PROJECT FINANCE: WHAT IT IS AND WHAT IT IS NOT- Review of Literature Iwora G Agara Finance and Accounts Dept Geometric

Power Ltd and Raphael Etim Department of Accounting University of Uyo, Nigeria

Abstract This paper reviews literature on project finance, explains the conceptual framework of project finance and discusses the attractions associated with the new financing strategy. Project finance is becoming inevitable in funding large projects and infrastructure by private investors in contemporary time. We posit that Nigeria would benefit immensely from project finance in her quest to develop infrastructure, especial in the areas of power, rail and road construction amidst budgetary constraints and revenue crunch of the various strata of governments. Therefore, Nigerian investors should embrace project finance arrangements to stimulate investment and create employment. Keywords: Project finance, expropriation, corporate governance, agency theory, non-recourse and limited recourse projects.

1.1 Introduction From the nineteen nineties, the economic fortunes of, especially, developing nations dwindled and it became increasingly difficult to fund infrastructural projects through the yearly direct budgetary allocations by governments. This condition was exacerbated by the change in lending policy of the World Bank that required borrowing countries to deregulate their economies and allow private participation in the provision of infrastructure that can provide economic goods and services to be paid for. In this way the government would reduce spending (Ham's and Knfhy, 1999). Second, key changes in lending policies from major multilateral banks shaped governments emphasis on private investment by restricting access to concessionary loans unless coupled with complementary moves to reform and privatize infrastructure. Furthermore, specifically between 1990 until 1996, the World Bank Group had a no-lend policy for specifically the power sector unless such requests, by countries, are accompanied by substantial reforms intended to commercialize and corporatize the electricity sector and to introduce independent regulation (Erik, 2006). These developments popularised the use of project finance, a hybrid project funding alternative, in the development of infrastructure which require huge capital outlay. Project finance emphasises the involvement of the private sector in infrastructural development.

Historically, project finance dates back to at least 1299 A.D, about 723 years ago, when the English Crown financed the exploration and the development of the Devon silver mines by repaying the Florentine Merchant Bank, Frescobaldi, with output from the mines. The Italian bankers held a one-year lease and mining concession, i.e., they were entitled to as much silver as they could mine during the year. The more recent prominent example of project finance is the construction of the Trans-Alaskan pipeline and exploration of the North Sea oil fields in the 1970s

(Kensinger and Martin, 1988). From the late 1990s, after a temporary stagnation of project finance due to the economic recession in Asia and America in the mid 1990s, the technique has become rather prevalent in the financing of independent power plants and other infrastructure projects around the world as governments face budgetary constraints (Comer, 1996). Project Financing has continued to grow in prominence as a tool for financing infrastructure and capital assets with huge cost at terms which would reduce risk to both the originators( project sponsors) and investors and help to stimulate economic development, especially in developing countries((Ahmed and Fang,1999; Ghersi and Sabal, 2006). In Africa, project finance is still at its infancy level with South Africa leading the pack. In Sub-Saharan Africa, the earliest example of project finance is the financing deal of Ashanti Goldfields in 1992 with the World Bank (Mitchell, 2002). Mitchell (2010) adds that the Chad-Cameroon Pipeline Project, at a total cost of around $4 billion, represented the largest foreign direct investment in sub-Saharan Africa to date. Three main reasons have been adduced for the difficulty in practicing project finance in Africa. These include poor credit rating of African countries by international investors, lack of depth and breadth in the capacity of domestic capital market to support project finance arrangements, and high regulatory risks such as regular government intervention and direct or indirect expropriation (Sheppard et al, 2006).

1.2 What is Project Finance? Esty(2004) observes that there is no single generally acceptable definition of Project Finance but defines project finance as the creation of a legally independent project company financed with equity from one or more sponsoring firms and non-recourse debt for the purpose of investing in a capital asset. The US Financial Standard FAS47 (1981) clarifies project finance concept further as:

The financing of major capital projects in which the lender looks principally to the cash flows and earnings of the project as the source of funds for repayment and to the assets of the project as collateral for the loan(p.11). Project finance for short entails setting up a distinct legal entity, called the project company, to execute an approved project, raises funds through equity contribution by the project initiators or proponents and by loans using the project assets and estimated cash flows as the collateral (Huang and Knoll, 2000). The loans can be either purely debentures (also referred to as senior debts) and/or preference shares (convertible or none convertible and also referred to as sub-ordinate or junior debts)

The most common applications of project finance according to Esty (2004) are in the natural resource (mines, pipelines, and oil fields) and infrastructure (toll roads, bridges,

telecommunications systems, and power plants). The practice of project finance entails the assemblage of a consortium of investors, lenders and other participants (i.e. contractors and human capital) to undertake infrastructure projects that would be too large for individual investors to underwrite and, such investments require the construction and management of greenfield(i.e. completely new) infrastructure or expanding of existing capacity. At least this is what theory depicts. However in practice, we note the difficulty in assembling investors to participate in the project concept, especially in the case of greenfield projects. Also, especially in the case of Nigeria and using the independent power projects as a reference, most project proponents see the projects as their family businesses and allocate significant proportion of the equity of the project company to themselves and to their acquaintances leaving out the participation of other international and viable local institutional investors who would have supported the project to completion within the

deadline. Also, there are indications of no effective sponsoring entities that ought to sponsor the projects separate from their internal operations, but rather the supposed proponents lean heavily on the funding provided for the projects by external lenders to fund programmes unrelated to the projects. These practices coupled with lack of adequate local human capacity to handle and properly manage power projects contribute to delay in project completion. 1.3 Types of Project Finance There are two basic types of project finance: non-recourse project finance and limited recourse project finance. Non-recourse project finance simply means that there is no recourse to the project sponsors assets for settlement of the debts or liabilities of an individual project. The limited recourse project finance, on the other hand, permits the loan providers and creditors some recourse to the project sponsors for some sort of support, usually in the form of guarantees and confirmations to support the project to completion (Ahmed and Fang, 1999 and Fight, 2006). 1.4 Project Finance and Corporate Finance Compared Corporate finance is the traditional project financing medium adopted by most companies using the in corporate balance sheets as collaterals for the project or investment fund raising. There are marked differences between corporate finance and project finance. Comer (1996) identifies the following differences between project and corporate finance: DIMENSION Financing vehicle Type of capital Dividend policy and reinvestment decisions Capital investment CORPORATE FINANCE Multi purpose organization Permanent - an indefinite time horizon for equity Corporate management makes decisions autonomous from investors and creditors Opaque to creditors Highly transparent to creditors PROJECT FINANCE Single purpose entity Finite - time horizon matches life of project Fixed dividend policy -immediate payout; no reinvestment allowed

decisions Financial structures Transaction costs for financing Size of financings Basis for credit evaluation Cost of capital Investor/lender base

Easily duplicated; common forms Low costs due to competition from providers, routinized mechanisms and short turnaround time Flexible Overall financial health of corporate entity; focus on balance sheet and cash flow Relatively lower Typically broader participation;

Highly-tailored structures which cannot generally be re-used Relatively higher costs due to documentation and longer gestation period Might require critical mass to cover high transaction costs Technical and economic feasibility; focus on projects assets, cash flow and contractual arrangements Relatively higher Typically smaller group; limited

deep secondary markets secondary markets Another striking difference between corporate and project finance is that in project finance the loan taken does not show in the books of the owner of the project and therefore is an off balance sheet transaction.

2.1 Evidences on the imperatives of Project Finance The use of project finance has grown dramatically over the years from $ 12.5 billion (bn) per annum in 1991 to $113.4 in 2005(Kleimeier and Versteeg, 2010). The increase in the use of project finance does not appear to have a clear explanation (Esty, 2003). Kleimeier and Versteeg(2010), however, hint that project finance is designed to reduce transaction costs of raising large financing to execute projects in particular those arising from a lack of information on possible investments and capital allocation, insufficient monitoring and exertion of corporate governance, risk management, and the inability to mobilize and pool savings. They add that project

finance should have a clear impact on economic growth; especially where the capital and financial market development is shallow. These variables aptly describe the Nigeria environment with low corporate governance, high risk, low savings, and shallow capital and financial development market. Would this suggest, therefore, that project finance would be popular in Nigeria? Indications point positively in favour of project finance, at least with the wave of deregulation of the critical sectors of the economy. But, we are yet to witness a marked participation of the private investors, under the project finance arrangement, in the development of infrastructure in Nigeria. 2.2 Motivations for Project Finance Esty(2003) adduced three reasons or motivations for the increasing use of project financing in spite of the high cost of concluding project finance deals occasioned by the long negotiations and the complexities required to establish a project company. The three motivators are: Agency Cost Motivation: This motivation recognizes that there exist conflicts between the owners (ownership) and managers (control) of economic entities according to Agency Theory of the firm. Agency Theory posits that agency conflicts can undermine the performance of the firm (Jensen and Mecklin(1976). However, the nature of project finance removes such conflicts and makes it possible for projects to function without being hindered by the idiosyncrasies of the individual project sponsors in their domains. According to Esty (2003) project companies utilize joint ownership and high leverage to discourage costly agency conflicts among participants. Today, these agency cost motivations remain the most important reasons why firms use project finance. The debt overhang motivation: Project finance involves the use of debt without recourse to the assets of the sponsors and so the balance sheets of the sponsors are not affected unlike corporate finance that considers the quality of the balance sheets which are normally used as collaterals for the debt facilities. The bad luck of one project does not transfer to another one. Project eliminates

the possibility that new capital will subsidize pre-existing claims with higher seniority or reduce the value of junior claims (Esty, 2003). Risk Management: The nature of project finance is that project assets have significant risk and investing in such assets drags the company into risks which could impact negatively on other investments in a port folio if not segregated. Project finance enables assets to be segregated so as to ensure that the risk of one project is not transferred directly or indirectly to another. By isolating the asset in a standalone project company, Esty(2003) posits that project finance would reduce the possibility of risk contamination, the phenomenon whereby a failing asset drags an otherwise healthy sponsoring firm into distress. Therefore, with project finance the project company is bankruptcy remote from all the stakeholders to the project as all the parties to the project agree in advance that in the event of failure recourse will not be made to the assets of the sponsors but rather to limit recourse only to the project assets (Vaaler, et al. 2008). Investors Protection and low bankruptcy cost- With project finance, various contracts are modelled and risks are allocated with the attendant penalties for default. This ensures that in the event of default, the lenders would have recourse to the project assets , thus leading to low bankruptcy cost (Subramanian, et all, 2007). Reduction in the earnings capacity of Industrialized Economies: Another motivation of project finance is the global economic integration that has provided the opportunity for capital to be internationally mobile. This enables international investors to seek investment opportunities in developing and emerging markets due to lower yields in industrialised countries and the advantages that come with risk diversification (Ferreira and Kanran (1996). According to Hams and Knreger(1999) Project Finance is like a chameleon; it always finds a way to take advantage of changes in the business.

Investable environment. The World Bank Group (2003) indicates that investors prefer to invest in projects in countries where the environment is investment friendly. Also Vaaler, et all(2008) indicate that environments with low overall project risk would attract project finance at very high leverage ratio, and if creditor rights are stronger, they are more willing to lend to projects while if time to enforce their rights increases, they are less willing to lend to projects. These may be the explanations for the increase use of project finance in developed countries they have stable economic policies, embrace the rule of law and obey investment covenants. Developing and emerging economies, including Nigeria may only be able to attract project finance arrangements by ensuring economic and political stability. 2.3 Evaluation of Project The selection of projects under the project finance model involves complex project appraisal. Several models of project appraisal models used in project finance have been identified to include the discounted cash flow (Net Present Value, Internal Rate of Return), the payback period, Weighted Average Cost of Capital, and some other variants or combination of these (Arnold, 1998; Andra, et al, 2009; Finnerty, 1996; Savvakis, 1994; Brealey and Myers, 1996; NERC, 2008). However, the use of Discounted Cash Flow analysis and Net Present Value (NPV) in project appraisal appears to be recommended in literature. Also, the estimation of cash flow is very critical in project finance because it is the basis for financing the project (Jenkins, et al, 2002). 2.4 Characteristics of Project Finance Literature is unanimous on the broad characteristics of project finance which are inherent in all forms of project finance arrangements. The broad characteristics can be more distinctly identified as : formation of an independent project company, funding of the project majorly with loans and less of equity with an average debt equity ratio of 70%:30%, the repayment of the loan and

associated interest is made from the cash flow of project, management transparency and effective corporate governance permeate project transactions, high level of Investment Risk( both financial , construction and operation risks), parties to project finance often prepare risk allocation matrixes to track the various risks and who would be responsible for what risk, project finance entails a series of complex and interwoven contract scenarios involving several parties to the project- a typical project may have as many as 15 parties united in a vertical chain from input( suppliers) to output (buyers),bulk of investments relate to tangible assets, compared with corporate finance, the cost of capital in project finance is very high because of the high risk associated with project finance arrangements and the cost of putting in place the consortium of both financiers and contractors to participate in the project(Jechoutek and Lamech, 1995; Subramanian and Tung, 2009; Esty, 2003; Pernice, 2005; Fight, 2006; V aaler, et al, 2006; Andra, et al, 2009; Didkovskiy, 2003; Esty and William, 2002; Erik, 2006; Esty, 2003 and Ghersi and Sabal, 2006) 2.5 Risk of expropriation Of all the risks associated with project finance, the risk of expropriation has been identified to be the worst distraction to investors. Commenting on expropriation, Erik (2006) states ... initially, the government needs private investors and thus offers attractive terms. Once operational, the investors require a long amortization period to attain their expected return while the host government has already secured what it needs; the original bargain has become obsolete. Theory predicts that the host will force a change in termseither by outright nationalization or by squeezing revenue streams as far as possible(p.127).

The overall risk profile of a project is however determined by several factors including the economic environment of the host country, volatility in the exchange rates, unpredictable inflation

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rates, the probability of the host country expropriating or nationalising the project, project type and its developmental stage, regulatory framework, political risk associated with stability of government, control of corruption adherence to the rule of law and the ability of the host country to mobilize and pool savings to facilitate access to long-term funds for the project (NEPAD-OECD Africa, 2009, Alike, 2010, David and Mody, 1998, Hainz and Kleimeier,2006 and Kleimeier and Versteeg, 2010 ). 2.6 Parties in Project Finance Project finance involves a complex network of participants; each assigned specific responsibilities in the project. The parties can be grouped into three main project stages: Pre-construction/ planning stage; Construction Management Stage and Operations Management Stage. Figure 1 below shows parties to a typical independent power project. Participants in the Project Participants in the Construction Participant in the operations and Maintenance Management Stage Management Stage

planning stage Project Sponsors and Project Sponsors and other project Sponsors and other other equity equity participants, equity participants, consultants, government (Environmental Monitoring, and Tax

participants, government, government,

consultants, lenders. lenders, property right owners ( Authorities), consultants (Auditors and Tax, ICT, project site and right of way), Trainers, lenders ,gas/fuel suppliers, management Engineering, Procurement and consultants Construction(EPC) Contractors takers(bulk (in-house power or outsourced),off agents and

purchase

and other contractors(Foreign consumers), trade unions and other pressure and local), and other groups. Project finance negotiations are anchored machines by the project owners and equity holders.

materials(Gas/Fuel,

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and pipes) (Ghersi and Sabal, 2006, Comer, 1996). 2.7 Importance of the Capital market Infrastructural development requires huge capital outlay which most banks, especially in developing economies, are unable to provide. To be able to obtain required funding, project proponents seek for long term funds through issuance of bonds. The capital market would provide the platform for this and therefore, the success of large projects, such as power, transport, ports etc. requires the support of the capital market. However, the use of capital market in project finance is generally low because of the low liquidity of the project related financial instruments since such instruments are private, made to measure and impregnated with contractual relationships. To access the required funding via the capital market at an economic cost of capital, project proponents participate in the equity of the project company and provide, in some cases, limited corporate guarantee in support of the project (Fletcher,2005; Corene and Banfield, 2006; Sorge, 2004; Sagar, 2006; Ghersi and Sabal, 2006; Okereke, 2010, National Treaury of South Africa, 2001)

3. Conclusion Given the current situation of the Nigerian economy, vis a vis the imperative on the government to proovide employment, the propagation of project finance arrangements cannot be overemphasized. With the deregulation of the power, petroleum, transport and other sectors, it is expected that significant employment would be generated arising from the huge investment that would flow into the deregulated sectors.

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The Central Bank should champion the concept and enlist the support of commercial banks and other financial institutions under her control. The intervention funds of N500 billion allocated by the Central Bank of Nigeria (CBN) in 2010 to support the power (N300 billion), aviation and the real manufacturing sectors (N200 billion) is commendable as this would enable projects in these sectors to access funds at more liberal terms and catalyze power generation and distribution and improve the performance of the other two sectors (Sanusi, 2010). But given the enormity of the capital investment required to support the sectors, the amount allocated by the CBN appears to be grossly inadequate and therefore calls for the embrace of project finance framework in order to encourage private participation in a more systematic and effective manner. Commercial banks that are the main project bankers can issue development bonds of 10 years minimum term in respect of the projects they support and have the CBN to co-guarantee such bonds. This way, cheaper funding can be raised to support infrastructure development continually.

The Government should be prepared to provide the required support to encourage investors to participate in the deregulated sectors. In this regard, sovereign guarantee that would be required by investors to guide against expropriation (directly or indirectly), unwarranted government interventions, and other contingencies should be provided by government. Investment in infrastructure is long term; therefore, the legal system should be resilient enough to withstand external influences. This will indicate reliance on the legal system and ensure effective enforcement of the rights of parties associated with the contracts that bind parties involved in the PF framework. There should also be clarity of investment regulations and incentives to avoid double standards and provide an objective interpretation of actions and decisions by potential investors.

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Esty(2004) advises that given the demand for investment and the growing importance of project finance as a financing pool, corporate executives, bankers, lawyers, and governments need to understand what project finance is and why it creates value. The starting point is to propagate the practice of project finance arrangements in Nigeria through seminars and workshops on the subject and to encourage the private sector investors (foreign and domestic) to participate in the new project financing phenomenon.

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Figure 1: PARTIES TO A TYPICAL INDEPENDENT POWER PROJECT

Consultants

Lawyers and Engineers

Land and property owners,

Host Communities

Development and Multilaterals Institutions Government

IFC, World Bank, ADB,

Regulator y bodies

Others

Trade Unions, Capital Markets and Insurance companies

Source: Howrey's Construction Practice Group: http://www.constructionweblinks.com/Resources/Industry_Reports__Newsletters/June_3_2002/project_finance.htm, Accessed 25/10/10. The diagram has been amended to accommodate other parties not included in the original Howreys diagram 15

Vaaler, et al. (2008) indicate that project finance mitigates the domestic risk of countries and makes investment in risky but also potentially rewarding countries more attractive for sponsors. The time has come when Nigeria should seek to introduce and maintain governance models that would ensure stability and sincerity in policy in order to encourage the practice of project finance arrangements. What is required is for proper enlightenment on the benefits associated with project finance arrangements, which include financial, developmental and social benefits associated with project success (Esty, 2004). To ensure this, efforts most be made to address some challenges such as inadequate legislation and gaps in existing statutes, lack of depth in debt capital market, absence of political will, weak local banks and government bureaucracy that have been identified to hinder infrastructure funding in Nigeria(Ekwere, 2009). There is no gain saying that given the fiscal position of many governments, including Nigeria, project finance is seen as an important mechanism to deliver much of the infrastructure finance requirement (KPMG, 2010). Collaboration among the government, the academia and the investing public to achieve the level of consciousness and popularise project finance is desired now than ever before given the need to simulate economic development through the public-private sector co-operation encapsulated in the adoption of project finance framework as one of the economic development strategies.

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