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What is project finance?
Project financing is an innovative and timely financing technique that
has been used on many high-profile corporate projects, including Euro
Disneyland and the Eurotunnel. Employing a carefully engineered financing
mix, it has long been used to fund large-scale natural resource projects,
from pipelines and refineries to electric-generating facilities and hydro-electric
projects. Increasingly, project financing is emerging as the preferred
alternative to conventional methods of financing infrastructure and other
large-scale projects worldwide.
Project Financing discipline includes understanding
the rationale for project financing, how to prepare the financial plan,
assess the risks, design the financing mix, and raise the funds. In addition,
one must understand the cogent analyses of why some project financing
plans have succeeded while others have failed. A knowledge-base is required
regarding the design of contractual arrangements to support project financing;
issues for the host government legislative provisions, public/private
infrastructure partnerships, public/private financing structures; credit
requirements of lenders, and how to determine the project's borrowing
capacity; how to prepare cash flow projections and use them to measure
expected rates of return; tax and accounting considerations; and analytical
techniques to validate the project's feasibility
Project finance is finance for a particular
project, such as a mine, toll road, railway, pipeline, power station,
ship, hospital or prison, which is repaid from the cash-flow of that project.
Project finance is different from traditional forms of finance because
the financier principally looks to the assets and revenue of the project
in order to secure and service the loan. In contrast to an ordinary borrowing
situation, in a project financing the financier usually has little or
no recourse to the non-project assets of the borrower or the sponsors
of the project. In this situation, the credit risk associated with the
borrower is not as important as in an ordinary loan transaction; what
is most important is the identification, analysis, allocation and management
of every risk associated with the project.
The purpose of this paper is to explain,
in a brief and general way, the manner in which risks are approached by
financiers in a project finance transaction. Such risk minimisation lies
at the heart of project finance.
In a no recourse or limited recourse project
financing, the risks for a financier are great. Since the loan can only
be repaid when the project is operational, if a major part of the project
fails, the financiers are likely to lose a substantial amount of money.
The assets that remain are usually highly specialised and possibly in
a remote location. If saleable, they may have little value outside the
project. Therefore, it is not surprising that financiers, and their advisers,
go to substantial efforts to ensure that the risks associated with the
project are reduced or eliminated as far as possible. It is also not surprising
that because of the risks involved, the cost of such finance is generally
higher and it is more time consuming for such finance to be provided.
Financiers are concerned with minimising the dangers of any events which
could have a negative impact on the financial performance of the project,
in particular, events which could result in: (1) the project not being
completed on time, on budget, or at all; (2) the project not operating
at its full capacity; (3) the project failing to generate sufficient revenue
to service the debt; or (4) the project prematurely coming to an end.
The minimisation of such risks involves a
three step process. The first step requires the identification and analysis
of all the risks that may bear upon the project. The second step is the
allocation of those risks among the parties. The last step involves the
creation of mechanisms to manage the risks.
If a risk to the financiers cannot be minimised,
the financiers will need to build it into the interest rate margin for
1 - Risk identification and analysis
The project sponsors will usually prepare a feasibility study, e.g.
as to the construction and operation of a mine or pipeline. The financiers
will carefully review the study and may engage independent expert consultants
to supplement it. The matters of particular focus will be whether the
costs of the project have been properly assessed and whether the cash-flow
streams from the project are properly calculated. Some risks are analysed
using financial models to determine the project's cash-flow and hence
the ability of the project to meet repayment schedules. Different scenarios
will be examined by adjusting economic variables such as inflation, interest
rates, exchange rates and prices for the inputs and output of the project.
Various classes of risk that may be identified in a project financing
will be discussed below.
2 - Risk allocation
Once the risks are identified and analysed, they are allocated by
the parties through negotiation of the contractual framework. Ideally
a risk should be allocated to the party who is the most appropriate to
bear it (i.e. who is in the best position to manage, control and insure
against it) and who has the financial capacity to bear it. It has been
observed that financiers attempt to allocate uncontrollable risks widely
and to ensure that each party has an interest in fixing such risks. Generally,
commercial risks are sought to be allocated to the private sector and
political risks to the state sector.
3 - Risk management
Risks must be also managed in order to minimise the possibility of
the risk event occurring and to minimise its consequences if it does occur.
Financiers need to ensure that the greater the risks that they bear, the
more informed they are and the greater their control over the project.
Since they take security over the entire project and must be prepared
to step in and take it over if the borrower defaults. This requires the
financiers to be involved in and monitor the project closely. Such risk
management is facilitated by imposing reporting obligations on the borrower
and controls over project accounts. Such measures may lead to tension
between the flexibility desired by borrower and risk management mechanisms
required by the financier.
Types of risks
Of course, every project is different and it is not possible to compile
an exhaustive list of risks or to rank them in order of priority. What
is a major risk for one project may be quite minor for another. In a vacuum,
one can just discuss the risks that are common to most projects and possible
avenues for minimising them. However, it is helpful to categorise the
risks according to the phases of the project within which they may arise:
(1) the design and construction phase; (2) the operation phase; or (3)
either phase. It is useful to divide the project in this way when looking
at risks because the nature and the allocation of risks usually change
between the construction phase and the operation phase.
Construction phase risk - Completion risk
Completion risk allocation is a vital part of the risk allocation
of any project. This phase carries the greatest risk for the financier.
Construction carries the danger that the project will not be completed
on time, on budget or at all because of technical, labour, and other construction
difficulties. Such delays or cost increases may delay loan repayments
and cause interest and debt to accumulate. They may also jeopardise contracts
for the sale of the project's output and supply contacts for raw materials.
Commonly employed mechanisms for minimising
completion risk before lending takes place include: (a) obtaining completion
guarantees requiring the sponsors to pay all debts and liquidated damages
if completion does not occur by the required date; (b) ensuring that sponsors
have a significant financial interest in the success of the project so
that they remain committed to it by insisting that sponsors inject equity
into the project; (c) requiring the project to be developed under fixed-price,
fixed-time turnkey contracts by reputable and financially sound contractors
whose performance is secured by performance bonds or guaranteed by third
parties; and (d) obtaining independent experts' reports on the design
and construction of the project. Completion risk is managed during the
loan period by methods such as making pre-completion phase drawdowns of
further funds conditional on certificates being issued by independent
experts to confirm that the construction is progressing as planned.
Operation phase risk - Resource / reserve risk
This is the risk that for a mining project, rail project, power station
or toll road there are inadequate inputs that can be processed or serviced
to produce an adequate return. For example, this is the risk that there
are insufficient reserves for a mine, passengers for a railway, fuel for
a power station or vehicles for a toll road.
Such resource risks are usually minimised
by: (a) experts' reports as to the existence of the inputs (e.g. detailed
reservoir and engineering reports which classify and quantify the reserves
for a mining project) or estimates of public users of the project based
on surveys and other empirical evidence (e.g. the number of passengers
who will use a railway); (b) requiring long term supply contracts for
inputs to be entered into as protection against shortages or price fluctuations
(e.g. fuel supply agreements for a power station); (c) obtaining guarantees
that there will be a minimum level of inputs (e.g. from a government that
a certain number of vehicles will use a toll road); and (d) "take
or pay" off-take contacts which require the purchaser to make minimum
payments even if the product cannot be delivered.
These are general risks that may affect the cash-flow of the project by
increasing the operating costs or affecting the project's capacity to
continue to generate the quantity and quality of the planned output over
the life of the project. Operating risks include, for example, the level
of experience and resources of the operator, inefficiencies in operations
or shortages in the supply of skilled labour. The usual way for minimising
operating risks before lending takes place is to require the project to
be operated by a reputable and financially sound operator whose performance
is secured by performance bonds. Operating risks are managed during the
loan period by requiring the provision of detailed reports on the operations
of the project and by controlling cash-flows by requiring the proceeds
of the sale of product to be paid into a tightly regulated proceeds account
to ensure that funds are used for approved operating costs only.
/ off-take risk
Obviously, the loan can only be repaid if the product that is generated
can be turned into cash. Market risk is the risk that a buyer cannot be
found for the product at a price sufficient to provide adequate cash-flow
to service the debt. The best mechanism for minimising market risk before
lending takes place is an acceptable forward sales contact entered into
with a financially sound purchaser.
Risks common to both construction and operational phases
Participant / credit risk
These are the risks associated with the sponsors or the borrowers
themselves. The question is whether they have sufficient resources to
manage the construction and operation of the project and to efficiently
resolve any problems which may arise. Of course, credit risk is also important
for the sponsors' completion guarantees. To minimise these risks, the
financiers need to satisfy themselves that the participants in the project
have the necessary human resources, experience in past projects of this
nature and are financially strong (e.g. so that they can inject funds
into an ailing project to save it).
This is the risk of technical difficulties in the construction and
operation of the project's plant and equipment, including latent defects.
Financiers usually minimise this risk by preferring tried and tested technologies
to new unproven technologies. Technical risk is also minimised before
lending takes place by obtaining experts reports as to the proposed technology.
Technical risks are managed during the loan period by requiring a maintenance
retention account to be maintained to receive a proportion of cash-flows
to cover future maintenance expenditure.
Currency risks include the risks that: (a) a depreciation in loan
currencies may increase the costs of construction where significant construction
items are sourced offshore; or (b) a depreciation in the revenue currencies
may cause a cash-flow problem in the operating phase. Mechanisms for minimising
resource include: (a) matching the currencies of the sales contracts with
the currencies of supply contracts as far as possible; (b) denominating
the loan in the most relevant foreign currency; and (c) requiring suitable
foreign currency hedging contracts to be entered into.
/ approvals risk
These are risks that government licenses and approvals required to
construct or operate the project will not be issued (or will only be issued
subject to onerous conditions), or that the project will be subject to
excessive taxation, royalty payments, or rigid requirements as to local
supply or distribution. Such risks may be reduced by obtaining legal opinions
confirming compliance with applicable laws and ensuring that any necessary
approvals are a condition precedent to the drawdown of funds.
This is the danger of political or financial instability in the host country
caused by events such as insurrections, strikes, suspension of foreign
exchange, creeping expropriation and outright nationalisation. It also
includes the risk that a government may be able to avoid its contractual
obligations through sovereign immunity doctrines. Common mechanisms for
minimising political risk include: (a) requiring host country agreements
and assurances that project will not be interfered with; (b) obtaining
legal opinions as to the applicable laws and the enforceability of contracts
with government entities; (c) requiring political risk insurance to be
obtained from bodies which provide such insurance (traditionally government
agencies); (d) involving financiers from a number of different countries,
national export credit agencies and multilateral lending institutions
such as a development bank; and (e) establishing accounts in stable countries
for the receipt of sale proceeds from purchasers.
This is the risk of events which render the construction or operation
of the project impossible, either temporarily (e.g. minor floods) or permanently
(e.g. complete destruction by fire). Mechanisms for minimising such risks
include: (a) conducting due diligence as to the possibility of the relevant
risks; (b) allocating such risks to other parties as far as possible (e.g.
to the builder under the construction contract); and (c) requiring adequate
insurances which note the financiers' interests to be put in place.
This paper only gives a brief overview of the common risks and methods
of risk minimisation employed by financiers in project finance transactions.
As stated previously, each project financing is different. Each project
gives rise to its own unique risks and hence poses its own unique challenges.
In every case, the parties - and those advising them - need to act creatively
to meet those challenges and to effectively and efficiently minimise the
risks embodied in the project in order to ensure that the project financing
will be a success.
Recommended further reading:
on a world wide level
The executive summary
on Project Financing
Plan information and resources