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PROJECT FINANCE
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project valuation
4. Case analyses
5. Recap
Definition:
Project Finance involves one or more corporate sponsors
investing in and owning a single purpose, industrial asset
through a legally independent project company
financed with limited or non-recourse debt.
Major characteristics:
Major characteristics:
Major characteristics:
Major characteristics:
Source: Esty, B., An Overview of Project Finance 2002 Update: Typical project structure for an independent power producer
Construction Contract:
A contract defining the
turnkey responsibility to
deliver a complete project
ready for operation (a.k.a.
Engineering, Procurement,
Construction (EPC) Contract)
Operation and Maintenance
Contracts:
Ensures that the operating
and maintenance costs stay
within budget, and project
operates as planned.
Permits:
Contracts that ensure permits
and other rights for
construction and operation of
the project, as well as for
investing in and financing of
the Project Company
May be provided by central
governments and/or local
authorities
Government Support
Agreements:
Provisions may include
guarantees on usage of public
utilities, compensation for
expropriation, tax exemptions,
and litigation of disputes in an
agreed jurisdiction
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project valuation
4. Case analyses
5. Recap
Contractual structure
Structuring the project contracts to allocate risk, return,
and control
Governance structure
Benefits of debt-based governance
Value Creation
Governance Structure
Organizational Structure
Contractual Structure
Contractual structure
Structuring the project contracts to allocate risk, return,
and control
Governance structure
Benefits of debt-based governance
Structural Solutions:
Risk shifting/debt
shifting by managers to
invest in high risk,
negative NPV projects
to recoup past losses
Refusal to make
additional investment
Structural Solutions:
Structural Solutions:
Structural Solutions:
Since project is large scale and the
company is stand alone, acts of
expropriation are highly visible in the
international arena which detracts
future investors
High leverage leaves less on the
table to be expropriated
Multilateral lenders involvement
detracts governments from
expropriation since these agencies
are development lenders and
lenders of last resort. However these
agencies only lend to stand alone
projects.
High leverage also reduces
accounting profits thereby reducing
the potential of local opposition to
the company.
Structural Solutions:
Non-recourse debt in an
independent entity allocates returns
to capital providers without any claim
on the sponsors balance sheet.
Preserves corporate debt capacity.
Sponsors under-investment in
positive NPV projects when
sponsor has:
Structural Solutions:
Structural Solutions:
Contractual structure
Structuring the project contracts to allocate risk, return, and
control
Governance structure
Benefits of debt-based governance
Sponsors bear the residual gains and losses, and make key investment decisions.
In simple terms,
Return to equity = Revenues Material / service costs Labor costs Depreciation Interest expenses Taxes
Variability in RHS variables lead to changes in return to equity
Other earners of net income (or net value added) from investment can also share
risk:
Net Value added =
Return to equity + Interest expenses + Taxes + Labor costs
= Revenues Material / service costs Depreciation
Profit sharing mechanisms or tax incentives may change how variability in income
among sponsors, lenders, government, and labor
is shared
Output purchasers and input suppliers can also share the risks as they experience
variability in their markets
Some risks can be reduced by spreading the burden across many participants; some
other risks cannot be spread, but can be shifted or reallocated
Gains in economic efficiency can be achieved if overall cost of risk declines through
risk shifting and reallocating:
The same risk will have a lower cost if born by parties better capable and willing
to do so
Generally well developed capital, financial, and futures markets may not always be
available
Special contractual arrangements are often required to manage risk to make projects
viable
The aim of extensive contracting is to reduce cash flow volatility, increase firm value
and debt capacity in a cost-effective way
Guarantees and insurance for those risks that cannot be handled through contracting
Elements of contracting:
General form:
Additional considerations:
Solution
Solution
Process failures
Solution
Solution
Solution
Hedging contracts
Operating cost risk: Uncertainty regarding the
changes in the operating cost throughout the life
of the project
Price ceilings
Profit sharing contract with labor
Output or cost target related pay
Solution
Solution
Solution
Legal system:
Solution
Solution
Default risk:
Contractual structure
Structuring the project contracts to allocate risk, return,
and control
Governance structure
Benefits of debt-based governance
Contractual structure
Structuring the project contracts to allocate risk, return,
and control
Governance structure
Costs and benefits of debt-based governance
Selection of strategic sponsors who would bring the most value to the
project
Mitigation of market risk: Growing demand and capacity shortfall that
triggers competition, rapid improvements in cable technology and resulting
price decline necessitates moving very quickly
Completion risk: Potential delays due to environmental approvals and
other permits
Management of possible agency conflicts between:
1.
sponsors and management
2.
sponsors and other parties (capacity buyers (purchasers), suppliers,
etc.)
3.
sponsors and creditors - decision of how many and which banks to
invite to participate
Telstra partnered with Japan Telecom (who would bring its landing station
in Japan and was interested in buying capacity) and Teleglobe (a major
carrier who would bring significant volume) as sponsors (reducing cash
flow variability)
2.
3.
5.
6.
8.
Bank debt with a small banking group was preferred rather than project
bonds to have flexibility
The second tranche would also be repaid in 5 years, but from future
sales, acting as trip wires for the management team
2.
3.
Benefits:
Issuing high yield bonds would not require collateral and reduce
legal fees
Bonds would leave Calpine free to switch between plants in the
power system
Costs:
The high-yield market was thinner and more volatile compared to
investment grade market, creating pricing and availability risk
As a firm with high leverage and sub-investment grade rating, the
high cost of corporate financing might lead Calpine to miss the
opportunity to invest in a positive NPV growth project (Debt
Overhang)
A large debt issue might further jeopardize Calpines debt rating
Benefits:
Opportunity to finance the growth strategy even if Calpine had low
investment ratings and limited debt capacity
Costs:
Time consuming and expensive to set-up and execute individual
deals
Limited size and absorption capacity of the project finance market
Possible restrictions to flexibly switch between the plants in the
power system if each plant would be collateralized separately
Corporate Finance:
i.
The structure gave Calpine flexibility to build the plants using equity,
and manage them flexibly as part of a power system (which would
be impossible with separately project financing the individual plants)
2.
3.
Benefits:
Costs:
BP Amocos absence in the IFC/EBRD finance deal for the MIG would make
it harder for the weaker partners to negotiate good terms, reducing flexibility
in operations and management
Other partners might accuse BP Amoco as free rider, since BP Amoco would
benefit at no cost from the political risk protection IFC/EBRD deal would
have provided
How they funded the initial phase would change possibilities of financing for
the coming stages
Benefits:
More protection from the many project risks due to risk sharing
Costs:
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project valuation
4. Case analyses
5. Recap
Project Valuation
Background
Approaches to calculating the Cost of
Capital in Emerging Markets
Country Risk Rating Model (Erb, Harvey and
Viskanta)
Background
Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating
Gives the cost of capital of an average project in the country in $).
Adjust for project specific risks that deviate the project from the average level of risk in the
host country
Risks incorporated in cash flows or industry adjustment:
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project Valuation
4. Case analyses
5. Recap
Case analyses
Chad-Cameroon Petroleum
Development and Pipeline Project
Background
Corporate finance vs. project finance
Why is there a difference between financing of field and export
systems?
The role of World Bank
Assessment of project risks and returns
Real options
Project update
Background
Subjects of opposition:
The environmental and social impacts were claimed to be irreversible
The revenue management plan was claimed to be flawed and to lack effective
oversight
Govt claimed to have little intention of allowing the plan to affect local
practice
Criticism on oversight committees composition and power
The RMP was a concept untested
According to Harvard Law School, Oil will not lead to development in Chad
without real participation, real transparency, and real oversight, none of which
currently exists
The revenue management plan also regarded as infringement of sovereign
rights
The sovereign rights controlled by undemocratic rulers versus people
The beneficiaries of the project were claimed more to be the corporate sponsors
and commercial banks, as opposed to people of Chad
Valuable funds could have been used in alternative causes, rather than
potentially strengthening a corrupt Govt
RMP provisions and future linking of developmental funds to Govt compliance may
deter potential misuse of project revenues by the Govt
Project helps leveraging WB and other financial resources which Govt could not have
mobilized by itself
Leveraging technical expertise of the reputable sponsors significantly reduces Chads
exposure to operational risks
Potential employment opportunities created for local people in operations
Environmental/social concerns seem to be well addressed in contingency plans with
extensive public consultation
Another positive externality may be WBs capacity building efforts to establish the
sufficient infrastructure for a well-functioning petroleum industry and investment climate
in Chad
Greatest protection from downside risk (i.e. price or volume risk) compared to
corporate sponsors, probably because bulk of the revenues (royalties) independent
from price or reserve levels.
Real options
Shadow costs: In case WB is not involved in the
project, it is likely that the Govt will go with Libya
Temporary stop option if oil price drops
Project Update
After WB approved the deal, President Deby used part of the proceeds to
buy weapons
Huge criticism by social activists/interest groups against WB and sponsors
WB responded by requiring that the proceeds should be repaid out of
general revenues, suspended new loan programs, and also set up a new
oversight body headed by external people
After these reforms, WB and IMF permitted debt relief to Chad
In December 2005, the National Assembly of Chad amended the countrys
Petroleum Revenue Management Law in the following ways*:
broadening the definition of priority sectors to include, among other areas,
territorial administration and security; and by allowing that further changes in
the definition of priority sectors can be made by decree;
eliminating the Future Generations Fund, thus allowing the transfer of more
than US$36 million already accumulated there to the general budget
increasing from 13.5 % to 30% the share of royalties and dividends that can
be allocated to non-priority sectors that are not subject to oversight and
control
* Chad-Cameroon Pipeline Project, World Bank Web Site
Project Update
The suspension automatically freezed the flow of part of Chads oil revenues
within the offshore escrow account
WB states in its web site that it remains in dialogue with the Chadian
authorities, and is determined to safeguard the oil revenues intended for
poverty reduction programs included in its original agreement with Chad,
while recognizing the fiscal strains currently experienced by the government
of Chad.
Pre-completion risks
Post-completion risks
Sovereign risks
Financial risks
Real options
Cost of capital calculation
Project update
Background
Strategic reasons in the long run: $2.4B Petrozuata will be the first in a
series of projects planned which total as high as $65 B.
PDVSA needs to preserve debt capacity for future funding needs.
Success in this project will be a proof of concept for the rest.
Project finance structure provides PDVSA a wider capital access
Under project finance, the project is subject to significantly lower income tax rates (34% as
opposed to 67.7%) and royalties.
But losing the benefit of co-insurance which would come with corporate financing
Risk management
Market risk: Uncertainty regarding the future price and demand for the
output
The price of oil is volatile
+ The off-take agreement with Conoco secures a significant portion of
the output to be purchased for 35 years at a price pegged to market
price of Maya crude
+ Petrozuata being a low cost producer with breakeven price well
below industry average could still operate even if prices fell
dramatically
Currently there is no broader market developed for syncrude
+ However, in expectation of the development of such a market in the
near future, Petrozueta retained the option to sell the syncrude to
third parties if they demand at a higher price than Maya crude.
+ According to an independently conducted assessment, the
development of a third party market was expected in 3-5 years, and
that the syncrude output would sell at a $1/barrel premium.
What happened?
The project received ratings that exceeded the sovereign ratings by five
notches
Completed a $1B bond issue, which was five times oversubscribed, and a
total of $450M bank financing (with 14 years maturity at 7.98%, 12 years
maturity at 7.86%)
The project considered by analysts as one of the best structured and best
executed project finance deals ever done, 1997
PDVSA continued to structure deals for the Orinoco Basin
Venezuelan economy was hit hard by the decline in crude oil prices
S&P revised its outlook for Petrozuata to negative, as a result of the cost
overruns, lower than expected early production revenues, falling prices, and
political uncertainty
As economic situation worsened, Govt demanded and received
extraordinarily high dividends from PDVSA reaching up to 134% of projected
income in 1999
Hugo Chavez won the 1998 elections and announced not to interfere with
foreign oil investments
Background
Mozal is a $1.4 B aluminum smelter project in Mozambique. The
sponsors are Alusaf, a subsidiary of a South African natural
resource company, and IDC, a government-owned South African
development bank with long-standing relationship with Alusaf.
The sponsors are interested in structuring a limited-recourse
financing deal with IFC involvement.
IFCs concerns are the size of the project, as well as the political
risks of doing business in Mozambique.
Risk Management
Sovereign risks
Expropriation risks:
- Outright seizure of assets very unlikely:
- The scale of the project relative to the size of the poor economy (9% of
GDP), combined with short-term survival concerns may be tempting for
a shortsighted Govt to expropriate
+ Govt wouldn't want to curb the investments, because they are
interested in development
+ Govt cannot afford an outright seizure, due to potential reactions from
WB/IFC, as this would jeopardize the much needed future development
funds
+ Following a direct seizure, international suppliers may not be willing to
work with the Govt, and Mozambique does not have local suppliers of
the raw materials to go on with the business alone
Sovereign risks
Expropriation risks:
- Seizure of cash flows (diversion) low risk:
- Govt may divert the aluminum and sell it to others
+ However, the spot market for aluminum is very thin for Govt to divert
and easily sell the output
+ Potential reactions from WB/IFC
- Changing of taxation creeping moderate risk:
- Govt may remove the privileges that the smelter would be exempt from
customs duties and income taxes
- It is highly likely that the Govt may change the 1% sales tax, which is
more critical than the income tax
Sovereign risks
Political events:
Political instability
Risk of war: not completely eliminated
Legal instability
Bureaucratic hurdles
Underdeveloped infrastructure
Unskilled / untrained labor
Macroeconomic risks:
Currency exposure:
+ Not a major risk as the major inputs and all the output would be
denominated in $.
Convertibility risk:
+ Not a major risk since the proceeds will be kept at an overseas
trustee
Real options
Option to expand
+ Mozal would be constructed with all the infrastructure to double the capacity
when needed.
What happened?
IFC approved the $120M investment in 1997, its largest investment by then
In 1998, Project Finance International declared Mozal as the Industrial Deal
of the Year
Construction temporarily stopped in 1998 when workers went on strike to
protest low wages and poor working conditions
Workers on strike held management hostage in 1999
Despite the ongoing strike, the project proceeded as planned, and was in
fact on time and below budget
Critics argued that the sovereign risk had been too high, showing the strike
as evidence
Critics also defended that sponsors were treated too generously in the deal
compared to Mozambique
Despite the criticisms, the Mozal project appeared to set the stage for an
inflow of additional private investments in Mozambique in the final analysis
OUTLINE
1. What is Project Finance?
2. How does project finance create
value?
3. Project Valuation
4. Case analyses
5. Recap
Acknowledgements
The content of this presentation has been derived from:
Emerging Markets Corporate Finance Course materials taught by Campbell
Harvey at Duke University
Project Finance lecture slides by Campbell Harvey, Aditya Agarwal, Sandeep Kaul
at Duke University
Modern Project Finance: A Casebook, Benjamin Esty, John Wiley & Sons, 2004
Principles of Project Finance, E.R. Yescombe, Academic Press, 2002
Petrozuata, A Case Study of the Effective Use of Project Finance, Benjamin Esty,
Journal of Applied Corporate Finance
Contracting and Project Finance Lecture Notes, Program on Project Appraisal and
Risk Management, May 16-June 10 2005, Duke Center for International
Development
Risk Management Lecture Notes, Evaluating Projects in the Public Sector Course,
Program in International Development Policy, Duke University