal. The agency found the transaction to to the senior debt level. In Lakes opinion, it is important
be well structured with lenders enjoying the benefits of for bankers to understand and properly explain these
a comprehensive security package, but noted that there structures. Generally, for a debt-service reserve facility,
is no treaty or other agreement between the U.S. and sponsors are willing to pay a slight spread over the rate for
Colombia for the reciprocal enforcement of judgments. their senior debt, but they try to avoid paying subordi-
Although New York law governs the financing docu- nated-debt prices for such facilities.
ments, the exercise of remedies by the collateral agent in
the event of a default likely would require litigation in ENDNOTE
the Colombian courts.
As of late 1998, S&Ps rating for TermoEmcali The views and opinions expressed in this article are
continued to be BBB-. The estimated completion those of the author and do not necessarily express those of
date for the plant after minor turbine problems was Dresdner Kleinwort Benson.
633

Project Financing
634

Glossary

Glossary
Accreting swap An interest rate swap in which the notional principal amount increases at
a predetermined way over time.
Account party In a commercial letter of credit, the party instructing the bank to open a
letter of credit and on whose behalf the bank agrees to make payment. In most cases, the
account party is an importer or buyer, but alternately, may be a construction contractor
or a supplier bidding on a contract.
Accounts payable Money owed to suppliers. Also called payables and trade payables.
Accounts receivable Money owed by customers. Also called receivables and trade credit.
Accrual accounting A method of accounting in which revenue is recognised when earned
and expenses are recognised when incurred without regard to the timing of cash receipts
and expenditures (see cash accounting).
Accrued interest Interest due from the issue, or from the last coupon date to the present
on an interest-bearing security, or from the last payment date on a loan.
Acid test or quick ratio Current assets, less inventories, divided by current liabilities.
Advance payment guarantee An arrangement whereby a person employing a contractor
makes funds available to the contracting party for purchase of equipment and organi-
sational expense necessary to get the construction under way.
Advised letter of credit A commercial letter of credit whose authenticity has been verified
by a bank, generally in the beneficiarys location. This bank then advises the beneficiary
of the authenticity of the letter of credit but does not take on any payment obligation.
Affiliate A corporation which directly, or indirectly through one or more intermediaries,
controls, is controlled by, or is under common control with another corporation.
Affiliated corporation See Affiliate.
After-tax cash flow Total cash generated by an investment annually, defined as profit
after-tax plus depreciation, or equivalently, operating income after tax plus the tax rate
times depreciation.
After-tax real rate of return Money after-tax rate of return minus the inflation rate.
Agent A firm that executes orders for or otherwise acts on behalf of another party (the
principal) and is subject to its control and authority. The agent may receive a fee or a
commission for its services.
Agreement among (by) underwriters A legal document forming underwriting banks into
a syndicate for a new issue and giving the lead manager the authority to act on behalf
of the group.
Alternative risk transfer In risk management, the creation of products to transfer the
increasingly complex risks identified by companies that cannot be dealt with by tradi-
tional insurance. These products combine elements of traditional insurance and capital
market instruments to achieve a customised solution to the risk transference problem.
All-in cost Total costs, explicit and other.
All-in rate An interest rate on a loan which includes the cost of compensating balances,
commitment fees and any other charges.
637

Glossary
Allocated costs Costs, systematically assigned or distributed among parties, products, depart-
ments, or other elements.
American option An option that can be exercised at any time prior to and including its
expiration date.
Amortisation The gradual reduction of any amount over a period of time. A general term
which includes various specific practices such as depreciation depletion, write-off or
intangibles, prepaid expenses and deferred charges; or general reduction of loan prin-
cipal. Gradual repayment of a debt over time. Repayment through the operation of a
sinking or purchase fund.
Amortising swap An interest rate swap in which the notional principal amount decreases
in a predetermined way over the life of the swap.
Annual report A yearly report to shareholders by a corporation containing financial state-
ments (balance sheets, income statement, source and application, and funds statement),
auditors statement, presidents letter and various other information.
Annuity A level stream of cash flows for a limited number of years (see also perpetuity).
Arbitrage A general term for transactions involving moving capital from one market to
another, from one security to another or from one maturity to another, in the hope of
realising a higher yield or capital gain.
The simultaneous purchase and sale of the same commodity in two different markets
in order to profit from price discrepancies between the markets. Economists believe
the elimination of intermarket price differentials through arbitraging renders markets
more efficient.
Asset-backed securities Securities collateralised by a pool of assets. The process of creating
securities backed by assets is referred to as asset securitisation.
Asset turnover ratio A broad measure of asset efficiency, defined as net sales divided by
total assets.
Assignment A transfer of legal title.
At-risk rules Federal tax laws that prohibit individuals (and some corporations) from
deducting tax losses from equipment leases in excess of the amount that they have
at risk.
At-the-money option An option with an exercise price equal to or near the current price
of the underlying futures contract.
Atradius The trade finance agency for the Netherlands.
Auditors statement A letter from the auditor to the company and its shareholders or
investors in which the accounting firm certifies the propriety of the methods used to
produce the firms financial statements.
Average collection period The number of days required, on average, to collect
accounts receivable.
Average life Average life is the weighted average of the maturities of a given loan.
Average payment period The number of days, on average, within which a firm pays off
its accounts payables.
Average rate currency option An option that has a payoff that is the difference between
the strike exchange rate for the underlying currency and the average exchange rate over
the life of the option for the underlying currency. Also called an Asian currencyoption.
638

Glossary
Back-to-back letter of credit A letter of credit issued on the strength of another letter of
credit (backing credit). It is, in effect, an extension of the terms and conditions of the
backing credit. To qualify as a back-to-back credit, the terms must be identical with those
of the backing credit except for any or all of the following features: the beneficiarys
name; the account party; the amount, which cannot be more than that of the backing
credit; the validity date; and the insurance amount.
Balance reporting A computerised service offered by banks to clients that allows clients
to obtain daily balance information on their different bank accounts.
Balance sheet An accounting statement that displays the assets, liabilities and equity of
a company.
Balloon payment Where a term loan is amortised in equal periodic installments except
for the final payment, which is substantially larger than the other payments, the final
payment is known as a balloon payment.
Bank draft An international transfer of funds using an instrument that is much like a
cheque in use and appearance.
Bank line A line of credit granted by a bank to a customer.
Bankers acceptance A form of credit created when a bank accepts a time draft drawn
on itself. By accepting a draft, the bank is obligated to pay the face amount at a
specified time in the future, usually six months or less after the acceptance of the draft.
In many situations, a seller of merchandise can sell the acceptance for an amount
less than face value and have use of funds until repayment on the maturity date of
the acceptance.
Bankruptcy A legal condition in which an individuals or companys assets are assumed
by a federal court official and the company is operated and/or its assets are used to
pay off creditors.
Bareboat charter A net lease of a ship.
Bargain purchase option A provision that allows a party, at its option, to purchase an
asset for a price that is sufficiently lower than the expected fair market value at the
time such option becomes exercisable so that the exercise of the option appears, at the
inception of the lease, to be reasonably assured.
Barter Known also as countertrade, it entails the settlement of trading accounts by a method
of indirect swap and has become increasingly important in trade between East and West
and with currency starved Third World nations. It obviates the need to dip into precious
foreign exchange reserves.
Base rate Floating interest rates on bank loans in the United States are quoted on the basis
of the prime rate or the base rate of the lender.
Base rent Rental paid during the base term of the lease.
Base lease term The basic term of the lease used by the lessor in computing payout and
relied on by the lessee as the minimum time period during which the lessee will have
the use and custody of the equipment.
Basic term Same as base term.
Basis In the futures market, the difference between the cash price and the futures price.
Basis point One one-hundredth of a percent, typically used in expressing rate or
yield differentials.
639

Glossary
Basis risk In a swap, the risk between two different instruments used to index the floating-
rate side of a swap transaction. For example, if one swap is written at 4% fixed against
six-month Libor and the offsetting swap is written at 4% against six-month certificates of
deposit (CD), then there is a risk that over time the spread between Libor and CDs will
vary, resulting in a gain or loss for either party. In hedging, the risk that the hedger takes
that the basis will change because the futures will be mispriced relative to the cashprice.
Basis swap An interest rate swap from one reference into another reference in the
same currency.
Bear market A declining market or a period of pessimism when declines in the market
are anticipated.
Bearer bond A bond for which the only evidence of ownership is possession.
Bearer security A security whose owner is not registered on the books of the issuer. A
bearer security is payable to the holder.
Berne Union Leading global organisation for export credit insurance agencies.
Bid and ask price Bid is the highest price a prospective buyer is prepared to pay at a
given time for the tradeable unit of a specific security; asked is the lowest acceptable
price to a prospective seller of the same security. Collectively, the two prices represent
a quotation and the difference between them is the spread.
Bid bond A bond to ensure that a party awarded a contract will accept the award and
perform the contract. A financial guarantee given in support of the obligation of a bidder
to sign a contract if he is successful in his bid.
Bid price The price offered.
Bid rate The rate at which a dealer is willing to purchase foreign currency in the spot or
forward market.
Bills Government debt securities issued on a discount basis by the US Treasury or similar
in other countries for periods of one year or less (Treasury bills).
Bill of lading A document issued by a transportation company giving evidence of the
movement of the goods from one location to another. The bill of lading is a receipt
for the goods and a contract for their delivery and in some forms represents the title to
the goods.
Black/Scholes formula An option pricing formula based on the assumption that a riskless
hedge between an option and its underlying should yield a riskless return. Black/Scholes
asserts that option value is a function of the underlyings price, strike price, volatility,
riskless interest rate, exercise style and maturity.
Blocked accounts In a foreign exchange context, deposits maintained in a country
which does not allow exchange into another currency or removal of the deposits from
the country.
Blocked currency A currency whose convertibility or transferability is restricted, in part or
whole, by government regulations. There are generally considered to be three categories
of currency: convertible, semi-convertible and non-convertible. Blocked currency belongs
in the latter two categories.
Bond A bond is a negotiable note or certificate which evidences indebtedness. It is a legal
contract sold by one party, the issuer, to another, the investor, promising to repay the
holder the face value of the bond plus interest at future dates. Bonds are also referred
640

Glossary
to as notes. The term note usually implies a shorter maturity than bond. Some bond
issues are secured by a mortgage on a specific property, plant, or piece of equipment.
Bond rating An appraisal by a recognised bond rating service of the soundness of a bond
as an investment.
Bond warrants Warrants attached to bonds (or other securities) that permit the purchase of
further bonds with the same or a lower coupon in the future are called bond warrants.
The investor is given the benefits if interest rates fall before he receives money from the
sale of the warrants. This warrant or option reduces the overall cost of borrowing by
the original issuer.
BOO Build, own and operate type project financings.
BOOT Build, own, operate and transfer type project financings.
Book value The value at which an item is reported in financial statements.
Book value of project Assets minus liabilities.
BOT Build, own and transfer type project financings.
Bought deal A Eurobond issue which is fully underwritten on fixed terms and conditions
by the lead manager. A bought deal occurs when the Lead manager offers to launch an
issue with a specified price and coupon.
Bracketing The group of underwriters in a syndication. The major investment banking firms
come first, but they can be elsewhere. Other brackets are determined by participating
underwriters size and capacity to place securities.
Break-even analysis Analysis of the level of sales at which a firm or product will just
break even.
Bridge financing Interim financing of one sort or another.
Broker Brokers are intermediaries who trade in a variety of financial instruments including
foreign exchange, equities, commodities, bullion or insurance on behalf of their clients
and who charge a fee or commission for this service and advice. Brokers fulfil
an important function in the market by bringing together buyers and sellers in an
efficient manner.
A broker brings buyers and sellers together for a commission paid by the initiator of
the transaction or by both sides.
Bulldog bond A foreign bond, denominated in sterling and issued in the UK domestic bond
market in London is known as a Bulldog bond.
Bullet loan A term loan with periodic instalments of interest only with the entire principal
due at the end of the term as a final payment. The final payment on a balloon loan is
sometimes referred to as a bullet.
Business risk Risk due to uncertainty about investments outlays, operating cash flows and
salvage values without regard to how investments are financed.
Buy-back Another term for a repurchase agreement.
Buy on close To purchase traded security or a futures contract at the end of the
exchanges trading day at a price within the closing range. Buy on opening is the
opposite arrangement.
Call money Interest-bearing bank deposits that can be withdrawn on 24-hour notice. Many
Eurodeposits take the form of call money.
641

Glossary
Call option A contract sold for a price that gives the holder the right to buy from the
writer of the option, over a specified period, something (referred to as the underlying)
at a specified price.
In a bond or loan, the call option gives the borrower a refinancing option if interest
rates fall below the call option interest rate. The borrower will pay a higher coupon for
this right.
Call price The price at which an issuing firm may call in its bonds. Usually the call price is
set above the par value. In the case of convertible bonds, a call price is a feature used
to force conversion into common stock.
Callable bond A bond that the issuer has the right to redeem prior to maturity by paying
some specified call price.
Cap An agreement between two parties whereby one party, for an upfront premium, agrees
to compensate the other at designated times if the underlying (that is, a designated price
or rate) is greater than the strike level.
Capital The amount invested in a venture.
Capital appreciation The upward change in the value of an asset from one date toanother.
Capital appreciation bonds Zero-coupon bonds sold at par or better.
Capital budget List of planned investment projects.
Capital budgeting A method for evaluating, comparing and selecting projects to achieve
the best long-term financial return.
Capital cost recovery allowances Tax depreciation deductions.
Capital expenditures Long-term expenditures for plant and equipment.
Capital gains Profits from the resale of assets that have been held for investment. In many
jurisdictions capital gains are taxed at a different rate than profits from operations.
Capital impairment rule A requirement in most states limits the payment of cash dividends.
This is to protect the claims of creditors in case of insolvency.
Capitalised lease A lease is classified and accounted for by a lessee as a capital lease in
the United States if it meets any of the following criteria:
the lease transfers ownership to the lessee at the end of the lease term;
the lease contains an option to purchase property at a bargain price;
the lease term is equal to 75% or more of the estimated economic life of the
property (exceptions for used property leased towards the end of its use ful life);
or
the present value of minimum lease rental payments is equal to 90% or more
of the fair market value of the leased property less related ITC retained by the
lessor. (In the UK, a subjective test is substituted).
Capital structure The financing mix of a firm. The more debt in relation to equity, the
more financial leverage or gearing the firm is said to have.
Capped FRN A floating rate note with a maximum rate of interest.
Captive finance company Finance company established by a parent company to provide
financing of its manufactured goods or services.
Captive insurance company An insurance company established by a parent company
often for the specific purpose of insuring against difficult-to-cover risks identified by the
parent company.
642

Glossary
Carve-out An exception to a general rule or provision or covenant. Refers to a production

payment carved out of a larger production payment, or a right to a specified share of
production from a certain mineral property.
Carved-out production payment loan A loan secured by a carved-out productionpayment.
Cash accounting A method of accounting in which changes in the condition of an organi-
sation are recognised only in response to the payment or receipt of cash.
Cash budget A plan or projection of cash receipts and disbursements for a given period
of time.
Cash cow Company or product that generates more cash than can be productively reinvested
in that particular company or product.
Cash cycle The number of days between the purchase of raw materials and the collection
of sales proceeds for finished goods.
Cash flow Reported profits plus depreciation, depletion and amortisation. Net income, depre-
ciation and amortisation during the period analysed. A measure of a companys liquidity,
consisting of net income plus non-cash expenditures (such as depreciation charges). In
a credit analysis, cash flow is analysed to assess the probability that debt retirement
commitments can be met without refinancing, that regular dividends will be maintained
in the face of falling earnings, or that plant and equipment can be modernised, replaced
or expanded without increasing the equity or debt capital.
Cash market This term has been used to denote the market in which stocks, debt instru-
ments and commodities are traded for immediate delivery against cash.
Cash turnover The number of times a firms cash is collected in a year.
CBO Collateralised bond obligation.
Central bank The official government-owned bank in a foreign country.
Certificate of deposit (CD) A negotiable, interest-bearing, instrument evidencing a time
deposit with a commercial bank on which the bank pays principal at maturity. Interest
may be paid at intervals or at maturity. Large denomination CDs are typicallynegotiable.
CHIPS An acronym for the Clearing House Interbank Payments System, a computer system
operated by New York banks to settle international payments. Using CHIPS, checks are
cleared, other instruments are exchanged and net balances are settled among banks. Most
Eurotransactions are cleared and settled through CHIPS rather than over the Fed wire.
Clean letter of credit A letter of credit payable upon presentation of a draft, not requiring
the presentation of documents.
Clearing house Facility through which transactions executed on the floor of an exchange
are settled. Also assures the proper conduct of an exchanges delivery system and the
adequate financing of trading.
Clearing member Member of an exchanges clearing house or professional association.
Trades executed by non-members must typically be registered and settled through a
clearing member.
Clearstream Formerly known as CEDEL, this is one of the two major organisations in the
Eurobond market which clears, or handles, the physical exchange of securities and stores
securities. Based in Luxembourg, the company is owned by several shareholding banks
and operates on a non-profit basis.
643

Glossary
Clip and strip bonds In this type of bond, the principal and coupon portion of the bonds
may be split apart and sold separately.
CLO Collateralised loan obligation.
Closed-end lease A true lease in which the lessor assumes the risk of depreciation and
residual value. The lessee bears little or no obligation at the conclusion of the lease.
Usually a net lease in which the lessee maintains, insures and pays property taxes on the
equipment. The term is used to distinguish a lease from an open-end lease, particularly
in automobile leasing.
Closing documents The final documents designed to complete a business transaction.
COFACE Compagnie Francaise dAssurance pour le Commerce Exterieur. The trade finance
agency for France.
Co-generation facility A plant which produces steam to generate electricity and residual
steam or heat for other uses.
Collar swap A swap of fixed rate dollars against floating rate dollars with the latter having
a maximum and minimum rate.
Collateral Assets pledged as security under a loan or lease, to assure repayment.
Collecting bank A bank, generally in the vicinity of the buyer, that acts as an agent for
the remitting bank. The collecting bank demands payment from the buyer and handles
the funds received as instructed; generally, the funds are sent back to the remittingbank.
Co-manager A member of the management group of a securities offering other than the
lead manager(s).
Commercial bank A bank that both accepts deposits and grants loans and, under certain
stipulations in some countries such as the United States, pays interest on checkingaccounts.
Commercial mortgage mortgage-backed securities Mortgage-backed securities collat-
erised by commercial mortgages.
Commercial paper An unsecured promissory note with a fixed rate and fixed maturity of
no more than 270 days in the US. Commercial paper is normally sold at a discount
from face value.
Commercial risks Out-of-pocket costs that go to the financial health and soundness of
the project. Construction costs, equipment costs, overrun exposure, raw material supply
cost, energy supply cost, operating costs and contracts for a sale of product or services.
Commission Fee charged by brokers for handling sales or trades or for arrangingtransactions.
Commission house Firm that buys/sells actual commodities of futures contracts for customer
accounts. Income is generated through commissions charged to customers.
Committed loan facility A legal commitment undertaken by a bank to lend to a customer.
A line of credit.
Commodity bonds Bonds with interest rates or par value tied to the price of a
certain commodity.
Commodity swap A swap in which the exchange of payments by the counterparties is
based on the value of a particular physical commodity such as oil.
Common equity The value of common stock issued by the firm. Common stockholders
are the junior equity owners and are the last to receive payment in case of insolvency.
Common stock Securities representing ownership of a corporation. Classification of stock
which is junior to other classes stock. (See common equity.)
644

Glossary
Compensating balances A banking practice whereby the lending bank requires the
borrower to maintain deposit balances equal to specified percentage of the loan amount
and/or the commitment. In addition to charging interest on loans, banks frequently require
a borrower to maintain demand-or-time-deposit balances at the bank in proportion
to the amount of funds borrowed, or the amount of the commitment, or both. The
compensating balance requirement raises the effective cost of borrowing if the borrower
maintains above the amount the borrower would normally retain on deposit.
Compound interest Interest resulting from the periodic addition of simple interest to prin-
cipal, the new base thus established being the principal for the computation of interest
for the following period. Interest returns are compounded by reinvesting one periods
income to earn additional income the following period.
Compound value The end-period value of a sum earning a compounded return.
Concentration In banking terms, the centralisation of a cash pool.
Conditional sale A transaction for the purchase of an asset in which the user, for
federal income tax purposes, is treated as the owner of the equipment at the outset of
the transaction.
Conditional sale lease A lease which in substance is a conditional sale (sometimes called
a money-over-money lease or a lease intended as security).
Confirmed letter of credit A letter of credit in which the issuing banks obligation to pay
is backed by a second bank. The confirming bank agrees to pay if the terms of the letter
of credit are met, regardless of whether the opening bank pays.
Conglomerate diversification Ownership of operations in a number of functionally unre-
lated business activities.
Consortium project A project structured by two or more parties as a partnership or
joint venture.
Constant-dollar accounting System of inflation accounting in which historical-cost items
are restated to adjust for changes in the general purchasing power of the currency.
Constant purchasing power The amount of a currency required over time to purchase a
stable basket of physical assets.
Consumer price index (CPI) An index measure of inflation equal to the sum of prices of
a number of assets purchased by consumers weighted by the proportion each represents
in a typical consumers budget.
Contingent liability A contingent liability is a liability which may arise sometime in the
future, may never arise and is dependent upon some factor other than the passage of
time. Examples of this kind of liability are potential legal rulings against the company
or contract payments due in the future. The notes to financial statements should include
a description of contingent liabilities.
Contingent rentals Rentals in which the payment of rents are dependent on some factor
other than the passage of time.
Contingent swap A swap in which terms are predetermined but which is activated by the
action of a third party, such as the exercising of a warrant. Also known as an optionswap.
Continuous tender panel In connection with Euronotes, a panel which has characteristics
of both a sole-placing agency and a tender panel. The CTP agent agrees on the issue
price (the strike offered yield or SOY) with the issuer and underwriting banks may
645

Glossary
request protection on their national allocations at the agreed price. Such allocations are
calculated pro rata to their underwriting commitments but are only exercisable to the
extent that the CTP agent has not pre-sold the issue tranche. The SOY can change during
the bidding period and underwriters may be able to increase their initial allocations by
bidding at or under the SOY.
Contract for differences Contract that specifies that any difference between the market
price at a settlement date and the contractual specified sale price at the settlement date
is settled via a cash payment.
Conversion premium The difference between the current price of a firms stock and the
conversion price of a convertible security.
Conversion price The price at which a convertible security may be exchanged for
common stock.
Conversion ratio The number of shares of stock for which a convertible security can be
exchanged. It is calculated by dividing the par value by the conversion ratio.
Convertible bond A bond containing a provision that permits conversion into other securi-
ties of the issuing entity, typically common stock at some fixed exchange ratio.
Convertible currency A currency which can be freely exchanged into foreign currency
or gold without government central bank restrictions or authorisation. Major inter-
national currencies like the dollar, the euro, yen and sterling are fully convertible and
are the lifeblood of international trade. To be truly convertible, a currency must have
adequate foreign exchange reserves or gold to support possible demand on the currency.
Alternatively, it must enjoy the confidence of global money markets.
Convertible debt Debt convertible to other equity or debt issues of the issuer upon the
happening of certain events and/or at the option of the lender.
Convertible security A feature of certain bonds, debentures or preferred stocks which
allows them to be exchanged by the owner for another class of securities; in accordance
with the terms of the issue.
Cost company A corporation with nominal capital which holds title to a mineral interest
and production facilities, in which the shareholders agree to take product in propor-
tion to their ownership. For tax purposes, the corporation files an information return
and its shareholders report their pro rata shares of income and deductions. Sometimes
used to describe a joint venture which has elected not to report federal income tax as
a partnership, but instead will flow through expenses and revenues to joint venturers.
Cost of capital The rate a firm must pay to investors in order to induce them to purchase
the firms stock and/or bonds.
Cost of debt Yield to maturity on debt; frequently after tax, in which event it is one minus
the tax rate times the yield to maturity.
Cost of goods sold (cost of sales) The sum of all costs required to acquire and prepare
goods for sale.
Countertrade Known also as barter, it entails the settlement of trading accounts by a method
of direct exchange of goods or services of agreed equivalent value between parties and
has become increasingly important in trade where precious foreign exchange reserves
might otherwise be diverted from core activities, such as food or fuel import programs
in emerging economies.
646

Glossary
Coupon The annual rate of interest on the bonds face value that a bonds issuer promises
to pay the bondholder. One of a series of actual certificates attached to a bond, each
evidencing interest due on a payment date.
Coupon rate The rate of interest received by a bondholder on an annual, bi-annual or
quarterly basis.
Covenant A loan covenant is agreement by a borrower to perform certain acts, such as the
timely providing of financial statements, or to refrain from certain acts such as incurring
further indebtedness beyond an agreed level.
Covered option An option whereby the seller, or writer, owns the underlying stock, as
against uncovered options, or naked options, where the option is written against cash
or other margin.
Credit default swap Simplest and most common type of credit derivative for transferring
credit risk.
Credit derivative Derivative instrument designed to transfer the credit exposure of an
underlying asset or assets between two parties.
Cross-border leasing A lease transaction in which the lessee is located in one country and
the lessor is located in another country.
Cross-border loans Cross-border loans consist of loans in which a bank in one country
lends to the borrower in a separate country. Also refers to a syndicate of banks from
one or more countries loaning to a project or borrower in another country.
Cross-collaterised pooled financing Pooled securities allowing recourse to other mortgages
or security interests in the pool.
Cross-currency interest rate swap A swap that combines the features of single currency
interest rate swaps and currency swaps.
Cross-currency loans Cross-currency loans refer to a bank in one country making a
commercial loan to a borrower in the same country or in a second country using the
currency of a third country.
Cross hedge Hedging a risk in a cash market security by buying or selling a futures contract
for a different but similar instrument.
Cross hedging risk When cross hedging, the risk that the price movement of the under-
lying of the futures contract may not accurately track the price movement of the asset,
currency, or commodity whose risk is to be hedged.
CRUF A collateralised revolving underwriting facility. The collateral can be receivables, shares,
loans or other assets.
Cumulative preferred stock Preferred stock containing the requirement that any unpaid
preferred dividends accumulate and must be paid in full before common dividends may
be distributed.
Currency option A currency option entitles the holder to buy or sell a certain amount
of foreign currency at a specific price until a specific date. It differs from a future or
forward purchase or sale of exchange in that the forward or future contract implies an
obligation to buy or sell currency, while the option confers a right which need not be
exercised. To the seller, or writer, the option is a contingent obligation to buy or sell
currency at a stated price until a specific date. From the sellers viewpoint, the option
647

Glossary
differs from a forward or future purchase or sale of currency because he cannot know
whether the option will be exercised.
Currency swap A swap in which the parties sell currencies to each other subject to an
agreement to repurchase the same currency in the same amount, at the same exchange
rate, and at a fixed date in the future.
Current asset Any asset which will turn into cash within one year.
Current expenditures Short-term expenditures that are completely charged to income in
the year in which they occur.
Current liability Any liability which is payable within one year.
Current maturity Current time to maturity on an outstanding note, bond, or other money
market instrument; for example, a 10-year note one year after issue has a current matu-
rity of nine years.
Current portion of long-term debt That portion of long-term debt which is payable
within one year.
Current ratio Current assets divided by current liabilities (a liquidity measure).
Current yield The current yield measures the annual income return on a particular security.
Expressed as an annual percentage the current yield is defined and calculated as follows:
Current yield (%) = Coupon/Net price 100
The net price is expressed as a percentage of the securitys market price and excludes
accrued interest.
Cushion bonds High-coupon bonds that sell at only a moderate premium because they
are callable at a price below that at which a comparable non-callable bond would sell.
Cushion bonds offer downside protection in a falling market.
Daily adjustable securities Puttable long-maturity bonds with coupon rate adjusteddaily.
Daily sales in cash A measure of managements control of cash balances, defined as cash
divided by sales per day.
DBFO Design, build, finance, operate.
Dealer A securities dealer, as opposed to a broker, acts as a principal in all transactions,
buying and selling for his own account.
Debenture An obligation secured by the general credit of the issuer rather than being backed
by a specific lien on property.
Debt (liability) An obligation to pay cash or other goods or to provide services toanother.
Debt capacity The total amount of debt a company can prudently support, given its earn-
ings expectations and equity base.
Debt/capitalisation ratio The ratio of a firms debt to its capitalisation. The higher this
ratio, the greater the financial leverage and the risk.
Debt/equity ratio The ratio of a firms debt to its equity. The higher this ratio, the greater
the financial leverage of the firm.
Debt leverage The amplification in the return earned on equity funds when an investment
is financed partly with borrowed money.
Debt securities IOUs created through loan-type transactions such as: notes, commercial
paper, bank CDs, bills, bonds and other instruments.
Debt service Payments of principal and interest on a loan.
648

Glossary
Deep discount bond Similar to a zero coupon bond, except that the coupon rate is
substantially under market at time of issuance. The bonds are purchased at less than
par value and the investor realises a return on the difference between the issue price
and par value.
Default Failure to make timely payment of interest or principal on a debt security or to
otherwise comply with provisions of a bond indenture or loan agreement.
Default premium The increased return on a security required to compensate investors for
the risk the company will default on its obligation.
Defeasance In loans and leases and swaps, a substitution of a lump sum payment for the
present value of a stream of payments.
Deferred coupon bonds Bonds in which the interest payment is postponed to some date
prior to maturity.
Deferred tax liability An estimated amount of future income taxes that may become
payable from income already earned but not yet recognised for tax reporting purposes.
Deficiency agreement An agreement to guarantee revenues will be received or expenses
paid to make up a shortfall needed to pay debt.
Demand deposit A bank deposit that may be withdrawn by the depositor at any time
without prior notice of intended withdrawal.
Demand line of credit A bank line of credit that enables a customer to borrow on a daily
or an on-demand basis.
Depletion An income tax deduction figured as a percent of the gross income received from
the sale of natural resources, computed property-by-property, but not to exceed 50% of
net income. Percentage depletion deduction varies for various minerals.
Depreciation The allocation of an assets cost, for tax or management purposes over a
period of time based on its age.
Derivatives Financial arrangements whose returns are linked to, or derived from, some
underlying stock, bond, commodity or other asset. They come in two basic types: options
and forward-type derivatives, which include forwards, futures and swaps. They may be
listed on exchanges or negotiated privately between institutions.
Derivative securities Trade like normal bonds, but their returns are determined by, or
derived from, other factors than plain old interest rates. For instance, returns on structured
notes may vary in line with changes in stock prices, commodity prices, foreign-exchange
rates or two different interest rates. Returns on mortgage derivatives involve bets on the
rate at which homeowners will repay mortgages and often act like leveraged interest
rate options.
Devaluation A formal government action which has the effect of decreasing the value of its
own national currency by reducing the equivalent value in gold, special drawing rights,
US dollars or other currencies is a devaluation. However, devaluation is only possible
where fixed exchange rates exist.
Development bank A lending agency that provides assistance to encourage the establish-
ment of productive facilities in different countries.
Development carve-out A portion of the production payment estimated to cover the
development costs (intangible expenses) of an oil or gas well or mine. In the case of an
oil well, most of the expenses up to installation of the Christmas tree.
649

Glossary
Development carve-out loan A loan secured by a development carve-out.

Dim sum bond A renminbi or Chinese yuan denominated bond issued in Hong Kong by
Chinese and non-Chinese companies.
Direct bid facility In Euronotes, a provision in tender panel facilities whereby members
may make unsolicited bids to the issuer for particular note amounts or maturities.
Direct collection A service offered by a bank on a case basis to sellers with high volumes
of collection activity in order to expedite processing and thus accelerate payment. The
remitting bank provides the collection forms which the seller, rather than the bank,
prepares and mails, with any accompanying documentation, to the overseas collecting
bank. Copies of the collection form are sent to the remitting bank for control and for
follow-up if payment is not received.
Direct financing lease A lease classification for a financing lessor in which the lease meets
any of the criteria defining a capital lease and for which (a) collectibility of the minimum
lease payments is reasonably assured; and (b) there exists no important uncertainties as
to costs yet to be incurred by the lessor under the lease.
Direct lease A lease in which the lessor provides the entire purchase price for the leased
asset from the lessors own funds.
Direct paper Commercial paper sold directly by the issuer to investors.
Direct placement Selling a new issue not by offering it for sale publicly but by placing it
with one or several institutional investors.
Direct reduction loan A loan in which the interest portion of the periodic payment is
computed for the amount of the principal base outstanding for that period. The new
principal base is then established by subtracting the remaining portion of the loan payment
amount that was not designated as interest.
Disbursement A term used in accounting and finance to indicate the actual paying out
of cash.
Discount bond A bond selling below par.
Discount note A note sold on a discount basis; the standard form of a Euronote.
Discount securities Non-interest-bearing money market instruments that are issued at a
discount and redeemed at maturity for full face value; for example, US Treasury bills.
Discount window A facility provided by the US Federal Reserve Bank enabling member
banks to borrow reserves against collateral in the form of government securities or
acceptable paper.
Discounted cash flow A cash flow occurring sometime in the future which has been
discounted by a given discount factor on a compounded basis; the present value of a
future cash flow.
Discounted note An instrument of indebtedness specifying the full repayment amount at
par or face value. The current proceeds of the note are thus less than the face value,
the difference representing the interest portion or the discount amount.
Discounted rate of return The effective periodic rate that would equate the present value
of an investment with the accumulated present values of a stream of future cash flows,
each appropriately discounted by the periodic rate.
Discounted value The computation of the present value of a given stream of future
cash payments.
650

Glossary
Dividend A return on an investment in stock, usually in the form of cash or stock.

Dividend yield The annual dividend payment divided by the market price of a share of
the stock.
Documentary letter of credit A letter of credit that requires documents to accompany the
draft or demand for credit.
Documented discount notes Commercial paper backed by normal bank lines plus a letter
of credit from a bank stating that it will pay off the paper at maturity if the borrower
does not. Such paper is also referred to as LOC (letter of credit) paper.
Dodd-Frank Act The Dodd-Frank Wall Street Reform and Consumer Protection Act was
signed in to law in the US in 2010 and makes a number of major changes to regula-
tion and market surveillance, as well as securitisation and derivatives trading and risk.
Dollar price of a bond The percentage of face value at which a bond is quoted.
Domestic bonds Domestic bonds are bonds issued by a borrower in its countrys own
domestic bond market.
Double-declining balance method A method that uses a constant rate (usually double
the straight-line ratio) to depreciate the book value of an asset.
Double-dip lease A lease that uses significant tax or funding incentives from two sources,
usually situated in two countries.
Down-under bonds Euro-Australian dollar bond issues and Euro-New Zealand dollar
bond issues.
Draft A written order, much like a cheque in appearance, used as a formal order for payment
in a business transaction.
Drawee The party named on a cheque or draft from whom payment of the draft isexpected.
Drawer The party who orders, in a bill or draft, that money be paid over to a third party
by the drawee.
Dual convertible bond A bond convertible into more than one type of instrument, at the
option of the investor.
Dual currency account An account kept by a bank in one country with a bank in a second
country. The bank in the first country keeps the account in both its currency and the
other countrys currency.
Dual currency bonds Interest on dual currency bonds is paid in one currency and the
principal is repaid in a different currency with the rate of exchange fixed when the
issue is launched.
Dual-currency yen bonds and so on A bond in which interest is paid in yen and principal
is paid in other currency at a specified exchange rate.
Due from account A banks deposit account maintained in another bank.
Due to account A deposit account maintained by one bank for another bank.
Dun & Bradstreet A firm that rates the creditworthiness of many borrowers and generates
financial ratios for many industry groups.
Dutch auction An auction in which the lowest price necessary to sell the entire offering
becomes the price at which all securities offered are sold.
E-commerce Business conducted by electronic data transfer.

EBIT Abbreviation for earnings before interest and taxes.
651

Glossary
EBRD European Bank for Reconstruction and Development based in London and focused
on eastern Europe and the former Soviet Union.
ECGD Exports Credits Guarantee Department of the United Kingdom.
ECICS Export Credit Insurance Corporation of Singapore.
EDC Export Development Corporation. The trade finance agency for Canada.
EKN Exportkreditnamden. The trade finance agency for Sweden.
ERG ERG Geschaftsstelle fur die Export-risikogarantie. The trade finance agency
for Switzerland.
Earnings The excess of revenues over all related expenses for a given period of time.
Sometimes used to describe income, net income, profit or net profit.
Earnings per common share The net income of a company, minus any preferred dividend
requirements, divided by the number of outstanding common shares.
Earnings per share Same as earnings per common share.
Earnings yield Earnings per share divided by stock price.
Economic life of property The estimated period during which the property is expected to
be economically usable by one or more users, with normal repairs and maintenance, for
the purpose for which it was intended at the inception of the lease.
Edge Act subsidiary A subsidiary established under Section 25(a) of the US Federal Reserve
Act passed on December 24, 1919 with the title Banking Corporations Authorised to
do Foreign Banking Business. In practice the structure was used by many US banks
to establish an operation presence outside their home states. Less important nowadays
following changes that permit interstate branching of banks many Edge Acts are owned
by non-US banks.
Efficient market A market in which asset prices instantaneously reflect new information.
Eligible acceptance A bankers acceptance that meets US Federal Reserve requirements
related to its financing purpose and term. Most business transactions eligible for accep-
tance financing arise out of the importation or exportation of goods to or from the United
States or between two foreign countries. Other eligible transactions include the domestic
or foreign storage of readily marketable staples, goods that are either under sales contract
or expected to move into a channel of trade within a certain time period and the domestic
movement of goods. In the case of storage, the bank creating the acceptance must hold
the title documents for the goods to be stored for the entire storage period. In the case of
domestic shipment, when the bank is asked to accept a draft, it must have evidence that
the shipment did take place, when it was made and what the merchandise was. The bank
usually has a copy of the bill of lading or invoice for this purpose. Financing for transac-
tions that meet these criteria generally costs less than financing for ineligibleacceptances.
End-taker The end-user taking the product produced by a project. The term is often used
in connection with a take-or-pay contract.
EPS Earnings per share.
Equity Net worth; assets minus liabilities. The stockholders residual ownership position.
Equity kicker A share of ownership interest in a company, project or property, or a potential
ownership interest in a company, project or property in consideration for making a loan.
The kicker may take the form of stock, stock warrants, purchase options, a percentage
of profits, or a percentage of ultimate ownership.
652

Glossary
Equity warrants Equity warrants may be included with either bonds or equity issues.
An equity warrant gives the holder the right to buy shares in the company at a fixed
price at some time in the future. The lower the exercise price for the shares, the more
valuable the warrants will be, because the holder has a greater chance of exercising his
rights profitably.
Equivalent bond yield The annual yield on a short-term, non-interest-bearing security
calculated so as to be comparable to yields quoted on coupon securities.
Euler Hermes Group The credit insurance and trade finance agency for Germany, formerly
known as Hermes.
Euro The official currency of a number of the member states of the European Union since
1995 replacing currencies such as the French franc, German deutschmark and Italian
lira. Notable non-Euro EU members include the UK, Sweden, Hungary and Poland.
Euro CDs CDs issued by a US bank branch or foreign bank located outside the United
States. Almost all Euro CDs are issued in London.
Eurobond A Eurobond is any bond in any currency issued outside a borrowers domestic
market and sold to international investors by a group of international banks. Eurobonds
have no domestic market. A note or bond issued in Europe. Eurobonds are bearer
instruments. Eurobonds are not registered in the United States and cannot be originally
sold to a US investor. Eurobonds may be denominated in any major currency. They are
truly international instruments.
Euroclear Belgium Euroclear is one of the two major organisations in the Eurobond
market which clears, or handles the physical exchanges of securities and stores securi-
ties. (The other is Clearstream.) It is owned by 125 investment institutions and brokers
worldwide and offers four interrelated services. Clearance provides buyers and sellers
of internationally traded securities with a confidential, efficient and economic means of
settling transactions.
Euro-commercial paper (ECP) A non-underwritten or uncommitted note issuance program
in which one or more dealers place the issuers paper.
Eurocurrency A Eurocurrency refers to any currency European or otherwise domi-
ciled outside its country of origin. The most obvious example is the Eurodollar which
accounts for over 70% of the Eurocurrency market. Other examples, however, are the
Euro, Euroyen, Eurosterling and so on. Collectively, they comprise the Euromarkets and
derived this appellation from the presence of dollars in Europe after the war; Euromarkets
could apply equally to Sterling held in Singapore or Swiss francs in Hong Kong. The
Euromarkets grew rapidly in the 1970s because US banks found it an attractive way of
circumventing reserve requirements by holding dollars abroad.
Eurocurrency deposits Deposits made in a bank or bank branch that is not located in the
country in whose currency the deposit is denominated. Dollars deposited in a London
bank are Eurodollars; Yen deposited there are Euroyen.
Eurodollar US dollars held by a non-resident of the United States usually in the form
of a deposit with a commercial bank. Any US dollar denominated deposit held at a
bank outside the United States in a US bank branch or a foreign bank outside the
United States.
Eurodollar bonds A Eurobond denominated in dollars.
653

Glossary
Eurodollar futures contract A futures contract in which the three-month Libor is the
underlying. The contract traded on the CME involves US$1 million of face value; the
Liffe involves 500,000. Both contracts are traded on an index price basis. The index
price basis in which the contract is quoted is equal to 100 minus the annualised futures
Libor rate.
Euro lines Lines of credit granted by banks (foreign or foreign branches of US banks)
for Eurocurrencies.
European option An option that can only be exercised at the expiry date.
Eurosterling bond Eurosterling bond is a bond denominated in pounds but issued outside
the UK domestic market.
Euroyen bond A Euroyen bond is a bond denominated in yen but issued outside the Japan
domestic market.
Evergreen loan A term loan that renews automatically, usually year to year, unless specifi-
cally terminated by either party.
Evergreen renewal A renewal of a true lease at the end of the base term and any fixed renewal
terms based on an appraisal of the value and remaining life that is made shortly before the
conclusion of the fixed term and renewals. The lessee can renew the lease for a term that is
consistent with a remaining useful life at the end of the renewal term of at least 20% of the
original useful life. Stated another way, the lease term can be renewed such that the sum
of the base term and fixed rate renewals do not exceed 80% of the reappraised usefullife.
Exchange controls Restrictions that are applied by a countrys monetary authority,
or central bank, to limit the convertibility of the local currency into other specific
foreign currencies.
Exchange rate The price at which one currency trades for another.
Exchange traded currency options Options traded in organised markets whose participants
are committed to quoting both buy and sell prices.
Ex-dividend Without dividend; refers to a share of stock purchased after a dividend
was declared.
Exempt securities In the United States, instruments exempt from the registration require-
ments of the Securities Act 1933 or the margin requirements of the Securities and
Exchange Act 1934. Such securities include commercial paper and private placements.
Exotic options Include a wide variety of options with unusual underlying assets or peculiar
terms and conditions. For instance, returns on rainbow options depend on the amount
by which one asset outperforms another. Quanto options involve rights to buy a foreign
asset at both a set price and a set exchange rate.
Exotic swaps Complex swaps whose returns are derived from formulas that may include
numerous indexes or financial assets, such as both interest rates and oil prices. In some
exotic swaps, the difference between two indexes may be multiplied or leveraged,
amplifying potential gains and losses.
Expected returns The future revenue which investors anticipate will be received from
their investments.
Export credit incentive programs The governments of most of the worlds industrial
and trading nations sponsor trade support programs that are designed to promote the
host countrys exports. The programs have included a variety of short-, medium- and
654

Glossary
long-term financing, guarantee, or insurance programs in which governments share both

commercial and political risks ranging from currency inconvertibility and bankruptcy to
war, riot and revolution.
Export-Import Bank of the United States (Eximbank) An independent, self-sustaining
and wholly owned agency of the US government that aids in financing and facilitating
US exports. The Eximbank supplements and encourages, but does not compete with,
private capital. Its assistance falls into four categories: a medium-term guarantee program,
a direct loan and financing guarantee program, a discount loan program and a coopera-
tive financing facility program.
Extended term agreement An agreement to renew a lease, commonly used to describe a
guaranteed renewal of a lease by a third party.
Extension swap Extending maturity through a swap; for example, selling a two-year note
and buying one with a slightly longer current maturity.
Face value The maturity value of a bond or other debt instrument. Sometimes referred to
as the bonds par value or nominal value.
FAS 13 Federal Accounting Standard on leasing IAS 17 is the international standards equivalent.
FASB Financial Accounting Standards Board of the US. Currently engaged in an international
financial reporting standards convergence project with the IASB.
Fed Short for Federal Reserve Board.
Fed wire A computer wire transmission service established by the Federal Reserve to link
member banks and to the Fed to facilitate the movement of funds of member bank
accounts at the Fed.
Federal Reserve Board of Governors The governing body of the US Federal Reserve
System. The seven members are appointed by the president for long and staggeredterms.
Federal Reserve System The US federal government agency that exercises monetary policy
through its control over banking system reserves.
Fiduciary An individual, corporation, or association, such as a bank or trust company, to
whom certain property is given to hold in trust, according to the trust agreement.
Financial guarantee Provides for a payment by an insurer to the policy beneficiary if (1)
a loss is incurred on a financial obligation insured and (2) the loss is attributable to a
specified event that causes the default. The payment on the insured loss can be equal to
the entire amount of the loss or for a partial amount of the loss. A financial guarantee
can be classified as either (1) a pure financial guarantee or (2) a financial surety bond
(also referred to as an insurance wrap).
Finance lease A capital lease. A financing device whereby a user can acquire use of an asset
for most of its useful life. Rentals are net to the lessor; and the user is responsible for
maintenance taxes and insurance. Rent payments over the life of the lease are sufficient
to enable the lessor to recover the cost of equipment plus interest on its investment. A
finance lease may be a true lease or a conditional sale.
Financial leverage The use of debt of finance investments.
Financing statement A notice of a security interest filed under the Uniform CommercialCode.
First-in, first-out (FIFO) A method of inventory accounting in which the oldest item in
inventory is assumed to be sold first (as contrasted to last-in, first-out).
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Glossary
First-loss provision A guarantee that is measured by some percentage of the total liability.
The guarantor suffers the first loss up to that amount.
First user The person that first places equipment into service. Certain tax benefits associated
with original ownership of new equipment flow to the owner at the time of first use.
Fish or cut bait provision Where a technical default occurs and is not remedied, this
provision requires the indenture trustee to take some action.
Fitch A credit rating agency.
Fixed assets to total debt ratio This ratio is a measure of the amount of fixed assets
owned by a company which are available to reduce the companys debt in a possible
liquidation. Obviously, the higher this ratio, the higher the protection to creditors.
Fixed cost Any cost which does not vary over the observation period with changes involume.
Fixed currency A currency whose official exchange value in terms of gold or other currencies
is maintained by the central bank or monetary authority of the concerned country and
does not vary. Although most exchange rates are now floating rates, they will usually
fix them against the dollar.
Fixed-income security Any security which promises a payment stream to holders over
its life.
Fixed rate bond A bond with a fixed interest rate pays the same rate of interest to inves-
tors throughout its life and has a final maturity date.
Fixed rate of interest An interest rate established at the time a loan is made or liability
incurred and remains unchanged throughout the term of the loan or liability.
Fixed rate loan A loan on which the rate paid by the borrower is fixed for the life of
the loan.
Floating currency A currency whose rate of exchange is allowed to fluctuate according to
the forces of supply and demand. All currencies are subject to some degree of central
bank intervention to soften the effects of market forces. Conversely, governments also
manipulate their domestic economies to boost their currencies.
Floating interest rate An interest rate which fluctuates during the term of a loan and
which is adjusted upwards or downwards during the term of a loan in accordance with
some index of short-term rates (reference rate).
Floating rate notes A floating rate note issue has no fixed rate of interest. The coupon is
set periodically according to a predetermined formula tied to short-term interest rates in
the appropriate market. Usually refers to floating rate notes issued in Europe, although
all kinds of floating rate instruments are issued in the United States. The holder may
have the right to demand redemption at par on specified dates.
Floor An agreement between two parties whereby one party, for an upfront premium, agrees
to compensate the other at designated times if the underlying (that is, a designated price
or rate) is less than the strike level.
Floor broker Any person who, in or surrounding any pit, ring or other place provided by
a contract market for the assembly of persons similarly engaged, executes for another
any orders for the purchase or sale of any commodity for future delivery and receives
a prescribed fee or commission.
Floor trader Member of an exchange who normally executes his own trades by being
personally present in the pit or place for futures trading; also known as a local.
656

Glossary
Floored FRN A floating rate note with a minimum of interest.

Foreign bond A bond issue for a foreign borrower offered in the domestic capital market
of a particular country and denominated in the currency of that country. They may also
be sold to international investors as well as domestic investors.
Foreign currency futures An exchange-traded contract to sell or to buy a certain amount
of foreign currency at a specified rate for delivery at a future time.
Foreign currency option A contract that gives the purchaser the right to buy or sell a fixed
amount of currency at a fixed rate on or before a specified expiration date.
Foreign draft A draft drawn by any bank or other drawer in one country on a bank or
other drawee in another country. It may be in any currency.
Forex Foreign exchange.
Foreign exchange The currency of foreign countries; and the process of converting the
currency of one country to that of a second country.
Foreign exchange exposure management The strategies adopted and actions taken by
companies to minimise the possibilities of loss in transactions involving foreignexchange.
Foreign exchange rate The price at which the currency of one country can be bought
with the currency of another country.
Foreign exchange risk The risk that a long or short position in a foreign currency will have
to be closed out at a loss, due to an adverse movement in the relevant exchange rate.
The long or short position which may arise out of a financial or commercialtransaction.
Foreign leasing As used in international leasing foreign leasing refers to a lease in which
the lessor is an entity domestic to the lessees country but is owned by an entity located
outside the lessees country.
Foreign source income Income earned overseas (net of depreciation and other expenses
allocable to such income) as reported for US federal income tax purposes.
Foreign tax credit A credit against taxes in one country for taxes paid to another country
on the same income.
Forward contract Contract between two parties to exchange a currency at a set price on
a future date. Differs from a futures contract in that most forward commitments are
not actively traded or standardised and carry the risk from the creditworthiness of the
other side of the transaction.
Forward market A market in which participants agree to trade some commodity, security,
or foreign exchange at a fixed price at some future date. Unlike futures and options,
trading in forward markets does not occur on organised exchanges but through the
forex traders of financial institutions. Forward currency contracts are not transferable
instruments and settlement is usually expected to be through actual delivery of curren-
cies. Also known as forwards.
Forward premium The difference between the spot and forward values of a currency. Also
known as discount premium.
Forward rate The rate at which forward transactions in some specific maturity are being
made; for example, the dollar price at which yen can be bought for delivery three
months hence.
Forward rate agreement A customised agreement between two parties (one of whom is
a dealer firm a commercial bank or investment banking firm) where the two parties
657

Glossary
agree at a specified future date to exchange an amount of money based on a reference

interest rate and a notional principal amount.
Forward swap A forward contract on swap. The terms of the swap are set today, but the
parties agree that the swap will begin at a specified date in the future.
Forward transaction A foreign exchange transaction in which currency is bought or sold
at a fixed rate of exchange for delivery at some specified time in the future. Generally,
an amount is added or subtracted from the current rate of exchange to account for
premium or discount, respectively.
FRNs Floating rate notes, similar to Eurobonds but with a floating interest rate.
Full-coupon bond A bond with a coupon equal to the going market rate and consequently
selling at or near par.
Full-payout lease A lease in which the cash flows from firm rents and an estimated conser-
vative residual value will return to the lessor an acceptable return on investment and
the cost of the leased equipment after payment of the cost of financing and overhead.
Full-service lease This type of lease obligates the lessor to provide maintenance, repair
and insure the leased equipment. The lessor also pays the property taxes. Full-service
leases are nearly always true leases in which the lessor owns the equipment at the end
of the lease.
Future value The value of an initial investment after a specified period of time at a certain
rate of interest.
Futures contract An legal agreement between a buyer (seller) and an established exchange
or its clearing house in which the buyer (seller) agrees to take (make) delivery of some-
thing at a specified price at the end of a designated period of time. The price at which
the parties agree to transact in the future is called the futures price. The designated date
at which the parties must transact is called the settlement or delivery date.
Future market A market in which contracts for future delivery of a commodity or a secu-
rity are bought and sold. Different exchanges specialise in particular kinds of contracts.
The exchange generally acts as a middleman, guaranteeing payment in case either buyer
or seller defaults. In return, both sides of the trade put up collateral, which is adjusted
daily, to back their obligations.
Futures option An option that gives the buyer the right to buy from or sell to the writer a
designated futures contract at a designated price at any time during the life of theoption.
GAAP Generally accepted accounting principles, also known as US GAAP. These are US
standanrds and their harmonisation with the international standards, known as IFRS
produced by IASB is an ongoing project of importance to project financiers.
Gearing Debt to equity ratio.
General creditor Unsecured creditor.
General obligation bond Municipal securities secured by the issuers pledge of its full faith,
credit and taxing power, as contracted to an industrial revenue bond which is dependent
upon revenue generated by a particular facility.
General partnership A partnership in which all partners have unlimited liability forfuture.
Global commercial paper Non-underwritten Euronote issuance programs which are sold
on a global basis with the book moving between time zones for 24-hour coverage.
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Glossary
Global note facility A facility whereby the medium term underwriting commitment of banks
which are parties to the facility is available to back up both the issue of US commercial
paper and Euronotes. Should the issuer be unable to roll over US commercial paper, his
failure will trigger off a Euronote issuance process by tender panel.
Goodwill The intangible assets of a firm, calculated at the excess purchase price paid over
book value.
Grantor trust A trust used as the owner trust in a leveraged lease transaction, with only one
equity participant. The Internal Revenue Code refers to such a trust as a grantor trust.
With more than one equity participant the grantor trust is usually treated as apartnership.
Grey market In the Eurobond market, the trading in the bonds from the date that the
issue announced, on what is known as an if, as and when issued basis, is called the
grey market.
Gross lease Opposite of a net lease. The lessor pays property tax, insurance and mainte-
nance costs on a gross lease of equipment.
GUN An acronym for grantor underwritten note often seen in the context of a floating rate
note facility similar to a Euronote facility whereby a group of banks (grantors) commit
to purchase any notes put back to them by investors on any FRN interest rate fixing
date. Any put notes thus accumulated are then auctioned out to the market between
the grantors.
Haircut A discount.
Hard currency A currency considered by the market to be likely to maintain its value
against other currencies over a period of time and not likely to be eroded by inflation.
A soft currency, on the other hand, is one whose value melts away as you hold it. Hard
currencies are usually freely convertible. The most obvious hard currencies in recent times
have been the US dollar, yen, Swiss franc and sterling.
Harmless warrants Warrants attached to a host bond that protect the issuer from the
potential doubling of debt in the event of warrant exercise by allowing the issuer to call
a corresponding amount of the host bond.
Hedge A method whereby currency exposure (the risk of possible loss due to currency
fluctuations) or commodity exposure is covered or offset for a fixed period of time.
This is accomplished by taking a position in futures equal and opposite to an existing
or anticipated cash or commodity position, or by shorting a security similar to one in
which a long position has been established.
Hedging See hedge.
Hell-or-high-water clause A requirement that an obligation, such as rent payments, be
carried out come hell-or-high-water. An unconditional, absolute obligation not subject
to defence of non-performance by the other party to the contract.
High gearing A high debt to equity ratio.
High-low debt Debt with higher payments early in the term.
Hire-purchase agreement Same as conditional sale lease.
Historical-cost depreciation Depreciation based on amount originally paid for asset.
Host bond A Eurobond issue carrying warrants.
Hurdle rate Minimum acceptable rate of return on investment.
659

Glossary
IAS 17 International Accounting Standard on leasing FAS 13 is the US accounting leasing

standard equivalent.
IASB The International Accounting Standards Board. IASB and FASB are presently negoti-
ating convergence of local accounting standards to eliminate disparities and with an end
goal of a single set of accounting standards that may apply internationally and be used
for cross border and domestic financial reporting. This project is ongoing and will have
major implications for project finance deal structuring.
ICMA International Capital Market Association, formed from various mergers. This body sets
standards and reglates markets to support cross -border trading, issuing and investing in
securities through its liaison with regulators, governments and market professionals. It
has replaced ISMA and AIBD, organisations that represented markets and bonddealers.
IDC Intangible drilling costs.
IFC International Finance Corporation, a subsidiary of the International Bank for
Reconstruction and Development (World Bank).
IFRS International Financial Reporting Standard, produced by IASB. Harmonisation discus-
sions to develop a single international set of reporting standards are continuing withFASB.
Inbound lease A cross-border lease from a foreign lessor to a US lessee.
Incipient default An event or condition that, after the giving of notice or the lapse of time,
or both, would become an event of default under a lease or a mortgage, entitling the
lease to be terminated or the mortgage to be foreclosed.
Income statement A report of a companys revenues, associated expenses and resulting
income for a period of time. The profit and loss statement.
Income warrant A debt warrant that carries interest on its issue price.
Incremental borrowing rate The interest rate which a person would expect to pay for a
certain loan at a certain time.
Indemnitee A term used to describe the class of persons entitled to indemnification under
the general indemnity and general tax indemnity provisions of an agreement.
Indemnity agreement When used in the context of a leveraged lease, an agreement whereby
the owner participants and the lessee indemnify the trustees from liability as a result of
ownership of the leased equipment.
Indemnity clauses Refers to the indemnity provisions in a lease or loan.
Indenture of a bond A legal statement spelling out the obligations of the bond issuer and
the rights of the bondholder.
Indenture trustee An indenture trustee holds the security interest in property for the benefit
of the lenders.
Indexed loan A loan with debt service repayment tied to some standard which is calculated
to protect the lender against inflation and/or currency exchange risk.
Indexed rate notes A note with the interest rate set at take-down on the basis of an
agreed interest rate index.
Industrial development revenue bond In the United States, a form of municipal revenue
bond for financing certain types of projects where the interest paid is exempt from US
taxes. Also known as industrial revenue bond.
Inflation premium The increased return on a security or an investment which is required
to compensate investors for expected inflation.
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Glossary
Initial margin requirement For a futures contract, when a position is first taken, the
investor must deposit a minimum dollar amount per contract as specified by theexchange.
Institutional investors Investors such as banks, insurance companies, trusts, pension funds
foundations and educational, charitable and religious institutions.
Insurance-linked notes Bond whose payments depend on the occurrence of a credit event.
Also knows as a catastrophe-linked bond.
Intangible assets Intangible assets include such items or accounts as: goodwill, patents and
patent rights, deferred charges and unamortised bond premium.
Intangible expenses Development expenses of an oil or gas well or mine, which are
deductible for income tax purposes in the year incurred.
Inter-creditor agreement An agreement between the lenders to a company as to the rights
of creditors in the event of default, covering such topics as collateral, waiver, security
and set-offs.
Interest Cash amounts paid by borrowers to lenders for the use of their money. Normally
expressed as a percentage.
Interest rate exposure Risk of gain or loss to which a company is exposed due to possible
changes in interest-rate levels.
Interest rate implicit in a lease The discount rate which, when applied to minimum lease
payments (excluding executory costs paid by the lessor) and unguaranteed residual value,
causes the aggregate present value at the beginning of the lease term to be equal to the
fair value of the leased property at the inception of the lease.
Interest rate swap A swap in which two parties agree to exchange interest rate payments
based on a notional principal amount, with typically one paying a fixed rate and the
other paying a floating rate.
Interim rent Daily rental occurring from delivery, acceptance and/or funding until a later
starting date for a basic lease term. Often used when equipment delivers over a period
of time.
Internally generated funds Cash that a firm generates from retained earnings
and depreciation.
Inventory turnover ratio A measure of managements control of its investment in inven-
tory, usually defined as cost of goods sold divided by ending inventory.
Investment bank A financial institution specialising in the original sale and subsequent
trading of company securities, and private placements including management and under-
writing of issues as well as securities trading and distribution. The main function of
an investment bank is to locate and collect funds for clients so they can finance new
investment projects. Investment banks engage in buying and selling securities, such as
stocks, bonds and mortgages. Investment banks also act as intermediaries between the
corporation, who requires funds for such improvements as new equipment, new build-
ings, or plant expansions; and the investor, who wishes to invest his savings. Investment
banks may promote a new industry, handle the finances of a corporation for expan-
sion purposes, or act as brokers with other investment banking firms in the flotation of
stocks and bonds.
Investment tax credit (ITC) In the US, tax credits (that is reduction of taxes) is given to
encourage investment in certain areas deemed important for the economy. For example,
661

Glossary
as part of the American Recovery and Reinvestment Act of 2009, there is a federal
business energy investment tax credit for eligible energy renewables and technologies.
IPO Initial public offering.
IRC Internal Revenue Code.
IRR Internal rate of return.
Issuer-set margin A letter of credit that cannot be changed or cancelled without the
consent of all parties involved. Most letters of credit today are irrevocable; however, if
not specifically labelled as such, letters of credit are understood to be revocable.
IRS Internal Revenue Service.
Issuer set margin A Euronote distribution system which permits the issuer to set the note
margin, usually in relation to Libor, at which facility underwriters may opt to take a
certain proportion of the notes pro rata to their commitments at the set margin. Notes
not taken up or not sold by facility underwriters are placed with the facility arranger
who also is allocated a fixed proportion of each issue.
ITC Investment tax credit.
Japanese government yen bond futures Japanese financial futures contracts.

Joint venture Often used to describe any jointly owned corporation or partnership which
owns, operates or constructs a facility project or enterprise. More specifically, an
arrangement between two or more parties for the joint management or operation of
a facility, project enterprise or company under an operating agreement which is not
a partnership.
Junk bonds Bonds that have a credit rating that is below investment grade.
Kamikazi bond A term used to describe an alleged below market bid usually used by one
competitor to describe an especially low bid by another competitor.
Keep well letter A form of guarantee in which the guarantor agrees to keep the recipient
of the guarantee well, by injecting capital as needed. Sometimes called a maintenance of
working capital guarantee. If properly worded, a keep well letter can be the equivalent
to a formal guarantee.
Last-in, first-out (LIFO) A method of inventory accounting in which the newest item in
inventory is assumed to be sold first (see first-in, first-out).
Lead bank The bank which negotiates a large loan with a borrower and solicits other
lenders to join the syndicate making the loan.
Lead manager In a new securities issue, the managing bank responsible for initiating the
transaction with the borrower and for organising (or designating another to organise)
the successful syndication and placement of the issue in the primary market.
Lease In an equipment lease, one party, called the lessor, provides equipment to a second
party, called the lessee, for a fixed period of time for compensation.
Lease backed collateralised securities Securities collateralised by leases on plant
and equipment.
Lease-buy analysis A financial analysis comparing the cost of leasing equipment with the
cost of purchasing equipment.
662

Glossary
Lease intended as security A lease in which the lessee is considered the owner for both
state law and federal income tax purposes. A conditional sale or instalment purchase
for income tax purposes.
Lease line A lease line of credit similar to a bank line of credit that allows a lessee to add
equipment to a lease, as needed, under the same basic terms and conditions, without
negotiating a new lease.
Lease multiple The number of lease payments due a lessor against which a lender is willing
to lend. The lease multiple reflects the lenders assumptions as to interest rate, cash flow,
yield, credit and other variables.
Lease rate The equivalent simple annual interest rate implicit in minimum lease rentals.
Not the same as interest rate implicit in a lease.
Lease term The fixed, non-cancellable term of the lease includes, for accounting purposes,
all periods covered by fixed rate renewal options which, for economic reasons, appear
likely to be exercised at the inception of the lease and for tax purposes, all periods
covered by fixed rate renewal options.
Lease underwriting An agreement whereby a packager commits firmly to enter into a lease
on certain terms and assumes the risk of arranging any financing.
Legal reserves The portion of its deposits which a bank is required by law to maintain in
the form of cash or readily available balances to meet the demands of the depositors.
Lessee The user of equipment being leased.
Lessees incremental borrowing rate The interest rate which the lessee at the inception
of the lease would have incurred to borrow over a similar term the funds necessary to
purchase the leased assets. In a leveraged lease the rate on the bonds is normally used
as the lessees incremental borrowing rate.
Lessor The owner of equipment which is being leased to a lessee or user.
Letter of credit A guarantee limited as to time and amount.
Level payments Equal payments over the term of a loan or lease.
Leveraged lease A lease which meets the definition criteria for a direct financing lease,
plus all of the following characteristics.
1 At least three parties are involved: a lessee, a lessor and a long-term creditor.
2 The financing provided by the creditor is substantial to the transaction and without
recourse to the lessor.
3 The lessors net investment typically declines during the early periods of the lease
and rises during the later periods of the lease.
Liability An obligation to pay an amount or perform a service.
Libor The London interbank offered rate of interest on Eurodollar deposits traded between
banks. There is a different Libor for each deposit maturity. Different banks may quote
slightly different Libor because they use different reference banks.
Lien A security interest on property to secure the repayment of debt and the performance
of related obligations.
Limited liability company A special purpose corporation formed under state laws which
permit the entity to have the characteristics of a partnership.
Limited partnership A partnership consisting of one or more general partners, jointly and
severally responsible as ordinary partners, by whom a business is conducted; and one
663

Glossary
or more limited partners, contributing in cash payments a specific sum as capital and
who are not liable for the debts of the partnership beyond the funds so contributed.
Limited-use property Same as special-purpose property.
Line of credit A commitment of a bank to a borrower to extend a series of credits to the
borrower under certain terms and conditions up to an agreed maximum amount for a
specified period of time. In addition to loans of funds, a line of credit may include issu-
ance of a succession of letters of credit, acceptances and/or discounting of a series of
drafts, extension of multiple loans or advances and other forms of credit. The amount of
credit, as well as the conditions under which it is provided, is established byagreement.
Liquid asset A liquid asset is one that can be converted easily and rapidly into cash without
a substantial loss of value.
Liquidation The process of closing down a company, selling its assets, paying off its credi-
tors and distributing any remaining cash to owners.
Liquidity The ability to convert assets into cash. A measure of how easily assets can be
converted into cash.
Liquidity ratio Any ratio used to estimate a companys liquidity (such as the acid test or
current ratio).
LLC A limited liability company.
Loan certificates Debt certificates, notes, or bonds issued to lenders to evidence debt.
Loan participant A holder of debt evidenced by loan certificates, notes, or bonds.
Local currency The official domestic currency (currency of issue) of any particularcountry.
Long bonds Bonds with a long current maturity.
Long coupons Bonds or notes with a long current maturity.
Long hedge A hedge undertaken to protect against an increase in the price of an asset,
a currency, or a commodity to be purchased in the cash market at some future time.
Long-term debt A borrowing for a long period of time, usually through bank loans or
the sale of bonds. On a balance sheet, any debt due for more than one year is classi-
fied as long term.
Lookback currency option An over-the-counter option where the option buyer has the
right to obtain the most favourable exchange rate that prevailed over the life of
the option.
Lowball bid A bid to enter into or to arrange a lease or loan transaction that is purposely
priced below market or with terms not acceptable from a tax or accounting standpoint,
with a view to renegotiation of a higher price and/or more expensive terms at a later
date. Once the bid has been awarded the other interested lessors may no longer be
available. Typically, the lowball bidder raises the price or strengthens the terms when it
is too late for the lessee to seek other sources of finance.
Low-high debt Debt with lower payments early in the term.
MACRS Modified accelerated cost recovery system. Tax depreciation permitted by the IRS.
MACRS replaced ACRS.
Maintenance bond A bond to provide funds for maintenance and repair of equipment or a
facility. Maintenance bonds are used in connection with construction contracts to ensure
that a contractor will repair mistakes and defects after completion of construction. The
664

Glossary
bond may be used in lieu of the contractor leaving a portion of the contract price on
deposit with the employer to ensure performance.
Maintenance margin For a futures contract, the minimum level (specified by the exchange)
by which an investors equity position may fall as a result of an unfavourable price
movement before the investor is required to deposit additional margin.
Majority in interest of participants The term typically used in loan indentures to indicate
those persons that are entitled to instruct the indenture trustee to take action under
the indenture.
Make-up agreement Where a product contracted to be supplied cannot be provided from
a certain project, a make-up agreement provides that the product will be supplied from
some other source controlled by the sponsor.
Mandate Authorisation from a borrower to proceed with arranging a financing.
Manufacturers bills of sale The bill of sale from the manufacturer or supplier of the
property usually containing the manufacturers warranty that the purchaser has received
good title to the equipment being purchased by it.
Marginal cost of capital The incremental cost of financing above a previous level.
Marginal tax rate The tax rate that would have to be paid on an additional dollar of
taxable income earned.
Market value The price at which an item can be sold.
Master lease A lease line of credit that allows a lessee to add equipment to a lease under
the same basic terms and conditions without negotiating a new lease contract.
Maturity The date on which a given debt security or any obligation to pay money becomes
due and payable to the holder in full.
Medium-term note A debt instrument with the unique characteristic that notes are offered
continuously to investors by an agent of the issuer. Investors can select from several
maturity ranges: nine months to one year, more than one year to 18 months, more than
18 months to two years and so on up to 30 years. In the United States, medium-term
notes are registered with the Securities and Exchange Commission under Rule 415 (the
shelf registration rule) which gives a corporation the maximum flexibility for issuing
securities on a continuous basis.
Merger The combining of two or more enterprises. Corporate mergers involve the exchange
of securities or the issuance of new securities or both.
Mezzanine financing A form of structured subordinated loan transaction, usually with an
equity kicker offered in order to get better terms from investors and carrying a higher
interest rate to reflect the greater risk.
Micro factors Factors that pertain to supply, demand and pricing.
Mini max FRN An FRN with both minimum and maximum rates of interest.
Mismatched FRN A floating rate security with coupon reset and coupon payment occurring
at different frequencies.
MITI The Ministry of International Trade and Industry. Export-Import Bank of Japan.
MOF An acronym in Euronotes for multi-option facility. A MOF is broader than the typical
underwritten Euronote facility (NIF) in that the banks medium-term commitment is
to backstop, not only the issuance of Euronotes but also a wide range of other short-
term instruments, such as bankers acceptances and short-term advances in a variety of
665

Glossary
currencies. MOFs require care in balancing client choices with banks cost structures to
deliver those choices.
MOF (Japan) Ministry of Finance.
Monetary asset Any asset having a value defined in units of currency. Cash and accounts
receivable are monetary assets; inventories and plant and equipment are physical assets.
Money centre bank See money market bank.
Money market The market for shorter-term securities, generally those with one year or
less remaining to maturity, handled by such financial institutions as commercial banks,
savings banks, trust companies, insurance companies, stock brokerage firms, investment
banks, investors, or mortgage banks. The market in which short-term debt instruments
(such as bills, commercial paper and bankers acceptances) are issued and traded.
Money market bank A bank that is one of the nations largest and consequently plays an
active and important role in every sector of the money market.
Monte Carlo analysis A statistical technique used in project modelling whereby repeated
random sampling of one of the variable in a projects financial model and an examina-
tion of the effect of those changes on NPV or IRR offers decision makers a view on
the projects sensitivity to changes in a particular variable and thence insights into risk
management policies and hedging decisions.
Moodys A credit rating agency.
More likely than not opinion More likely than not opinions by attorneys indicate a better
than even chance that some event will occur. This term is generally used in connection with
individual tax shelter schemes to avoid fraud or negligence charges against a promoter.
Mortgage A pledge or assignment of security of particular property for payment of
debt or performance of some other obligation. The same as an indenture of trust or
security agreement.
Mortgage bond A bond secured by a lien on property, equipment, or other real assets.
Multi option facility See MOF.
Multicurrency bonds Bonds payable in more than one currency at the discretion of
the investor.
Multicurrency clause Such a clause in a Euro loan permits the borrower to switch from
one currency to another on a rollover date.
Multicurrency loan A loan made by a bank in one or more of several currencies.
Multilateral netting A system generally offered by financial institutions to multinational
corporations to cut down the number of transactions necessary to complete complex
international payments.
Multinational corporation A firm with significant operations outside its national borders
and/or with subsidiaries or divisions in more than one country.
Multinational lending agencies A number of trade support organisations are jointly
owned by a group of countries and are designed to promote international and regional
economic co-operation. In particular, these lending agencies have such goals as aiding
the development of productive facilities and furthering social and economic growth in
member countries. These include the following major multinational agencies:
Asian Development Bank;
European Bank for Reconstruction and Development;
666

Glossary
Inter-American Development Bank;

International Bank for Reconstruction and Development (the World Bank); and
International Finance Corporation (IFC).
Municipal (muni) notes Short-term notes issued by municipalities in anticipation of tax

receipts, proceeds from a bond issue, or other revenues.
Municipals Securities issued by state and local governments and their agencies.
Mutually exclusive alternatives Two projects which accomplish the same objective, so
that only one will be undertaken.
Naked position A long or short position that is not hedged.

Naked warrants An issue of warrants without any host bond.
National banks In the United States, national banks are federally chartered banks that are
subject to supervision by the Comptroller of the Currency. State banks, in contrast, are
state chartered and state regulated.
Negative carry The net cost incurred when the cost of carry exceeds the yield on the
securities being financed.
Negative pledge Undertaking by a borrower not to offer improved security arrangements
to other lenders without offering the equivalent security to the instant lender.
Negotiable instrument Any written evidence of a payment obligation which may be trans-
ferred by endorsement or by delivery, such as checks, bills of exchange, drafts, promissory
notes and some types of bonds or securities and of which the transferee may become a
holder in due course.
Net lease In a net lease, the rentals are payable net to the lessor. All costs in connection
with the use of the equipment are to be paid by the lessee and are not a part of rental.
For example, taxes, insurance and maintenance are paid directly by the lessee. Most
finance leases are net leases.
Net-net lease Same as net lease.
Net present value (NPV) Present value of cash inflows less present value of cashoutflows.
Net profit Earnings.
Net profit margins Net profits after taxes divided by sales.
Net sales Total sales revenue less certain offsetting items such, as returns and allowances
and sales discounts.
Net working capital Current assets minus current liabilities, used as an indication
of liquidity.
Net worth Equity, shareholders equity.
New-issues market The market in which a new issue of securities is first sold toinvestors.
NIF Stands for: note issuance facility, which is a general reference to describe all types of
underwritten Euronote facilities.
Nominal rate A stated rate which is usually subdivided for compounding purposes, resulting
in a higher effective rate.
Non-commercial risk Risks such as: casualty risk, political risk, expropriation, acts of God,
currency, convertibility, technological risks, failure of management. A non-commercial
risk can usually be covered by insurance.
667

Glossary
Non-convertible currency Non-convertible currencies are those whose circulation is

restricted by the local authorities and where the exchange rate is artificially set by those
authorities (usually well above the inevitable local black market rate).
Non-dollar FRNs FRNs in currencies other than the dollar such as euro and
yen-denominated FRNs.
Non-payout lease A lease in which cash flows from rents and nominal residual value
are insufficient to cover the cost of financing and administration of the lease. The
lessor relies on a renewal or release of equipment to recover its investment and realise
a profit.
Non-performing loan A loan on which interest or some payment due under the loan
agreement is not paid as it accrues. Since banks are examined only periodically, a non-
performing loan may or may not be classified.
Non-recourse debt Debt without recourse to the sponsor of a project. Lender looks to the
project or other interested parties for repayment.
Note An instrument recognised as a legal evidence of a debt that is signed by the maker,
promising to pay a certain sum of money, on a specified date, at a certain place of
business, to the payee or other holder of the note. The difference, if any, between notes
and bonds is normally that of maturity, notes having a shorter life. Coupon issues with
a relatively short original maturity are often called notes. However, US Treasury notes
are coupon securities that have an original maturity of up to 10 years.
Note issuance facility Called a NIF. A note issuance facility is a general reference used
to describe all types of underwritten Euronote facilities.
Notional amount The nominal or principal amount of a swap as measured in a base
currency, usually US dollar.
OKB Osterreichische Kontrollbank AD. The trade finance bank for Austria.
Offshore entity A generalisation for an entity located outside the boundary of the country
of origin.
Off-take The product produced by a project.
Off-take agreement Contract whereby the project sponsor and a customer enter into an
agreement specifying that the project sponsor agrees to sell to the customer a designated
amount of the product at a predetermined price. The agreement is structured so that
there are very few conditions under which parties may terminate the contract prior to
the contracts expiration date.
Offering circular Also called a prospectus. The offering circular usually contains a complete
description of the terms of the securities being offered, together with financial informa-
tion relating to the borrower and any guarantor.
Offering memorandum The complete description of the transaction under discussion that
forms the basis of an invitation to providers of debt or equity capital, so including terms
of the securities being offered, together with financial information relating to the borrower
and any guarantor. The sponsors are responsible for the accuracy of the contents of the
offering memorandum.
Off-taker The user taking the product produced by a project. The term is often used in
connection with take-or-pay contract.
668

Glossary
Open-end lease A conditional sale lease in which the lessee guarantees that the lessor
will realise a minimum value from the sale of the asset at the end of the lease. If the
equipment is not sold for the agreed residual value, the lessee pays the difference to
the lessor. If the equipment is sold for more than the agreed residual value, the lessor
pays the excess to the lessee. The lease is called an open-end lease because the lessee
does not know the extent of its liability to the lessor until the equipment has been sold
at the end of the lease. The lessees liability is open-ended. The term open-end lease is
commonly used in automobile leasing. Individual liability under open-end leases is limited
by consumer protection laws.
Operating agreement Used in mining or other natural resource joint ventures to describe
the basic agreement between the joint venturers.
Operating lease For financial accounting purposes, a lease which does not meet the criteria
of a capital lease and does not have to be shown on the balance sheet by the lessee,
although it will be reported in a footnote as a fixed charge. The term operating lease
is also, used generally to describe a short-term lease whereby a user can acquire use
of an asset for a fraction of the useful life of the asset. The lessor in such a lease may
provide services in connection with an operating lease such as maintenance, insurance
and payment of personal property taxes. This treatment may be subject to change and is
thought likely to disappear under the proposed new international accounting standards.
Operating profit margins The rates of profits earned from operations, excluding taxes
and interest from consideration.
Opportunity cost The cost of pursuing one course of action measured in terms of the
forgone return offered by the most-attractive alternative investment.
Optimal capital structure The theoretical structure of debt and equity that results in the
lowest cost of capital and the maximum wealth of a firm.
Option A contract in which the writer of the option grants the buyer of the option the right,
but not the obligation, to purchase from or sell to the writer something at a specified
price within a specified period of time (or at a specified date). The writer, also referred
to as the seller, grants this right to the buyer in exchange for a certain sum of money,
which is called the option price or option premium. The price at which the asset may
be bought or sold is called the strike or exercise price. The date after which an option
is void is called the expiration date.
Option put securities Puttable bonds with detachable puts.
Option series Type of options which are either entirely call options or put options on the
same underlying security and all of which have the same strike price and maturitydate.
Outbound lease A cross-border lease in which a US lessor leases equipment to a foreign
lessee for use by the foreign lessee.
Out-of-the-money A call option is out-of-the-money when the strike price is markedly above
the current price of the underlying futures contract. A put option is out-of-the-money
when the strike price is markedly below the current price of same.
Over-the-counter (OTC) market A market created by dealer trading as opposed to the
auction market prevailing on organised exchanges.
Overseas Private Investment Corporation (OPIC) A self-supporting US government corpo-
ration providing insurance and, in some cases, partial financing to US private investment
669

Glossary
in developing countries. In eligible countries, its insurance services provide political risk
insurance to US investors for new capital investment and its financial services provide
direct loans to new US investment projects. Medium-term and long-term loan guarantees
are provided for the same projects. Criteria for financing state that the project must have
at least 51% private ownership and 25% US ownership.
Owner trustee In a leveraged lease, the primary function of the owner trustee is to hold
title to the equipment for the benefit of the equity participants. Also sometimes called
grantor trustee.
Paid-in capital That portion of shareholders equity which has been paid-in directly as
opposed to earned profits retained in the business.
Paper Money market instruments, commercial paper and other.
Paper gain (loss) Unrealised capital gain (loss) on assets, based on a comparison of current
market price and original cost.
Par The principal amount at which the issuer of a debt security contracts to redeem that
security at maturity. The face value.
Par bond A bond selling at par.
Par value An arbitrary value set as the face amount of a security. Bondholders receive par
value for their bonds on maturity.
Pari passu Instruments which rank equally in right of payment with each other and with
other instruments of the same issuer.
Partly paid bond In a partly paid bond, part of the purchase price is deferred so that only a
relatively small portion, say 20%, is payable on issue, with the balance being due in one
or more instalments at later dates. If the investor fails to subscribe the subsequent calls,
the bond is forfeit and the issuer benefits to the extent of the subscriptions abandoned.
Partnership A voluntary contract between two or more persons to place their money, efforts,
labour and skill in lawful commerce or business with the understanding that there shall
be a proportional sharing of profits and losses between them.
Partnership A business entity by two or more persons (or corporations) and conducted
for a profit.
Partly paid FRN After an initial payment for the first part of a floating rate security issue,
the purchaser must subscribe to future parts of the issue.
Pass-through A mortgage-backed security on which payment of interest and principal on
the underlying mortgages is passed through to the security holder by an agent.
Pass-through trust A trust used in public and in Rule 144A offerings of public debt in
leveraged leases. The trustee typically is the indenture trustee. The trustee from proceeds
from the sale of certificates to public purchasers purchases notes.
Payables period A measure of a companys use of trade credit financing, defined as accounts
payable divided by purchases per day.
Payback period The amount of time required to recover the initial investment in aproject.
Payee Partly named on a cheque or draft as recipient of the payment.
Paying agents Paying agents are appointed in different financial centres, to arrange for
the payment of interest and principal due to investors under the terms of a bond issue.
Paying agents are usually banks.
670

Glossary
Payout lease A lease in which the lessor expects to recover its investment, plus interest,
over the life of the lease from any or all of the following: rentals, cash flow from tax
benefits and a modest expectation of residual value.
PEFCO See Private Export Funding Corporation.
Performance bond A bond supplied by one party to protect another against loss in the
event of default of an existing contract, usually to motivate a contractor to perform a
contract. Some performance bonds require satisfactory completion of the contract. Other
performance bonds provide for payment of a sum of money for failure of the contractor
to perform under a contract.
Perpetual FRNs A type of FRN which investors can (in theory) sell at close to par on
coupon dates. Consequently investors are less concerned regarding the life of the bonds
that are held. However, market prices for perpetual FRNs have been erratic.
Perpetuity An annuity forever; periodic equal payments or receipts on a continuous basis.
Physicals Actual commodity delivered to the contract buyer at the completion of a
commodity contract in either the futures markets or the spot market such as corn,
cotton, gold, coffee, oil, wheat and soya beans.
Placement A bank depositing Eurodollars with or selling Eurodollars to another bank is
often said to be making a placement.
Point 100 basis points is equal to 1%. However, 1% of the face value of a note or bond
is also called a point.
Poison pill An anti-takeover defence in which a new diluting security is issued to existing
shareholders if control of the firm is about to shift.
Pooling of interest A merger that involves the combination of the assets, the liabilities and
the equity positions of two companies. This method differs from the purchase approach,
which involves goodwill on any excess payment over book value.
Precautionary UCC filings A financial statement filing under the UCC perfecting the secu-
rity interest of the lessor in leased equipment in the event the lease is deemed to be a
security agreement under the UCC.
Preemptive rights Shareholder rights to maintain their proportional share of their firm by
subscribing proportionally to any new stock issue.
Preferred stock A kind of equity whose owners are given certain privileges over common
stockholders, such as a prior claim on the assets of the firm. Preferred stockholders may
have no voting rights and are usually paid a fixed dividend.
Premium bond A bond selling above par.
Prepayment A payment made ahead of the scheduled payment date.
Present value The current equivalent value of cash available immediately for payment or
a stream of payments to be received at various times in the future. The present value
will vary with the discount interest factor applied to future payments. The current value
of a given future cash flow stream, discounted at a given rate.
Price earnings ratio Current market price/annual earnings per share. The price earnings
multiple is a measure of the stock markets judgement as to the future earning potential
of a firm.
Pricing base The mutually agreed upon basis for setting a rate of interest, such as the
prime rate or Libor.
671

Glossary
Primary market The market for new issues during the syndication period is called the
primary market. A bond issue remains in this primary stage until allotments have been
made by the lead manager.
Prime rate The rate at which banks lend to their best (prime) customers. The all-in
cost of a bank loan to a prime credit equals the prime rate plus the cost of holding
compensating balances.
Principal A sum on which interest accrues. Capital, as distinguished from income. Par
value or face amount of a loan, exclusive of any premium or interest. The basis for
interest computations. Another definition of a principal is a person who acts for his
own account.
Private debt placement A placement of debt securities to a limited number of sophisti-
cated investors in the United States, as opposed to a public placement. SEC registration
requirements are much easier in a private placement of debt.
Private Export Funding Corporation (PEFCO) This corporation, in conjunction with
US commercial banks and the Eximbank, provides a source of private capital for
US exporting ventures. It was established for the purpose of mobilising non-bank
funds for medium- and long-term loans to borrowers outside the United States for the
purchase of US goods and services. PEFCO makes loans only when facilities are not
available from traditional private sector sources on normal commercial terms and at
competitive rates of interest. Accordingly, PEFCO extends loans with maturities that
are longer than those available from US commercial banks; the loans are guaranteed
fully by the Eximbank.
Private placement The raising of capital for a business through the sale of securities to
a limited number of well-informed investors rather than through a public offering. In
the United States a private placement is a debt or securities issue offered to a limited
number of sophisticated investors and not subject to the registration requirements of the
US Securities Act 1933.
Private ruling A ruling by the IRS requested by parties to a lease transaction that is appli-
cable to the assumed facts stated in the opinion.
Pro forma statement A financial statement prepared on the basis of some assumed events
that have not yet occurred.
Processing agreement As used in connection with project financing, a processing agreement
is an agreement to pay for processing, through some type of processing plant, minimum
amounts of some product in certain time frames at a certain price. Such an agreement
is similar to a through-put agreement in that it provides cash flows to service debt and
serves as an indirect guarantee for a project financing.
Production payment A mineral production payment is a right to a specified share of the
production from a certain mineral property (or a sum of money in place of production).
The payment is secured by an interest in the minerals in place. Payment is discharge-
able only out of runs of oil or deliveries of gas or minerals accruing to certain property
charged with the production payment. It cannot be satisfied out of other production.
The right to the production is for a period of time shorter than the expected life of the
property. A production payment usually bears interest payable out of future production
for payment.
672

Glossary
Production payment loan A loan secured by a production payment.

Profitability index The ratio of the present value of future cash flows from a project to
the initial investment in the project.
Project, as used in the term project financing An economic unit capable of generating
sufficient cash flow to conservatively cover operating costs and debt service for financing
the project over a reasonable time period which is less than the economic life of theasset.
Proprietorship An operation owned by one person and conducted for a profit.
Prospectus Also called a offering circular. The offering circular contains a complete descrip-
tion of a loan offering or securities issue, including a complete statement of the terms
of the issue and a description of the issuer, as well as its historical and latest financial
statements. A prospectus for a public offering must be filed (in the US) with the SEC
prior to the sale of a new issue.
Public issue Newly issued securities sold directly to the public.
Public offering Same as public issue.
Public utility property As defined in the Internal Revenue Code, public utility property
includes property used predominantly in the trade or business of furnishing or selling (a)
electrical energy, water, or sewage disposal businesses, (b) gas or steam through a local
distribution system, (c) telephone services or other communications services if furnished
or sold by Comsat, or (d) transportation of gas or steam by pipeline if the rates for such
furnishing or sale have been established or approved by a state (or political subdivisions
thereof), by an agency or instrumentality of the United States, or by a public service or
public utility commission.
Purchase option An option to purchase property during a certain period of time or on
the happening of certain events.
Put An option one person has to sell an asset to another person at a set price at some estab-
lished point in time in the future. A contract allowing the holder to sell some property
to some person at a fixed price for a given period of time.
Put bond A bond with an indenture provision allowing it to be sold back to the issuer at
a prespecified price.
Put option (generally) A contract sold for a price that gives the holder the right to sell
to the writer of the contract, over a specified period, a specified property or amount of
securities at a specified price.
Put options (in a bond) In a bond or loan, a put option gives investors the chance to
demand repayment early, affording them the opportunity to redeem low-coupon bonds
at par and to reinvest elsewhere at higher rates. For this right in the future investors will
have to accept a lower coupon today than that the coupon on a comparable instrument
which does not incorporate a put option.
Put-or-pay contract See supply-or-pay contract.
Quick ratio Cash, accounts receivable, government securities and cash equivalents to current
liabilities. This ratio nets out all current asset items of questionable liquidity such as
inventories. This is a measure of how quickly a company can pay off short-term obliga-
tions without relying on the sale of relatively illiquid assets. A ratio 1:1 of at least is
considered desirable.
673

Glossary
Range forward contract A forward exchange contract that specifies a range of exchange
rates for which currencies are exchanged on the expiration date.
Rating An evaluation given by Moodys, Standard & Poors, Fitch or other rating services
as to a securitys creditworthiness.
Rating agencies Agencies that study the financial status of a company and then assign a
quality rating to securities issued by that firm. Standard & Poors, Moodys and Fitch
are the leading rating agencies that will rate project finance debt.
Refinancing Repaying existing debt and entering into a new loan, typically to meet some
corporate objective such as the lengthening of maturity or lowering the interest rate.
Refunding Redemption of securities by funds raised through the sale of a new issue.
Registered bond A bond whose owner is registered with the issuer.
Registration statement A statement that must be filed in the United States with the SEC before
a security is offered for sale. The statement must contain all materially relevant information
relating to the offering. A similar type of statement is required when a firms shares arelisted.
Reinvestment rate The rate at which an investor assumes interest payments or cash
payments made on a debt security can be reinvested over the life of that security.
Relative value In finance, the attractiveness, measured in terms of risk, liquidity and return
of one investment relative to another or for a given instrument of one maturity relative
to another.
Remittance A transfer of funds from one place to another. A remittance may be any
payment in full or in part on a debt or obligation. However, a remittance need not be
payment of an obligation.
Renewal option An option to renew a lease at the end of the initial lease term. In order
to protect the tax characteristics of a true lease, a lessors option to renew a lease of
equipment from a lessor that is granted at the beginning of a lease must be at a price
equal to the equipments fair market value at the time the right is exercised.
Rent holiday A period of time in which the lessee is not required to pay rents. Typically,
the rents are capitalised into the remaining lease payments.
Required rate of return The minimum future receipts an investor will accept in choosing
an investment.
Requirements contract A contract whereby a user of a product agrees to buy its require-
ments for a plant or operation from a supplier. There is no requirement to take a
minimum amount or to pay if not delivered as in a take-or-pay contract.
Residual or residual value In a lease, the value of equipment at the conclusion of the
lease term. To qualify as a true lease for tax purposes, residual value at the end of the
lease term is usually expected to equal 20% of the original cost.
Residual insurance An insurance policy stipulating that equipment will have a certain
residual value after the elapse of a certain period of time.
Restricted subsidiary A subsidiary of a debtor company, the obligations of which are
combined with the parent for purposes of determining compliance with loan covenants.
Retained earnings Earned surplus. The amount of earnings retained and reinvested in a
business and not distributed to stockholders as dividends.
Retention money bonds A portion of the payments due under a construction contract are
sometimes to be retained by the employer to cover costs of repair of unforeseen defects.
674

Glossary
The contractor can receive those payments immediately by furnishing the employer a
bond for such payments.
Return on assets (ROA) Net profits after taxes divided by assets. This ratio helps a firm
determine how effectively it generates profits from available assets.
Return on equity (ROE) Net profits after taxes divided by stockholders equity.
Return on investment (ROI) Net profits after taxes divided by investment.
Return on tangible net worth The ratio of net income after tax to tangible net worth.
The ratio measures the return on the money invested in the corporation by the owners.
It should be viewed cautiously because different leverage policies can greatly distort this
ratio, even underlying profitability has not changed.
Revaluation A formal and official increase in the exchange rate of a currency that is made
unilaterally by a country or through the International Monetary Fund.
Revenue bond A municipal bond issued by a political subdivision of state or local govern-
ment and secured by revenue from tolls, user charges, or rents derived from the facility
financed. Municipal revenue bonds are not backed by the tax base or other assets of
the municipality.
Revenue ruling A written opinion of the Internal Revenue Service requested by a party to
a transaction which seeks a decision on one or more tax issues and which is applicable
to assumed facts stated in the opinion. It may also refer to published IRS rulings with
general applicability.
Revenues Sales.
Revocable letter of credit A letter of credit that can be changed or cancelled by the issuing
bank or by any party involved until the time payment is made.
Revolver See revolving credit agreement.
Revolving credit agreement A legal commitment on the part of a bank to extend credit
up to a maximum amount for a definite term. The notes evidencing debt are short-term,
such as 90 days. As notes become due, the borrower can renew the notes, borrow a
smaller amount or borrow amounts up to the specified maximum throughout the term
of commitment. The borrower is usually required to maintain compensating balances
against the commitment and pay a commitment fee on the average unused portion of
the revolving credit. The term of a revolving credit agreement is generally for two years
or longer. A revolving credit agreement is regarded as an intermediate loan.
Revolving letter of credit A letter of credit that provides the beneficiary with a credit limit
which can be reinstated to cover transactions involving repetitive shipments or needs.
Revolving line of credit Same as revolving credit agreement.
Right (stock right) A security allowing shareholders to acquire new stock at a pre-specified
price over a pre-specified period. Rights are generally issued proportional to the number
of shares currently held and are normally exercisable at a specified price, usually below
the current market. Rights usually trade in a secondary market after they are issued.
Risk Instability; uncertainty about the future; more specifically, the degree of uncertainty
involved with a loan or investment.
Risk adjusted discount rate A discount rate which includes a premium for risk.
Risk aversion An unwillingness to either bear any risk or to bear risk without compensa-
tion of some form.
675

Glossary
Risk finance In risk management, the management of retained risk.

Risk-free interest rate The interest rate prevailing on a default-free bond in the absence
of inflation.
Risk premium An additional required rate of return that must be paid to investors who
invest in risky investments to compensate for the risk.
Risk retention In risk management, decision as which risk to retain.
ROA Return on assets.
ROE Return on equity.
ROI Return on investment.
Roller coaster swap A swap in which the notional principal amount can rise or fall from
period to period according to a borrowers cash flow structure.
Rollover term loan Most term loans in the Euromarket are made on a rollover basis, which
means that the loan is periodically repriced at an agreed spread over the appropriate,
currently prevailing Libor rate.
RUF A revolving underwriting facility. A medium-term commitment by a group underwriting
banks to purchase one, three or six month Euronotes at a fixed Libor-related margin
should a sole-placing agent or tender panel fail to sell the notes to investors at or under
that margin. A GRUF is a guaranteed revolving underwriting facility.
Rule 144A A rule adopted by the US Securities and Exchange Commission in April 1990,
that eliminates the two-year holding period of privately placed securities by permitting
large institutions to trade such securities among themselves without having to register
them with the SEC.
Rule 415 An SEC rule allowing shelf registration of a security which may then be sold
periodically without separate registrations of each part.
Running the books, or book-runner The manager who has total control over an offering
(usually appears on the upper left of the list of underwriters in a tombstone advertisement).
SACE Sezione Speciale per lAssicurazione del Credito allEsportazione. The export credit
finance agency for Italy.
Safe harbour lease A lease clearly in compliance with Internal Revenue Rules is sometimes
called a safe harbour lease. Historically, a safe harbour lease was a lease which met the
criteria of Section 168(f)(8) of the Internal Revenue Code which was added by ERTA
and amended by TEFRA and repealed by DRA. These have now disappeared in the US,
following tax changes.
Salvage value The estimated selling price of an asset once it has been fully depreciated.
Sale and leaseback A transaction in which an investor purchases assets from the owner
and then leases such assets back to the same person. The lessee receives the sale price
(and can return it to his capital) and continues to enjoy the use of the assets.
Sale-type lease The same as a direct financing lease except that manufacturer or dealer
profits are involved. A lease that meets the definitional criteria of a capital lease under
FAS 13 or IAS 19, as appropriate, plus two additional criteria: (a) collectibility of the
minimum lease payment is reasonably predictable; and (b) no important uncertainties
surround the amount of unreimbursable costs yet to be incurred by the lessor under
the lease. International leases should also check IAS 19 for compliance.
676

Glossary
Samurai bond A Samurai bond is a foreign bond denominated in yen and issued in the
Japanese domestic bond market in Tokyo.
Sandwich An agreement essentially between two parties with a third party in between the
two parties, usually adding some value, such as a lease, sublease, for example.
Savings and loan association In the US, a federal or state chartered institution that
accepts savings deposits and invests the bulk of the funds thus received in mortgages.
In recent years, savings and loan associations have been authorised and have engaged
in some commercial lending including fixed-rate term loans.
Savings deposit An interest-bearing deposit at a savings institution that has no
specific maturity.
Sawtooth rents Rents that vary throughout the term of the lease, usually to match
debt payments and tax payments in a leveraged lease so as to lessen the need for a
sinking fund.
Scale A bank that offers to pay different rates of interest on CDs of varying maturities is
said to post a scale. Commercial paper issuers also post scales.
Scenario analysis Cash flow analysis testing a defined series of consistent changes to
variables in a project model. Many major companies define 2-3 scenarios in great detail
and project selection decisions are made by testing a project against these scenarios. The
scenario planning and development process has become well known following publica-
tions by Arie de Geuss, formerly of Shell.
SDRs Special drawing rights. An international reserve asset created by the International
Monetary Fund and based on a basket of four key currencies euro, Japanese yen, UK
pound sterling and US dollar. SDRs are exchanged only among central banks and are
convertible into other currencies.
Seasoned issue A public securities issue that has been well distributed and trades in well
the secondary market.
Secondary market After the initial distribution of bonds or securities, secondary market
trading begins. New issue houses usually make a market in bonds or securities which
they have co-managed. Other institutions, such as banks, investment banks and securities
trading firms, generally act as market makers in a wide range of issues and instruments
by quoting two-way prices and being prepared to deal at those prices.
Secured creditor A creditor whose obligation is backed by the pledge of some asset. In
liquidation, the secured creditor receives the cash from the sale of the pledged asset to
the extent of the amount of the loan.
Securitisation Process of: (1) pooling of assets; (2) creating different bond classes that are
backed by the pool of assets; and (3) de-linking of the credit risk of the pool of assets
from the credit risk of the originator.
Security agreement An agreement in which title to property is held as collateral under a
financing agreement, usually by a trustee.
Securities and Exchange Commission (SEC) An agency in the United States created by
Congress to protect investors in securities transactions by administering securities laws
and regulations.
Selling group Those firms that are not members of the underwriting group who want to
participate on a registered distribution.
677

Glossary
Semi-convertible currency Semi-convertible currencies can only be bought or sold through

a central bank at specific fixed rates of exchange. Included are many Third World nations
where transactions are limited to documented commercial deals.
Senior creditor Any creditor with a claim on income or assets prior to that of
general creditors.
Senior debt Senior debt is generally defined as all debt, both short- and long-term, which is
not subordinated to any other liability. This debt includes obligations to banks (revolving
credit lines or term loans), to insurance companies and to other financial institutions.
Rentals under leases are senior debt. In addition, most current liabilities such as account
payable, accrued expenses and taxes payable are usually considered senior debt. If the
financial statements do not specify whether the debt is senior or subordinated, conserva-
tive practice is to assume it is senior.
Sensitivity analysis Analysis of impact on an economic analysis, plan or forecast of a
change in one of the input variables.
Serial bonds A bond issue in which maturities are staggered over a number of years.
Service lease A short-term lease accompanied by service such as maintenance andinsurance.
Settlement date The date on which a trade is cleared by delivery of securities against
funds. The settlement date may be the trade date or a later date.
Settlement limit The total US dollar amount of foreign exchange contracts a bank autho-
rises a customer to settle within a single day, under a credit agreement.
Settlement price In futures and options accounts, the figure used to determine gains and
losses. Settlement prices are used to determine gains, losses, margin calls and invoice
prices for delivery.
Shareholders equity The book value of the net assets (total assets less total liabilities)
is called shareholders equity, or net worth. Accounts which comprise net worth are
preferred stock, common stock, paid-in capital and earned surplus (retained earnings).
Deferred accounts and reserve accounts such as reserve for pensions, while generally not
thought of as true liabilities, are not considered equity.
Shoguns US dollar bonds issued in Japan.
Short A market participant assumes a short position by selling a commodity or security he
does not own.
Short bonds Bonds with a short current maturity.
Short coupons Bond or note interest payments with a short current maturity.
Short hedge The sale of a future contract to hedge, for example, a position in cash, a
commodity, securities or an anticipated borrowing need.
Short position An individual who has sold a future or option contract to estab-
lish a market position and who has not yet closed out this position through an
offsetting purchase.
Short sale The sale of securities or commodities not owned by the seller in the expectation
that the price of these securities or commodities will fall or as part of an arbitrage. A
short sale must eventually be covered by a purchase of the securities or commoditiessold.
Short-term debt An obligation maturing in less than one year.
Short-term lease Generally refers to an operating lease.
Sight draft A draft calling for payment at first presentation, or at sight of the draft.
678

Glossary
Simple interest The charge for the loan of money or for a deferment of the collection of
an account, computed by applying a rate (of interest) against the amount of the loan
or account. Contrasts with compound interest in that only the principal earns interest
for the entire life of the transaction.
Sinking fund A fund of cash set aside for the payment of a future obligation. A bond
sinking fund is a payment of cash to creditors.
Sinking fund A reserve or a sinking fund established or set aside for the purpose or payment
of a liability anticipated to become due at a later date. Indentures on corporate issues
often require that the issuer make annual payments to a sinking fund, the proceeds of
which are used to retire randomly selected bonds in the issue. Another type of sinking
fund permits the issuer to retire the bond by a market purchase.
Sinking fund rate The rate of interest allocated to a sinking fund.
Soft currency A currency perceived by the market to be reasonably unlikely to maintain its
value against other currencies over a period of time. The convertibility of soft currencies
usually is, or may become, restricted.
Solvency The state of being able to pay debts as they come due.
Sources and uses statement A document showing where a company acquired its cash
and where it spent the cash over a specific period of time. It is constructed by segre-
gating all changes in balance sheet accounts into those that provided cash and those
that consumed cash.
Sovereign risk The special risk, if any, that attaches to an investment or loan because the
borrowers country of residence differs from that of the investors. Also referred to as
country risk.
SPE Acronym for special purpose entity, such as a trust, special purpose corporation, or
limited liability company, formed for the purpose of holding title or acting as a conduit
of funds. An SPE is thought to provide protection to lenders in the event of bankruptcy
of the sponsor or lessor. Same as an SPV or special purpose vehicle.
Special drawing rights SDR. The currency of the International Monetary Fund (IMF)
which is used to settle international balances; it represents a composite of four curren-
cies weighted according to each countrys share of world exports.
Special purpose corporation An independent corporation with nominal capital which is
a party to a project financing for purposes of holding title as a nominee or acting as a
conduit of funds.
Special purpose property Property that is uniquely valuable to the user and is not valu-
able to anyone else except as scrap. A lease of special-purpose property will not qualify
as a true lease because the lessee controls the residual value. Also referred to as limited
use property.
SPV Special purpose vehicle.
Specialised tender panel In connection with Euronotes, a specialised tender panel is
similar to a direct bid facility except that members of the STP are limited to a nucleus
of financial intermediaries with perceived note placement strength who are expected to
make a market in the issuers paper.
Sponsor A party interested in supporting a project financing. A party providing the credit
to support a project financing.
679

Glossary
Spot market The market for buying and selling a specific commodity, foreign currency or
asset at the current price for immediate delivery. Markets in which goods, currencies,
assets or commodities are sold for cash and delivered immediately, except in the spot
market for foreign exchange, settlement is two business days ahead. Trades that occur
in futures contracts expiring in the current month are also called spot market trades.
The spot market tends to be conducted over-the-counter (via telephone trading) rather
than on the floor of an organised commodity exchange. Known also as actual market,
cash market or physical market.
Spot rate The price prevailing in the spot market.
Spot transaction A foreign exchange transaction in which foreign currency is bought at the
current rate of exchange and delivered within two business days after the transactiondate.
Standard & Poors A credit rating agency.
Standard deviation The volatility of returns, or the average deviation from an expected
value or mean.
Standby letter of credit A letter of credit that provides for payment to the beneficiary
when he presents a certification that certain obligations have not been fulfilled. For
example, if a construction company does not complete work in time, the beneficiary
(generally the building owner) can recover payment from the bank issuing the standby
letter of credit.
Stepped appreciation on income-realisation securities Zero-coupon bonds for an initial
period, after which they are converted to interest-bearing securities.
Stepped FRN A floating rate note where the spread over the reference rate changes with
time on a preset basis.
Stop payment order Instructions issued to a bank which direct the bank not to honour a
previously issued draft or check. The order must meet legal requirements.
Story credit A credit that looks poor from the standpoint of its financial statements but
that looks more favourable in light of the story about its prospects for the future.
Straddle Strategy comprising an equal number of put options and call options on the same
underlying stock, stock index, or commodity future at the same strike price and maturity
date. Each option may be exercised separately, although the combination of options is
usually bought and sold as a unit.
Straight debt A standard bond issue or loan lacking any right to convert into the common
shares of the issuer.
Straight letter of credit A letter of credit in which the opening bank limits its promise
to pay to the beneficiary.
Straightline depreciation Depreciating an asset by equal dollar amounts each year over
the life of the asset.
Strike price The price at which an option to purchase can be exercised.
Striking price method In connection with Euronotes where the issue price for the whole
tranche is set at the level of the last accepted bid which caused the tranche to be filled.
Notes are not priced at a sequential level from the most competitive bid upwards as in
standard tender panel.
Strip debt Debt arranged in tiers with different rates, maturities and amortisation to improve
the borrowers cost.
680

Glossary
Structured note A medium-term note created when the issuer simultaneously transacts in
the derivative markets. The most common derivative instrument used in creating struc-
tured notes is a swap. Examples of structured notes are step-up notes, range notes and
inverse floaters.
Subordinated creditor A creditor holding a debenture having a lower priority of payment
than other liabilities of the firm.
Subordinated debenture Holders of this issue rank after those of holders of various other
unsecured debts incurred by the issuer.
Subordinated debt All debt (both short- and long-term) which, by agreement, is subordi-
nated to senior debt. It does not include reserve accounts or deferred credits.
Sum-of-the-digits amortisation A method of amortising whereby the amount reduced
each period is obtained by multiplying the total amount to be amortised by a fraction
whose numerator is the digit representing the remaining number of amortisation periods
and whose denominator is the sum of the digits representing the number of periods
of amortisation.
Sum-of-the-digits depreciation Depreciation method utilising sum-of-the-digits amortisa-
tion technique.
Supply-or-pay contract A contract under which a supplier agrees to supply a raw mate-
rial, product or service for a certain price to a stated period and agrees to pay for an
alternative supply if it cannot perform.
Sushi bond A dollar issue undertaken by a Japanese company from Japan, designed to
be bought by Japanese institutions. They do not count against limits on holdings of
foreign securities.
Swap agreements Contract whereby two parties agree to exchange periodic payments.
The dollar amount of the payments exchanged is based on a notional principal amount.
There are four types of swaps: currency swaps, interest rate swaps, commodity swaps
and equity swaps. (See also exotic options.)
Swap buy-back A swap transaction that involves the sale of a swap to the original coun-
terparty. Also called a close-out sale or cancellation.
Swap exchanges In securities, selling one issue and buying another. In foreign exchange,
buying a currency spot and simultaneously selling it forward. In liability swaps, exchanging
fixed for variable liabilities.
Swap rate The quoted fixed rate that the fixed-rate payer must pay in an interest rateswap.
Swap sale A secondary swap market transaction in which a party that wishes to close out
the original swap finds another party that is willing to accept its obligations under the
swap. Also called a swap assignment.
Swap spread The spread that the fixed-rate payer pays in an interest rate swap above the
benchmark Treasury yield.
Swaps tender panel In a Euronote facility, a further refinement of a tender panel
whereby the issuer can ask for currency and for interest rate swaps on a particular
note issue tranche.
Swaption An option on an swap. The buyer of this option has the right to enter into a
swap agreement on predetermined terms by some specified date in the future. The buyer
of a put or call swaption pays the writer a premium.
681

Glossary
SWIFT Acronym for Society for Worldwide Information and Funds Transfer. This inter-
national system and organisation has been established to move funds and information
among member banks.
Swingline Used in a global note facility or bonus to allow the issuer to move from the US
commercial paper market to the Euronote market. Typically available for a maximum
of seven days and priced in relation to US prime.
Syndicate A group of banks making a syndicated loan. A group of bond houses which act
together in underwriting and distributing a new securities issue.
Syndicated bank loan See Syndicated credit facility.
Syndicated credit facility A syndicated credit facility is one in which a number of banks
undertake to provide a loan or other support facility to a customer on a pro rata basis under
identical terms and conditions evidenced by a single credit agreement. These facilities are
generally floating rate in nature, with or without amortisation and the pricing will normally
consist of a fixed spread over a short-term base rate (which base rate is adjusted periodically
during the life of the loan), with commitment fees, agency fees, management fees, offsetting
balances, security and so on, often included as well. Tenors may range from 112years.
Syndicated loan Similar to a syndicated credit facility. A commercial banking transaction in
which two or more banks participate in making a loan to a borrower. Interest is typically
paid on a floating rate basis linked to short-term interest rates in a particular currency.
Synthetic lease An equipment lease that qualifies as an off-balance sheet operating lease
for financial accounting purposes but as a loan or conditional sale for tax purposes, thus
enabling the lessee to retain tax benefits associated with equipment ownership.
Take-and-pay contract A take-and-pay contract is sometimes used to describe a contract

in which payment is contingent upon delivery and the obligation to pay is not uncon-
ditional, as in a take-or-pay contract.
Take-or-pay contract A take-or-pay contract is a long-term contract to make periodic
payments over the life of the contract in certain minimum amounts as payments for a
service or a product. The payments are in an amount sufficient to service the debt needed
to finance the project which provides the services or the product and to pay operating
expenses of the project. The obligation to make minimum payments is unconditional and
must be paid whether or not the service or product is actually furnished or delivered.
Taking a view An expression for forming an opinion about the movement of some financial
variable that impacts returns and acting upon it.
Tangible expenses Capital expenditures subject to depreciation and depletion in connec-
tion with an oil well or mine.
Tangible net worth Tangible net worth is shareholders equity adjusted for intangible assets.
A conservative practice is to subtract intangible assets from stockholders equity to more
truly represent (in terms of physical assets) the amount of equity which shareholders
have invested in a company. Though intangible assets may have some value, this value
is often quite different from the amount appearing on financial statements.
TAP basis In the Eurocommercial paper market, the method of issuance whereby the dealer
approaches the issuer for paper in direct response to particular investor demand rather
than the issuer seeking bids from the dealer.
682

Glossary
Tender acceptance facility The same structure as an underwritten Euronote facility using
a tender panel except that the short-term instruments under auction are bankers accep-
tances not Euronotes.
Tender bond Another name for a bid bond.
Tender panel In connection with Euronotes, a group, which includes Euronote facility
underwriters and additionally appointed banks and dealers, who are invited to bid on
an issuers paper in an open auction format. Notes are awarded to bidders in sequential
order from the most competitive bid upwards until the full tranche is allocated.
Term loan A business loan with an original or final maturity of more than one year, repay-
able according to a specified schedule.
Through-put contract Parties to a through-put agreement commit to ship certain
minimum quantities of oil, refined products or gas at a fixed rate through a pipeline.
Certain quantities have to be shipped in each period, such as a month or a year,
to provide the cash flow to meet operating expenses and debt service of the pipeline
company. In the event the product is not shipped and the pipeline company has
insufficient cash to meet is expenses and debt service, the parties to the through-put
agreement are unconditionally obligated to contribute additional funds in proportion
to ownership. The through-put contract is similar to a take-or-pay contract and serves
as an indirect guarantee for a project financing of the pipeline. Through-put agree-
ments are also used in connection with processing plants where some product is put
through the plant.
Time deposit An interest-bearing deposit at a savings institution that has a specificmaturity.
Time/usance draft A draft calling for payment at some specified date in the future.
Tolling contract Another name for take-or-pay contract.
Tornado chart A horizontal bar chart that displays the effect of changing a number of key
variables on a selected key result. The chart displays the most sensitive input variables
at the top and the overall effect can be likened to a tornado.
Total debt of tangible net worth ratio Total debt (current debt, long-term senior and
subordinated debt) ratio/net worth less intangible assets. The measure of the relative
amounts invested in a company by creditors and owners. A high ratio in comparison to
industry norms indicates a greater dependence on outside financing and an unwillingness
of the owners to risk their own capital. At some point, the risks of operations will shift
primarily to the creditors. Leases should be capitalised in accordance with FAS 13 or
IAS 19, as appropriate, in computing this ratio.
Total debt and capitalised lease to tangible net worth and subordinated debt
ratio The purpose of this ratio is to assess the protection afforded to the senior creditors
capital sources (and underlying assets) which will be satisfied only after senior creditors
are reimbursed.
Trade acceptance A draft drawn by the seller of goods on the buyer and accepted by the
buyer for payment at a specified future date.
Trade account An account in the balance of payments, also called the merchandise balance,
that shows exports and imports of goods and services in the local currency.
Trade payables Accounts payable in the normal operation of the business.
Trade financing programs See export credit incentive programs.
683

Glossary
Translation agreement In ship transactions, a transportation agreement for a term of

years with characteristics of a take-or-pay contract or a through-put contract is often
used to support a long-term character and/or the financing of the purchase of a ship.
A long-term lease would have to be reported on a lessees balance sheet under FAS 13
or IAS 19, as appropriate, whereas a long-term transportation agreement would not.
Treasury bill A non-interest-bearing discount security issued by the US Treasury to finance
the national debt. The maturity of a Treasury bill is one year or less and the maturities
actually issued vary.
True lease A true lease is a lease in which the lessor possesses the attributes of ownership
of the leased equipment and in the US needs to meet the following qualification tests.
1 At the start of the lease, the fair market value of the leased property projected
for the end of the lease term equals or exceeds 20% of the original cost of the
leased property (excluding front-end fees, inflation and any cost to the lessor for
removal).
2 At the start of the lease, the leased property is projected to retain at the end of
the initial term a useful life that (a) exceeds 20% of the original estimated useful
life of the equipment and (b) is at least one year.
3 The lessee does not have a right to purchase or release the leased property at a
price that is less than its then fair market value.
4 The lessor does not have a right to cause the lessee to purchase the leased prop-
erty at a fixed price.
5 At all times during the lease term, the lessor has a minimum unconditional at
risk investment equal to at least 20% of the cost of the leased property.
6 The lessor can show that the transaction was entered into for profit, apart from
tax benefits resulting from the transaction.
7 The lessee does not furnish any part of the purchase price of the leased property
and has not loaned or guaranteed any indebtedness created in connection with
the acquisition of the leased property by the lessor.
TRUF An acronym for transferable revolving underwriting facility. In connection with
Euronotes, whereby the banks contingent liability to purchase notes in the event of
non-placement is fully transferable.
Trust deed In a loan, a contract defining the obligations of the borrower and appointing
a trustee to represent the interests of lenders. Also known as a trust indenture in the
United States.
Trust indenture See trust deed.
Trust receipt A legal instrument allowing a party to receive custodial control over goods
for a short, predetermined period of time and for a particular purpose. After this time,
either the goods are paid for or custodial control is returned to the party acting as agent
in the transaction, usually the collecting bank.
Trustee A bank or other third party which administers the provisions of a trust agreement.
In financing transactions these provisions may relate to a loan.
UCC The Uniform Commercial Code, which has been adopted by every state except Louisiana
to govern commercial transactions.
684

Glossary
UCC financing statement A document filed with the county (and sometimes the secretary
of state) to provide public notice of a security interest in personal property.
US Treasury bond futures contract A futures contract in which the underlying instrument
is US$100,000 par value of a hypothetical 20-year, 6% coupon bond.
Underwrite An arrangement under which a financial house agrees to buy a certain agreed
amount of securities of a new issue on a given date and at a given price, thereby assuring
the issuer the full proceeds of the financing.
Underwriter A financial firm engaged in the business of underwriting securities issues.
A dealer who purchases new issues from the issuer and distributes them to investors.
Underwriting is one function of an investment banker. In a Eurobond offering, the lead
managers and co-managers act as underwriters for the issue, taking on the risk of interest
rates moving against them before they have placed the bonds. Additional banks may be
invited to act as sub-underwriters, so forming a larger underwriting group.
Underwriting syndicate A group of investment banks that band together for a brief time
to guarantee a specified price to a company for newly issued securities.
Undivided interest A property interest held by two or more parties whereby each shares,
according to their respective interest, in profits, expenses and enjoyment and whereby
ownership of the respective interest of each may be transferred but physical partition
of the asset is prohibited.
Unfunded retained risk In risk management, the potential losses that have been identified
for a retained risk that are only funded as they are realised.
Uniform customs and practices for documentary credits With reference to letters of
credit, UCP 600 issued by the International Chamber of Commerce (latest revision in
2007) outlines the rules and guidelines involved in letter of credit transactions. These provi-
sions are followed by most banks, unless there is an express agreement to the contrary.
Unrestricted subsidiary A defined term in a loan agreement. Typically a subsidiary of a
debtor company which is free from loan covenant limitations on amounts of debt and
lease liability. However, the parent debtor company cannot guarantee the debt obliga-
tions of the unrestricted subsidiary and the total amount which the parent can invest in
such a subsidiary is limited by loan covenant.
Unsecured loan A loan made on the general credit of a borrower. The lender relies upon
the borrowers balance sheet and the capability of the borrowers management to manage
its assets and produce cash flows sufficient to repay the debt. No assets are pledged.
Use-or-pay contract Another name for a take-or-pay contract or throughput contract.
Useful life The period of time during which an asset will have economic value and be
usable. The useful life of an asset is sometimes called the economic life of the asset.
VC or VCs Venture capital companies and funds. High risk investors willing to accept
high risk in return for high rewards. They concentrate today on e-commerce company
startups and bio-chemical startups in the medical field. Their investments are in equity
and equity related securities.
Variable rate CDs Short-term CDs that pay interest periodically on roll dates; on each roll
date the coupon on the CD is adjusted to reflect current market rates.
685

Glossary
Variable-rate loan Loan made at an interest rate that fluctuates with the prime, Libor or
some other index.
Variation margin For a futures contract, the additional margin necessary to bring the equity
in the account back to its initial margin level.
Vendor financing Financing offered by a manufacturer or dealer for its products.
Vendor lease A lease offered by a manufacturer or dealer to its customers for financing
its products. The manufacturer or dealer is the vendor.
Vendor leasing The term used to describe vendor leases offered by a manufacturer, a dealer,
or a third party leasing company under a working relationship between the third party
leasing company and the manufacturer or dealer.
Venture capital Risk capital in the form of equity investments or equity related debt securi-
ties extended to start-up or small going concerns.
Volatility The degree of fluctuations that occur away from a common denominator such as
the mean, or average value, of a series of figures. The greater the volatility in returns,
the higher the risk.
Warrant An instrument allowing the holder to purchase a given security at a given price;
for either a set period or into perpetuity.
Warrant bonds A warrant bond gives the holder the right to buy something in the future,
usually a share or a bond.
Wintergreen renewal Similar to an evergreen renewal except that the renewal term is
limited to a fixed period.
Working capital replenishment An undertaking by an industrial company sponsor and/
or parent to make liquid funds available to a special purpose subsidiary or company to
enable such a company to keep its working capital at levels sufficient to service debt
and meet operating expenses.
Wrap-around loan A long-term loan structured with a short-term loan in such a manner as
to postpone payments of principal (and sometimes interest) on the long-term loan until
the short-term loan is repaid. The combination short-term and long-term wrap-around
may produce level debt service for both loans over the life of the long-term loan.
Yankee bond A foreign bond issued in the US market, payable in dollars and registered
with the SEC.
Yankee CD A CD issued in the domestic market (typically in New York) by a branch of
a foreign bank.
Yield Rate of return on a loan, expressed as a percent and annualised.
Yield curve The relationship between yield and current maturity is depicted in graphic
form as a yield curve. This curve plots yield on the vertical axis and maturity on the
horizontal axis. A normal yield curve slopes upward from left to right, from short
maturities to long maturities.
Yield to maturity The rate of return yielded by a debt security held to maturity when
both interest payments and the investors capital gain or loss on the security are taken
into account.
686

Glossary
Zaiteku More correctly, zaimu tekunorojii, a Japanese term for making money purely from
financial operations.
Zero-coupon bonds A bond which does not pay interest. The security is sold at a discount
and its yield interest rate is determined by a rise in value per unit of time. Its maturity
value equals par.
Zero-coupon convertible Zero coupon bond with option to convert to common stock or
other security.
Zero-coupon note See zero-coupon bond.
Zero-coupon swap A swap in which the fixed-rate payer does not make any payments until
the maturity date of the swap but receives floating-rate payments at regular paymentdates.
687

The Journal of Structured Finance
The Journal of Structured Finance, formerly the Journal of Project Finance, takes a broad
view of structured finance, including all aspects of securitization, credit derivatives, leasing,
project and infrastructure finance, and associated legal, regulatory, accounting, tax, servicing,
and disclosure issues. The journal has current articles on the full range of asset-based securities
(ABS), including residential mortgage-backed securities (RMBS); commercial mortgage-backed
securities (CMBS); credit card, auto loan, and student loan ABS; asset-backed commercial
paper (ABCP); life settlements; catastrophe bonds and other insurance-linked securities; and
other esoteric asset classes.
The journal covers current trends related to analytics, valuation, pricing, the role of the
credit rating agencies and ongoing efforts to reform the U.S. housing finance system. The
journal is written by practitioners for practitioners. Our writers and readers include bankers,
lawyers, originators, institutional investors, securities and rating agency analysts, government
officials, consultants, academics, and other experts in the field.
A subscription to Institutional Investor Journals gives readers:
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Frank Fabozzi, Carmel de Nahlik Project Financing 8th Edition

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Frank Fabozzi, Carmel de Nahlik Project Financing 8th Edition

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Project Financing

ProjectFinancing.indb 1 18/06/2012 07:49

Frank J Fabozzi and Carmel F de Nahlik

ProjectFinancing.indb 3 18/06/2012 07:49

Tel: +44 (0)20 7779 8999 or USA 11 800 437 9997

Copyright 2012 Euromoney Institutional Investor PLC

ISBN 978 1 78137 070 4

Typeset by Phoenix Photosetting, Chatham, Kent

ProjectFinancing.indb 4 18/06/2012 07:49

1 An overview of project finance 1

2 Criteria for a successful project financing 13

ProjectFinancing.indb 5 18/06/2012 07:49

Contractual agreements among joint venture partners 25

3 Use of a financial adviser 37

4 The offering memorandum 44

ProjectFinancing.indb 6 18/06/2012 07:49

5 Risks that a lender may assume 58

6 Choosing a lead bank 65

7 Contacting lenders and investors 69

8 Credit risk appraisal 73

ProjectFinancing.indb 7 18/06/2012 07:49

3 General considerations in credit decisions 74

9 Risk analysis of a project loan 81

10 Types of capital and debt 99

ProjectFinancing.indb 8 18/06/2012 07:49

Security agent for senior debt 109

11 Sources of equity and debt 112

12 Use of captive insurance and finance companies 125

ProjectFinancing.indb 9 18/06/2012 07:49

13 Instruments used in project financing 132

14 Construction financing 154

ProjectFinancing.indb 10 18/06/2012 07:49

Construction supervision agreement 161

15 Term loans and private placements 163

ProjectFinancing.indb 11 18/06/2012 07:49

Limitations on mortgages, liens and other

16 Industrial development revenue bonds 189

17 Commercial paper and back-up credit facilities 202

18 General principles of leasing and types of leases 211

ProjectFinancing.indb 12 18/06/2012 07:49

6 Leveraged lease  217

ProjectFinancing.indb 13 18/06/2012 07:49

Computation of the loss or benefit 236

19 International leasing 246

ProjectFinancing.indb 14 18/06/2012 07:49

20 Financial models 257

ProjectFinancing.indb 15 18/06/2012 07:49

41 Using VBA  280

21 Financial modelling for different industries 282

22 Overview of risk management 298

ProjectFinancing.indb 16 18/06/2012 07:49

ProjectFinancing.indb 17 18/06/2012 07:49

Project financing supported by third-party guarantor 334

24 Controlling risk via risk-sharing derivatives contracts: futures and

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Short hedge and long hedge 363

25 Controlling risk via risk-sharing derivatives contracts: swaps 374

26 Controlling risk via insurance-type derivative contracts: options,

27 Entities for jointly owned or sponsored projects 396

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Example of a joint venture corporation with tax benefits

28 Reserves-oriented financing and drilling funds 432

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Oil and gas development funding outside the US 446

1 An overview of project finance 1

2 Criteria for a successful project financing 13

Contractual agreements among joint venture partners 25

3 Use of a financial adviser 37

4 The offering memorandum 44

5 Risks that a lender may assume 58

6 Choosing a lead bank 65

7 Contacting lenders and investors 69

8 Credit risk appraisal 73

3 General considerations in credit decisions 74

9 Risk analysis of a project loan 81

10 Types of capital and debt 99

Security agent for senior debt 109

11 Sources of equity and debt 112

12 Use of captive insurance and finance companies 125

13 Instruments used in project financing 132

14 Construction financing 154

Construction supervision agreement 161

15 Term loans and private placements 163

Limitations on mortgages, liens and other

16 Industrial development revenue bonds 189

17 Commercial paper and back-up credit facilities 202

18 General principles of leasing and types of leases 211

6 Leveraged lease 217

Computation of the loss or benefit 236

19 International leasing 246

20 Financial models 257

41 Using VBA 280

21 Financial modelling for different industries 282

22 Overview of risk management 298

Project financing supported by third-party guarantor 334

Short hedge and long hedge 363

25 Controlling risk via risk-sharing derivatives contracts: swaps 374

27 Entities for jointly owned or sponsored projects 396

Example of a joint venture corporation with tax benefits

28 Reserves-oriented financing and drilling funds 432

Oil and gas development funding outside the US 446

30 Public-private partnerships and the private finance initiative 485

Case studies 503