Credit Attributes of Project Finance
CHRIS BEALE, MICHEL CHATAIN, NATHAN FOX, SANDRA BELL,
CHRIS BEALE
is global head of project
finance at Citigroup in
New York, NY.
chris.beale@citi.com
MICHEL CHATAIN
is head of project finance in
the Americas at Société
Générale in New York, NY.
michel.chatain@us.socgen.com
NATHAN FOX
is assistant vice president,
project finance at Citigroup
in New York, NY.
nathan.fox@citi.com
SANDRA BELL is a senior
managing director and
JAMES BERNER is an
associate in project and
structured finance at
Deutsche Bank Securities,
Inc. in New York, NY.
sandra.bell@db.com
ROBERT PREMINGER
is head of the project finance
portfolio management group
in the Americas at Société
Générale in New York, NY.
robert.preminger@us.socgen.com
JAN PRINS
is head of structured
products of ABN
AMRO in Amsterdam,
The Netherlands.
jan.prins@nl.abnamro.com
FALL 2002
JAMES BERNER, ROBERT PREMINGER, AND JAN PRINS
n initial study conducted by Stan-
A dard & Poor’s Risk Solutions indi-
cated that project finance loans at
ABN AMRO, Citibank, Deutsche
Bank, and Société Générale perform better in
a default situation than corporate loans. This
article examines the results of this study, pro-
poses qualitative explanations for the conclu-
sions, and proposes next steps for the industry.
STUDY BACKGROUND
While anecdotal evidence exists that
project finance loans perform better than
unsecured corporate loans, there never has
been a rigorous analysis of project finance
loan performance. A study of project finance
credit statistics would be useful for refining the
rating agency process, educating credit com-
mittees on the risks of project lending, and
ensuring that project finance loans are prop-
erly managed and provisioned. However,
banks had been reluctant to share data col-
lectively until 2002, when the Basel Com-
mittee on Banking Regulation put forth new
regulatory proposals that would penalize proj-
ect finance based on the hypothesis that this
class of loans was riskier than corporate loans.
The Basel Committee on Banking Reg-
ulation charged its Models Task Force (“MTF”)
with the role of analyzing the unique credit con-
siderations of structured credit products
(including project finance) that merited special
attention. In its initial hypothesis, MTF deter-
mined that project finance should have a higher
capital weighting than unsecured corporate loans,
due to its unique risk characteristics. Indeed, the
MTF hypothesized, in the absence of rigorous
data, that project finance exposures are inher-
ently riskier than unsecured corporate loans:
The MTF has reviewed some initial
evidence on realised losses for each
product line [including project finance].
For the [project finance] portfolios, our
initial evidence suggests that realised
losses during difficult periods may
exceed those of senior, unsecured cor-
porate exposures…[however] the MTF
notes that data limitations in this area
are particularly severe, and welcomes
industry comment and evidence on the
loss data for each of these product lines.1
The MTF erred on the side of being
conservative in the absence of data and subse-
quently proposed a punitive risk-weighting
table for project finance loans.2
Unless banks could present sufficient data
to refute Basel’s hypothesis, the proposed reg-
ulations could result in adverse effects on the
syndicated project finance loan market. The
increased capital requirements at most banks
would reduce the economic returns of project
finance lending, possibly resulting in higher
loan pricing or diminished appetite for new
transactions. While larger banks in the project
finance industry might be able to adopt the
THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 5
Basel “advanced” approach (with a degree of self-regula-
tion based on their own historical project finance loan loss
experience), such an approach might not be feasible for
smaller banks. Indeed, even if a few smaller banks were to
exit the sector due to increased capital charges, overall
liquidity would be reduced, further impacting the project
finance loan sector and shrinking this important source of
capital to several industries.
In response, early in 2002, ABN AMRO, Citibank,
Deutsche Bank, and Société Générale—the “Four Lead
Banks”—formed a small group to analyze the credit statis-
tics of their combined project finance loan portfolios to
create the first industry database—with a primary goal to
respond to the regulator’s requests for more data. This
project finance loan database would contain the combined
results of all four banks’ portfolios, representing approxi-
mately 24% of the global project finance loan market over
the past five years for all industry sectors, according to the
Project Finance International/Thomson Financial Securities Data
League Tables.3 Although 24% of the market is a statistically
relevant sample, the Four Lead Banks realized early on that
a second phase of the study would be required, whereby
additional banks would join the study and contribute enough
data to enhance its validity and integrity. A broader study
would eliminate any question of statistical adequacy and
merit greater attention from regulators, investors, and the
rating agencies.
STUDY METHODOLOGY
The four banks provided their loan data to Standard
& Poor’s Risk Solutions (“Risk Solutions”—the con-
sulting division within the rating agency with significant
experience in developing and analyzing credit statistics
for corporate loans). The Four Lead Banks worked
together with Risk Solutions to develop a standard
methodology for the analysis of three key credit statistics:
• the probability of default of a project finance loan
(“PD”);
• the portion of the loan principal lost in the event
of a borrower default (“Loss Given Default,” or
“LGD”); and
• the expected loss (“EL”) for project finance loans,
essentially the product of the first two concepts.
(Refer to Exhibit 1 for an overview of these terms.)
A pivotal component of this analysis is the use of a
uniform, appropriate definition of “default.” An appropriate
6 CREDIT ATTRIBUTES OF PROJECT FINANCE
definition of default would be narrow enough to incorpo-
rate the unique experiences of project finance, yet broad
enough to be used in comparisons with corporate finance.
This study settled ultimately on a definition of default sim-
ilar to that used by Standard & Poor’s and Moody’s Investors
Service for corporate lending (see Exhibit 2). It incorporates
situations where banks restructure loans in anticipation of the
borrower missing a payment, but does not consider simply
a technical covenant violation as a default. Finally, this def-
inition is intentionally broad and conservative, leaving open
the possibility of conducting statistical analysis on the database
using a narrower definition of default, if requested.
STUDY RESULTS
The initial results of the Risk Solutions study of the
Four Lead Banks’ portfolios confirm the anecdotal expe-
rience that the LGD of project finance loans is quite low.
The LGD of the Four Lead Banks’ combined project
finance portfolios was approximately 25%. In addition,
the majority of the defaulted project finance loans in this
study resulted in a restructuring with 100% of loan value
maintained. Each of the Four Lead Banks had an individual
average recovery rate significantly above 50%.4
The loss given default of the Four Lead
Banks’ combined project finance
portfolios was approximately 25%.
In addition, the majority of the
defaulted project finance loans in this
study resulted in a restructuring with
100% of loan value maintained.
Risk Solutions concluded that the average recovery
rate of project finance loans in the Lead Banks’ portfo-
lios was at or above all other asset classes in the Standard
& Poor’s PMD Loss/Recovery database (including lever-
aged loans, unsecured bank loans, and bonds). The global
project finance loans in this study displayed recovery rates
similar to North American leveraged loans and the
project finance loans had better LGD rates than secured
debt, senior debt, and senior unsecured debt.
Regarding probability of default, Risk Solutions
determined that the historical default rates of project
finance loans are comparable to “BBB+”-rated corporate
FALL 2002
EXHIBIT 1
Credit Statistic Terminology

Term Explanation

Probability of Default (PD) A borrower’s PD is the statistical probability that a borrower will default within one year.
PD is a number (such as 1.0%) equal to a credit rating (such as “BB”—the rating assigned to
borrowers with a 1.0% PD). Borrowers with a lower annual PD receive a higher credit rating.
Loss Given Default (LGD) LGD is the financial loss a bank incurs on a facility when the borrower defaults. It repre-
sents the value of the loan in a default, through the subtraction of one minus the recovery
rate (represented as a percentage of the facility amount). For example, a loan that experi-
enced a 67% recovery of principal would have a 33% LGD.
Expected Loss (EL) EL is the mathematical product of PD and LGD. For example, a “BB”-rated portfolio with
a 33% LGD and a 1.0% PD would have a 0.33% expected loss rate (33%
1.0% = 0.33%).
Loss Rate The actual loss rate of a portfolio is the mathematical division of the total loan amounts
outstanding by the real credit losses experienced in a single year. For example, a $25
million annual loss on a $500 million portfolio has a 0.5% loss rate. Credit analysts try
to predict the actual loss rate by estimating the EL of a portfolio.

EXHIBIT 2
Different Definitions of Default

Source of Definition Definition

Project Finance Recovery Study Borrower was unable to make a contractually scheduled payment of principal and/or
interest. This would include bankruptcies that disrupt payments, including default and
cure within the grace period, consensual restructuring, amendment of the credit
facility’s repayment terms, and/or refinancing of the facility with the original lenders in
order to give the borrower more time to repay the loan.a
Standard & Poor’s A default is recorded upon the first occurrence of a payment default on any financial obli-
gation, rated or unrated, other than a financial obligation subject to a bona fide commercial
dispute; an exception occurs when an interest payment missed on the due date is made
within the grace period. Distressed exchanges, on the other hand, are considered defaults
whenever the debtholders are coerced into accepting substitute instruments with lower
coupons, longer maturities, or any other diminished financial terms.b
Moody’s Investors Service Includes three types of default events:
• There is a missed or delayed disbursement of interest and/or principal, including
delayed payments made within a grace period;
• An issuer files for bankruptcy (Chapter 11, or less frequently Chapter 7, in the
U.S.) or legal receivership occurs; or
• A distressed exchange occurs where: 1) the issuer offers bondholders a new
security or package of securities that amount to a diminished financial obligation
(such as preferred or common stock, or debt with a lower coupon or par
amount), or 2) the exchange had the apparent purpose of helping the borrower
avoid default.c
a
Standard & Poor’s Risk Solutions, Project Finance Recovery Study: An Analysis of Aggregate Data from ABN AMRO, Citigroup, Deutsche Banc Alex.
Brown, and Société Générale (unpublished; New York, March 18, 2002), p. 4.
b
Brooks Brady and Roger J. Bos, Record Defaults in 2001 the Result of Poor Credit Quality and a Weak Economy, Standard & Poor’s, February 2002, p. 11.
c
David Hamilton, et al., Default & Recovery Rates of Corporate Bond Issuers (Special Comment), Moody’s Investors Service, February 2002, p. 23.

FALL 2002 THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 7

EXHIBIT 3
Typical Project Finance Loan Characteristics
1. Perfected first priority liens on and pledges of the project’s
assets (including shares, physical assets, and material contracts
and funds on account) that preserve exclusive project finance
lenders’ access to repayments from a liquidation of the pro-
ject or for negotiating purposes with sponsors and other
lenders.
2. Involvement of “deep-pocket partners” with stakes in the
projects, including central governments, sponsors, contrac-
tors, insurers, suppliers, off-takers, etc. These parties often
have key stakes in the success of the project. While not obli-
gated contractually to support the project, these groups may
have vested interests in the project’s success and frequently
are willing to protect their interest in a troubled project bor-
rower by injecting equity into the project to preserve the
value of their investment or strategic relationship.
3. Step-in rights (which allow the lender to “step in” to the bor-
rower’s shoes and take over a contract) and covenant
triggers that serve as “early warnings” to banks to renegotiate
a structure before the borrower’s credit quality deteriorates
beyond a curable point. While corporate loans also have these
features, project finance loans are structured deliberately with
tighter covenants to trigger a renegotiation of loan terms
before any significant credit deterioration.
4. Sponsors often act as counterparties in the projects, giving
them vested interests in the success of the project.
5. Restrictions on facility drawdowns, use of proceeds, and
mandatory prepayments in favor of the lenders.
6. Contractual obligations, penalties, and remedies to influence
the activities of the sponsors in favor of the lenders.
7. Offshore and debt service accounts to mitigate cash flow
volatility, where appropriate.
unsecured loans in the long term, but “BB+”-rated loans
in the short term. Based on the aggregate experience of
the Four Lead Banks, static pools of project finance loans
from the 1998 to 2001 period would have a 10-year cumu-
lative average probability of default of approximately
7.5%—comparable to a “BBB+” corporate rating—and
a one-year average probability of default of approximately
1.5%—comparable to a “BB+” corporate rating.5 This
discrepancy between the short-term and long-term rat-
ings confirms the project finance sector’s experience that
project finance loans become less risky as they mature.
EXPLANATION OF THE RESULTS
Project finance loans have a better LGD than senior
unsecured corporate loans due to their unique structural fea-
8 CREDIT ATTRIBUTES OF PROJECT FINANCE
8. Prohibition on additional indebtedness, which, when com-
bined with the typically steady or increasing cash flows of
projects, increases debt service coverages over time.
9. Transparency of the project’s performance due to its single-
asset nature. This contrasts with corporate borrowers that fre-
quently have diverse streams of revenues, complicated
subsidiary structures and accounting treatments, and cash flow
streams that are difficult to analyze.
10. The essential commercial value of projects allows them to sur-
vive the bankruptcy or credit deterioration of a sponsor, sup-
plier, contractor, etc. Indeed, a handful of projects with sponsor
bankruptcies have demonstrated that projects often maintain
their ability to service their loans, despite the bankruptcy of
the sponsor or off-taker. This ability is due to the inherent
independent viability of the project’s value and cash flow.
11. The syndication of project financing loans encourages con-
servative structures that appeal to a broad retail market, limits
the possibility of unsophisticated banks being able to offer
aggressive bilateral loans, and ensures that all lenders benefit
from a controlled recovery process in a default situation irre-
spective of the size or importance of their respective partici-
pations. Project financings generally are so large that the
demands of syndication preclude any market participant being
able to set imprudent terms successfully. The syndication pro-
cess creates a de facto “checks and balances” relationship
among the participants so no single lender or small group of
lenders (depending, of course on the terms of the credit doc-
uments) can commit the entire syndicate to unfavorable
workout terms. In addition, the pari passu nature of syndica-
tion ensures that smaller lenders will have the same recovery
expectations as larger, more sophisticated lenders.
tures. Indeed, project finance loans include a number of credit
enhancements that mitigate risk, such as first-priority liens,
cashflow sweeps, covenant triggers, limitations on indebted-
ness, etc. (Refer to Exhibit 3 for more detail.) Since bank loans
are the primary source of non-recourse capital available to
new projects, banks use their favorable negotiating position
with the project sponsors to implement favorable structural
enhancements specific to project and leveraged finance. Estab-
lished corporate borrowers, on the other hand, have access
to a number of different sources of capital, including the
bond and equity market, securitizations of receivables, etc.
These various capital providers (bank loans, bonds, equity)
compete with each other on cost and deal terms. Since pro-
ject finance loans have less direct competition from other
forms of non-recourse capital, banks can use their advantage
to negotiate terms in their favor. These include construction
FALL 2002
features, cash traps, dividend restrictions, etc.
Although project finance loan agreements generally
do not contain all of these structural enhancements, banks
do use a number of these features as “early warning” mech-
anisms to notify them when projects are having difficulties,
thereby providing an opportunity for the parties to restruc-
ture the transaction or otherwise develop an acceptable
solution to avoid a default. As a result, project finance loans
experience lower LGD rates than comparably rated cor-
porate loans that do not incorporate these features.
Since the loss-given-default and
expected-loss results for project
finance loans are lower than corporate
finance loans of an equivalent rating,
less capital is required to reserve
against their expected losses.
IMPLICATIONS OF PROJECT FINANCE
CAPITAL REQUIREMENTS
Since the LGD and EL results for project finance
loans are lower than corporate finance loans of an equiv-
alent rating, less capital is required to reserve against their
expected losses. This is especially true as projects mature.
Indeed, based on the results of this study, project finance
loans should require roughly one-half the capital of cor-
porate loans of a comparable rating. Since project finance
loans in this study have default rates very similar to corporate
default rates, with more favorable LGD figures, they should
require less capital reserves than corporate loans.
INDUSTRY’S NEXT STEPS
The project finance industry should pursue two key
next steps:
First, the industry should expand the study to include
more participants. While the initial four-bank sample is
Reprinted with permission from the Fall 2002 issue of The Journal of Structured and Project Finance.
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FALL 2002
generally representative of the broader bank market (since
nearly all the loans studied were widely syndicated), a
larger study would serve to validate the results and be of
value to the existing and additional participants. In addi-
tion, there are a number of analytical possibilities with a
larger sample size: the study could incorporate statistically
relevant analysis of project finance credit statistics based
on region/country of borrower (jurisdiction), industry
sector, leverage, quality of collateral, and correlation, if
any, between PD and LGD.
Second, project finance banks should continue the
efforts initiated in this expanded phase of the study to
create in the future an ongoing industry-wide database
useful for credit analysis, bank regulation, and credit rating
agency analysis. This database should incorporate input
from Basel, national supervisors, banks, and rating agen-
cies. The database could serve as a useful tool for future
credit analysis and evaluation of project finance regulations.
ENDNOTES
The information in this article is accurate as of August
2002. Basel’s regulatory process and the S&P study results are
subject to modification from time to time.
1
Working Paper on the Internal Ratings-Based Approach to
Specialised Lending Exposures, p. 12.
2
Models Task Force on Specialized Lending, Revised Out-
line Proposals for Specialized Lending Exposures (unpublished
memo, January 2002), p. 1.
3
Project Finance International, January 23, 2002, Issue 233,
p. 56.
4
Standard & Poor’s Risk Solutions, Project Finance Recovery
Study: An Analysis of Aggregate Data from ABN AMRO, Citi-
group, Deutsche Banc Alex. Brown, and Société Générale (unpub-
lished; New York, March 18, 2002).
5
Standard & Poor’s Risk Solutions, Project Finance Default
Study: An Analysis of Aggregate Data from ABN AMRO, Citi-
group, Deutsche Banc Alex. Brown, and Société Générale (unpub-
lished; New York, July 18, 2002), p. 6.
To order reprints of this article please contact Ajani Malik at
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THE JOURNAL OF STRUCTURED AND PROJECT FINANCE 9