Introduction to Project Finance:

Rationale, Structure and Financing

Characteristics
Scott Jazynka
February 26, 2007
Amman, Jordan

Prepared by Gary Powell, PhD of IP3

 Project Finance
• Involves the creation of a legally independent
project company financed with:
• Non or limited recourse debt
• Equity provided by one or more sponsors
• Providers of the funds look primarily to the cash
flow from the project as the source of funds to
pay back the loans (interest & principal) and to
provide the return on the equity invested in the
project

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 Project Finance
• In project financing, those providing the senior debt
place a substantial degree of reliance on the
performance of the project itself.
• Therefore, a project financing structure is not primarily
dependent on the credit support of the sponsors or the
value of the physical assets involved (limited purpose
assets)

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 Growth in Project Financings
• Dollar value of project financings grown
steadily over the past three decades
• Project debt financing has surpassed $180
billion in 2006 with over 540 issuances - a
30% increase in value over 2005
• New project structure developing constantly
to meet investor and customer appetites

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 Infrastructure Development in the
Middle East
• Demand for infrastructure development in
Middle East exceeded $25 billion in 2006 is
expected to continue growing over the next 10
years
• Nearly 120 infrastructure projects (excluding
petroleum-based projects) are expected over
the next 5 years in the Middle East

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 Global Project Finance Volume
200 $180.6
In U.S. Dollars Billion

150 $139.4

100

50

0
2005 2006
Source: Thomson Financial

6
 2006 Project Finance:
Middle East and North Africa
US$29.4 Billion Total O man
10 %

Saud i A r ab ia
51%

Qat ar
15%

B ahar ain
4%

Kuw ait
8%
Eg yp t UAE Source: Thomson Financial
5% 7%

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Top 2006 Project Finance Arrangers
Arranger Volume Rank Number of
(in US$ Billion) Deals
Royal Bank of Scotland $13.2 1 66
Calyon $8.7 2 60
Mizuho Financial Group $7.7 3 54
Societe Generale $7.0 4 34
ABN AMRO $6.3 5 18
BNP Paribas SA $5.9 6 47
BBVA $5.8 7 32
WestLB AG $5.4 8 36
State Bank of India $5.4 9 27
Mitsubishi UFJ Fin. Grp. $4.4 10 47

Source: Thomson Financial

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Principle Features of Project Finance

• Separate Legal Entity

• Equity Sponsorship
• Contractual Arrangements
• Debt Financing
• Non or Limited Recourse

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 Traditional Debt Financing
- Corporate Finance Approach -

Lender

Loan repayment secured

by cash flows of company;
Corporation
company’s assets serve as (Borrower)
Company invests
collateral borrowed funds in project

Project

“ON-BALANCE SHEET” APPROACH

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 Problems with Corporate Finance
Approach
• Higher risk
• Limits capacity to bid and undertake other
projects
• Restricts ability to form consortium
• Difficult to divest

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 Traditional Debt Financing
- Public Finance Approach -
Lender

Loan repayment secured Government

by ability of government (Borrower) Government invests
to repay
borrowed funds in project

Project

“ON-BALANCE SHEET” APPROACH

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Problems with Public Finance Approach
• Constrained public expenditures
• Budget deficits in host country
• Draws from other social services
• Large financing needs for critical infrastructure
and development projects
• Reduced aid flows to developing countries
• Private sector not engaged effectively
• Perpetuates existing shortfalls
• Government not always well suited to deal with all
project risks
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 Project Finance Approach
- Non Recourse -

Lender has no or limited recourse to

Lender other sponsor assets
Sponsor(s)
Loan repayment secured
equity
by revenues from project;
project assets serve as Project
collateral for loan

“OFF-BALANCE SHEET” APPROACH

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Financial resources
required to LINK Project
execute project Revenues
(Capital and O&M)

• Allows financing of projects whose sponsors:

• unwilling to expose their general assets to liabilities to be incurred
in connection with the project, or
• do not enjoy sufficient financial standing to borrow funds on the
basis of their general assets
• Not interested in ownership
• Interested in maintaining flexibility to undertake other projects

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 Debt and Equity Securities

• The terms of the debt and equity securities

are tailored to the cash flow characteristics
of the project (Grace periods).
• The security of project debt depends, at least
partly, on:
• the profitability of the project
• the collateral value of the project’s assets

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 Limited Recourse and Non-
Recourse Lending
• Non-Recourse Debt:
• Project debt is non-recourse when the securities and
other borrowings are designed to be serviced and
redeemed exclusively from project cash flow.
• Limited Recourse Debt:
• Project debt is limited recourse when the project
sponsors/government provide undertakings that
obligate them to supplement the project’s cash flow
under certain, limited circumstances.

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 Agreements and Assurances
• Agreement for Project Completion
• Agreement for Sufficient Cash Flow for
Capital Investment and/or From Operations
• Assurance Against Project Disruption
• Agreement for Off-Take (Take-or-Pay)
• Concession Agreement
• Agreements of Funding
• Operating Agreements
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Basic Elements of a Project Financing

Loan Debt
Funds Lenders Repayment

Raw Materials Purchase Contracts

Assets Comprising
Suppliers the Project Purchasers
Supply Contracts Outputs

Cash Deficiency
Equity
Agreement, Other Forms
Funds
of Credit Support
Returns to Management
Equity Investors Investors Fee Investors/Sponsors
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 Parties Involved in Project
Financing

Contractors Suppliers

Other
Investors
Government Project
Company Project
Sponsors

Customers Lenders

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Parties Involved in Project Financing
• Sponsors and Investors:
• A controlling stake in the equity of the company will
typically be owned by a single sponsor or group of
sponsors, who will generally be involved in the
construction and management of the project.
• Other equity-holders may be companies with
commercial ties to the project including customers and
suppliers
• Financial investors may also take an equity stake in the
project (Funds)

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Parties Involved in Project Financing
• Lenders:
• A large fraction of the substantial investment needed is
usually raised in the form of debt from a syndicate of
banks
• Bond issues in capital markets
• Project companies will sometimes enter into production
payment (revenues bonds / escrow account)
arrangements instead of issuing ordinary debt

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Parties Involved in Project Financing
• Government:
• The project company will in most cases need to obtain a
concession or license from the host government in an
infrastructure investment
• The government may need to establish a new regulatory
framework, guarantee currency convertibility, non-compete
clause and provide environmental permits
• In many cases, the project company retains ownership of
project assets (BOOs); in other cases, ownership of project
assets is transferred to the government at the end of the
concession period (BOTs)

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Parties Involved in Project Financing

• Contractors (Construction / Operating

Company)
• The main contractor of the plant will often hold
a stake in the equity of the project company
• Other contractors will sometimes also hold an
equity stake, but generally to a lesser stake

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Parties Involved in Project Financing
• Suppliers and Customers
• Once the project facility has been built and becomes
operational, the project company will need to
purchase the supplies it requires and sell the
products and services it provides.
• The government is often the sole customer for some
infrastructure projects.
• Longer-term accounts receivable financing

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 Assessing Project Risks
• Completion Risk (Construction)
• Technology Risk
• Raw Material Supply & Pricing Risk
• Economic and Financial Risk
• Currency Risk
• Political Risk
• Environmental Risk
• Force Majeure Risk

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Distribution of Risks Among Parties

• Contractual arrangements distribute risk

among the various parties…
• These contractual arrangements are designed to
allocate the risks of the project to those parties
that can best appraise and mitigate those risks.

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 Distribution of Risks Among Parties
• Project Sponsors: bear the risks of project design,
construction, completion, operation, and
maintenance
• Facility management contract (mgt fee)
• Working capital maintenance agreement
• Cash deficiency agreement
• Main contractor will usually be required to post a
performance bond.
• Long term raw material purchase agreements

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Distribution of Risks Among Parties
• Lenders: will require the usual assurances from
the project company, including security for their
loans.
• In the early stages, lenders will have recourse to the
project sponsors in the event of specific problems such
as cost overruns.
• Lenders will want to ensure that cash that can be used to
service debt cannot be paid out to equity-holders
(dividend restriction)
• Lower risk and therefore return than equity investors

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Distribution of Risks Among Parties
• Customers: when there are only a few
potential customers for the project’s output,
revenue risk is likely to be transferred to those
customers by means of a long-term sales
contract.
• Contracts may include: take-or-pay clause,
throughput agreement, tolling contract.
• Indexed rates
• Purpose of transferring risk to customers
• Rate adjustment

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 Distribution of Risks Among Parties
• Government: when a government grants a concession to
a project company, there will be a concession agreement
that gives the company the right to build and operate the
project facility.
• Concession agreement may require the government to
construct supporting facilities such as access roads.
• May require non-compete condition
• Government may need to guarantee the performance of
state-owned companies.
• Government may be asked to provide guarantees for
currency convertibility

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Requirements for Project Financing
• The availability of funds depends on the
ability to convince providers of funds that
the project is:
• Technically Feasible
• Ability to Perform
• Economically Viable (incl. agreed upon
subsidies)

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 Global Trends in Project Finance
• Private-sector participation in infrastructure projects
• Build-Own-Operate (BOO)
• Build-Operate-Transfer (BOT)
• Risk management techniques
• Interest rate risk
• Currency risk
• Raw material price/supply risk
• Demand risk
• Deepening of capital markets in emerging countries
• Issuance of bonds in some developing capital markets

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 Debt Financing

• Typically fixed interest rate ==> Fixed payments

• Principal and interest payments
• Represents a legal obligation of project company
• Returns to lenders are fixed (they will not earn more than
the interest rate on the debt)
• Maximum term: usually 7-20 years (should be longer)
• Interest payments on debt are tax deductible
• Debt financing often represents 50% to 80% of total
project cost
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 Equity Financing
• Investment with highest risk
• Represents residual ownership interest in project
• interest and principal payments on loans must be paid before
dividends can be paid to equity investors
• Required return on equity investment (20-25%) is
always higher than interest rate on debt
• Equity investment in project financing is usually 20%
to 50% of total project cost

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 The Institute for Public-Private Partnerships (IP3)
Washington | Cairo | Jakarta | Dakar

Washington Cairo
1010 Wisconsin Avenue, NW, Suite 250 19 Ahmed El Shattoury Street
Washington, DC 20007 USA Dokki, Giza, Egypt

Jeff Wuorinen Tamer Shaltout

Regional Representative, Middle East/North Africa Program Manager, Egypt
E-mail: jwuorinen@ip3.org E-mail: tshaltout@ip3.org

Tel: 1-202-466-8930 Fax: 1-202-466-8934

www.ip3.org