Model for analysis and evaluation of...

Model for analysis and evaluation of risks in Project Financing operations

Massimo de Falco*, Donato Di Stasi**

*Department of Industrial Engineering, University of Salerno, Via Giovanni Paolo II 132 -84084 Fisciano (SA)- Salerno – Italy ([email protected])

**Department of Industrial Engineering,University of Salerno, Via Giovanni Paolo II 132- 84084 Fisciano (SA) ([email protected])

Abstract: The current paper is intended to support the stage of evaluating the potential investment project, providing an instrument for quantification of the risks in the various operations and for identification of the levels of maximum risk characterising the particular type of project under examination. The conceptual ap-proach considers three types of works, categorised according to their remunerative capacities: ‘hot’, ‘warm’ and ‘cold’. Beginning from this division we then conduct a data collection process to identify the descriptive characteristics useful for comparison of the three types.

We regard each input to the model as a parameter to be evaluated, for purposes of identifying a range within which to evaluate the risks of a specific project, belonging to one the types of works (hot, warm, cold). For this we develop a questionnaire for submission to experts. The calculation of the frequency of answers to the questionnaire permits identification of characteristic values for each descriptive variable, for each of the types of works. These values are gather in an input matrix, developed as part of the model.

We then develop a conceptual scheme to relate the variables of the different forms of Public-Private Partner-ships. We next translate the conceptual scheme as an interactive model.

The variables chosen for evaluation of the risks are evaluated in terms of the impact on each sub-type. This leads to a dynamic analysis for calculation of the minimum and maximum risk linked to each input, and ob-tains an interval in which to place each specific result from the analysis carried out using the model. The re-sult is identification of a range for evaluation of the riskiness of the projects, as the determining factor in guiding the acceptance or rejection of PF investment proposal on the part of the market or concessionary.

Keywords: Project Financing; Risks; Cash flows; Performance

XX Summer School "Francesco Turco" - Industrial Systems Engineering

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1 Introduction

Project Financing (PF) serves as an effective method for carrying out public infrastructure works or other works of major public interest, for a series of reasons: it permits sharing of risks and profits in a predeter-mined manner, according to the needs of the various actors; it rationalises the process of identifying the investments; it optimises operational management due to the inclusion of the necessary specialists; final-ly, it contains costs and responsibilities for the public administration. However the opening stages of pro-ject management involves a series of delicate steps, from the conduct of accurate feasibility studies to the formation of the necessary ad-hoc corporate vehicle (SPV). One of the most critical steps results as the identification of the allocation of risks. The purpose of the present work is to deepen the understanding of project financing instrument and the institutions involved in the Public Private Partnership (PPP), in order to ease and improve the operative approach to these critical opening steps in the process.

Figure 1 : Stages in structuring a Project Financing operation

2. A taxonomy of the actors participating in a

Project Financing operation

The project financing operation can understood as a form of contractual network, with the special-purpose company created by the sponsors at the cen-tre. Naturally, the number of participants varies with the structure and dimensions of the intended works, as well as due to other contingent factors. Still, it’s possible to distinguish some typical actors in a PF operation:

A. Project Promoters or Sponsors;

B. Special Purpose Vehicle (SPV);

C. Contractor (construction company or com-panies);

D. Operator (plant management company);

E. Commercial partners (purchasers and sup-pliers);

F. Public administrations;

G. Multilateral finance institutions;

H. Lending banks.

Equilibrium among the actors is ensured by suitable contractual structures, however as a starting point all parties must enjoy a good reputation and demon-strate solid capacities and potential. Any private companies must demonstrate commercial reliability and relevant professional experience.

2.1 Project Promoters or Sponsors

The promoters are the actors (generally private com-panies and/or public administrations) who are the core source of the business idea and provide the formal launch of the project, forming the SPV and investing their relative shares of the company capital. This category thus includes companies who partici-pate in creating the project or join in the execution, chosen on the basis of selection by competition. These companies intend to capture the economic benefits deriving from the entrepreneurial manage-ment of the finished plant. The state, local entities, and government agencies can also participate as promoters if there are specific objectives for eco-nomic development associated with the project. For example the public administrations could be interest-ed in development of a public infrastructure project or the provision of a publicly useful service, while the private companies would be interested in develop-ment of structures serving their core business, or in any case able to produce positive externalities for their own business. The experience of the promoters is clearly a determining factor in accepting or award-ing the project. In fact the banks will evaluate the project in terms of: the professional and management competencies relative to the particular project; the preliminary planning for the financing negotiations; the structuring of the entrepreneurial management. Other than the professionalism of the promoters, the banks will also analyse the solidity of their assets, in case of need of compensation.

2.2 Special Purpose Vehicle (SPV)

The corporate purpose of the Special Purpose Vehi-cle is to construct and manage the infrastructure, and to assume the investment rights and obligations un-der principles of ‘ring-fencing’. The SPV thus creates a situation of financial and juridical separation be-tween the project and its Sponsors. In fact it is essen-tial that the cash flows for the project are isolated from all other activities and assets of the promoters. The promoters can thus exclude the debt contracted for the project from their own financial statements, avoiding the obvious consequences for their own debt indexes. The SPV thus provides notable bene-fits, particularly when the off-statement operations


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involve a high degree of financial levering. The ring fence determines a direct correlation between the fi-nancial needs and coverage for the specific project, permitting the precise definition of the juridical, op-erational and economic-financial characteristics, and the establishment of direct links between the assets and liabilities.

2.3 Contractor

The Contractor is the company or consortium that wins the tender for executive planning and construc-tion of the intended plant or structure. The most typ-ical form is the consortium, headed by a ‘main con-tractor’ company, which assumes the obligations to the SPV and the responsibilities for correct and full execution of the works. The main company sub-tenders the works among the consortium partici-pants. In some cases the consortium may include the future managers of the infrastructure. At times the Contractor can also assume the role of Sponsor, or at the conclusion of the construction stage can cooper-ate with the Sponsors to create a purpose-formed company for the maintenance and management of the works. The main contractor and SPV agree to a ‘fixed-price, turn-key contract’ (TKC), in which the contractor assumes primary responsibility for damag-es in case of any delays in the completion of the structure, and for payment of penalties (liquidated damages) in case of any failure to meet performance standards.

2.4 Operator

At the end of the construction stage the Operator takes over the plant from the Contractor, in contrac-tual agreement with the SPV. The operator assumes the maintenance and management in a manner that ensures the SPV the operational conditions and yields for which it is defined as responsible. The Op-erator generally receives periodical remuneration, ei-ther as a fixed amount or as a percentage of the costs incurred during the period (pass-through structure). The Operator can be a single company, potentially one of the Sponsors or another pre-existing compa-ny, or can also take the form of a joint venture formed by a number of sponsors.

2.5 Commercial partners

The commercial partners of the SPV consist of the acquirers, purchasers or offtakers on the one hand, and the suppliers and providers on the other hand. They are the companies to which the SPV cedes the production achieved and from which it purchases the prime materials necessary for the function of the structure. The number of suppliers is often very small, and is sometimes only a single company. The Financial advisor will also require the identification of

emergency suppliers, to respond in the case of con-tingencies.

2.6 Public administrations

Public administrations (PAs) can participate in Pro-ject Financing both as sponsors, through formation of mixed companies with private entrepreneurs, and as clients. Indeed a specific PA may in some cases be the only purchaser of the project outputs. PAs can also serve in the role of regulator, limiting their ac-tions to conceding the rights and authorisations nec-essary for the private parties to complete and manage the project.

2.7 Multilateral finance institutions

These are multinational agencies formed for aims of promoting investment and economic development at the global or regional level. These institutions gener-ally participate in project financing by providing debt capital, risk capital or insurance coverage for initia-tives identified as strategic to the institutional mem-ber states. When project financing involves both multilateral institutions and commercial banks the structure is termed ‘co-financing’.

2.8 Lending banks

Banks are an essential element of Project Financing structures, external to the SPV and Sponsors. In fact the bankability of the project is highly dependent on the solidity of the industrial scheme. Banks partici-pate actively in the project dynamics, beginning with the first stages of structuring the initiative. In the role of Financial Advisors, they often assist both the pub-lic and private actors in identifying the best planning solution. The participating banks must then offer competitive financial structures, coherent with the project characteristics.

3. Identification of risks in Project Financing op-

erations

Project Financing is a system for the achievement of financing in complex projects. Above all, it accom-plishes this through the effective identification and allocation of risks among the parties, in a clearly ar-ticulated interlinked structure. In fact it is only through accurate risk management that it is possible to reduce the volatility of the cash flows in arrival and exit, and so secure the success of the initiative. The identification of risk factors also serves to organ-ise the contractual component and the sequential cre-ation of new instruments for programming and con-trol. The risk factors can be classified in macro-


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categories, lower level homogenous categories, and sub-components. Each category deserves strategic consideration.

The macro-categories correspond closely to the pro-ject ‘life cycle’ stages, and can be identified as:

a) Planning

b) Construction

c) Plant availability

d) Demand

e) Operations.

Table 1. Risk Matrix

Risks in

planning

Delays in delivery of definitive and executive projects

Project variations due to planning or design errors, leading to long

delays

Other project variations giving rise to delays and cost increases

Risks in

construction

Delays in handing over the comple-ted works

Suspension of works due to on-site discoveries

Failures, delays or other non-conformity in construction

Risks in plant availa-

bility

Variation in output volumes

Insufficient quality

Failures in programming or moni-toring

Risks in de-mand

Variability in demand, independent of quality of offer

Presence of more economical alter-natives for users

Business cycles

New market trends

Risks in the

operating stage

Shortage or failure in supply

Failure or non-performance in ma-nagement activities

Poor market analysis, revenues be-low predictions

Each stages presents economic, financial and infra-structural-obsolescence risks. Addressing these risk is even more important if the purpose of the PPP is for development of social infrastructure or ‘cold

works’, in which the project operations depend on public contributions or transfers.

4. Developing the risk evaluation model

A risk is any area of uncertainty that presents a threat or opportunity to the project. The most important task in risk management is to avoid or reduce the probability of events that could change the econom-ic-financial viability of the project. The purpose of the current study is to provide an instrument useful for this task, specifically for evaluating the impact of the risks on the project in course and on the principle performances of the completed works.

The purpose of a mathematical model is to represent a given object, phenomenon or set of phenomena in the most discerning possible manner. The model is often constructed with the aim of providing forecasts on the future state of a phenomenon or system. The model generally describes the probable evolution of the phenomenon or system on the basis of the initial data (initial conditions), as indicated by the user (the system inputs), thus predicting the final data (the sys-tem outputs). The development of the mathematical model is necessarily preceded by a conceptual dia-gram, describing the principle entities that operate in the system, and a logical diagram, which represents the connections and interdependencies of the varia-bles. The conceptual diagram for (Figure 4) for the PF risk evaluation model identifies two categories of input factors: static and dynamic.

Figure 2 – Conceptual diagram

The inputs to the model lead into the structure for project analysis. The analytical structure in turn leads to the final performance test for the project mod-elled. There is also a downstream update to the struc-ture through selected feedback.

4.1 The input variables

Given the variability of the types of PF projects to be analysed, the input variables to the system must be modelled in a manner as generic as possible, covering all possible factors influencing the risks of the differ-ent operations. Thus to assist in conceptualising the input variables, we first classify the broad range of


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Public-Private Partnerships into three types of pro-jects:

• Hot works, having a sufficient public tariffto guarantee the economic-financial equilib-rium of the project;

• Warm works, having a public tariff, but oneinsufficient to guarantee the economic-financial equilibrium of the project;

• Cold works, where the tariff is entirely atthe expense of the public administration.

For all of the above works, the inputs are classified and identified as:

− Static factors: this class includes the group of unpredictable ‘Act of God’ factors, which gener-ally cannot be covered by insurance policies.

− Dynamic factors, including: • Tariffs• Increasing costs of construction• Public contributions• Scheduling• Level of demand

• Bureaucracy• Internal guarantees• Correlations between works.

The significance of these factors relative to the three project types was evaluated through a survey ques-tionnaire submitted to experts via Internet. The sur-vey was composed of nine questions, each corre-sponding to one of the listed input variables. The ex-perts selected their answers from a pull-down menu containing three or four potential responses. Given each question (input variable) the expert provided an answer for each type of work (hot, warm, cold). The questionnaire was distributed, gathered and statisti-cally analysed using SurveyMonkey. To obtain the input matrix for the model we first cal-culate the absolute frequency of answers to the ques-tionnaire, and from this calculate the relative fre-quency of answers as the ratio between absolute fre-quency and the total number of the statistical unit. In order to obtain a unique value representative of each of the input variables, for every type of work, we cal-culate a weighted average (Errore. L'origine rifer-imento non è stata trovata.1): − Each of the possible answers is assigned a value

from 1 to 4 (given that any question has a max-imum of 4 possible answers);

− The weights used in the weighted average (fi) are the frequencies of answers, calculated:

𝑚𝑒𝑑𝑖𝑎 𝑝𝑒𝑠𝑎𝑡𝑎 = !!∙!!!!∙!!!!∙!!!!∙!!!!!!!!!!!!

.

Equation 1

The repetition of this analysis for each question achieves the numeric matrix presented in Table 1, from which we can extract row or column vectors permitting direct comparisons between the different types of works. The matrix becomes the input to the model, permitting simulations for calculation of the risks inherent to each type of project.

Table 2 :Input matrix for the model

4.2 Logical links and structure for calculations

Next we examine the logical connections between the variables of the model. The four main blocks of the conceptual scheme are described as follows: − The Input block, consisting of the impact factors

for the nine static and dynamic risk factors, as evaluated by the questionnaire;

− The Risk control block, for evaluating the risks of the various factors, calculated by multiplying the various impact factors by a maximum and mini-mum probability;

− The Feasibility plan. This block of the model is engaged in the case of a specific project, where the various analyses of the feasibility identify the most critical factors for that particular case;

− The Performance test, serving to identify the three macro-ranges under which to evaluate the riski-ness of a project and the effects that the risks can have on the business plan.

To diagram the logic for the model we will represent each intermediate and final index as a node, gathering one or more lines from the preceding nodes. The up-stream nodes are the inputs; the downstream nodes are the ranges of risk.


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_+_

_+_

_-‐_

Input 1

Input 2

Input 3

Output

p1

p2

p3

Figure 3. Diagrammatic representation of the indexes

Figure 3 illustrates an example of calculation of an output. Each of the incoming lines bears a weight and sign. The sign represents the type of relation be-tween the input and output linked by that line (+ in the case of direct proportionality; - in case of inverse proportionality). The weights are assigned depending on the individual input’s degree of influence on the output. For the example illustrated, the output is cal-culated:

𝑂𝑢𝑡𝑝𝑢𝑡!"# = input ! ∙ 𝑝!"# + 𝑖𝑛𝑝𝑢𝑡! ∙ 𝑝!"#+ 𝑖𝑛𝑝𝑢𝑡! ∙ 𝑝!"#!

− 𝑂𝑢𝑡𝑝𝑢𝑡!"# = input ! ∙ 𝑝!"# + 𝑖𝑛𝑝𝑢𝑡! ∙𝑝!"# + 𝑖𝑛𝑝𝑢𝑡! ∙ 𝑝!"#$

Equation 2

Once the formula for calculation of each index is de-fined there is sufficient mathematical basis for con-struction of the full model.

4.3 The dynamic model

The best method for evaluation of the effect of varia-tion in the probability of the impact of an input is to construct a dynamic model that permits variation of each index with instantaneous recalculation of all the model variables, and thus of the final output (thus identifying the level of riskiness reached). Various software platforms are available for carrying out dy-namic modelling. In the current study we developed the model using Microsoft Excel. Using a standard table, we create a matrix where the user selects the type of work (hot, warm, cold) using a drop-down menu. The various impacts of the inputs have been defined in precedence, and once inserted in the table are multiplied by their respective minimum and max-imum probabilities, giving us the minimum and max-imum risk of the indexes of the specific type of work. Each input will have a line with positive/negative sign corresponding to the direct or inverse propor-tionality regarding the output. Within the various matrixes we find :

• ID (code + name) identifying and de-scribing the risks for the different typesof works.

• The sign indicating the proportionalitybetween the input and the output.

• (+) Direct proportionality between in-put and output;

• (-) Inverse proportionality between in-put and output.

• The impact value typical of each typeof work, as determined by a team ofexperts. The value remains constant forthe specific projects belonging to eachtype of work.

• Minimum probabilityMin of occur-rence for each variable.

• Maximum probabilityMax of occur-rence for each variable. The maximumand minimum probabilities determinethe range of probability that each vari-able can assume for a specific project.

• Values of minimum and maximum risk,given by the product:

• Impact ⋅ Probability.

The colour of each box identifies the risk status, as determined using risk matrices available in the litera-ture.

Table 3 : Risk score matrix identification

The definition of the indexes in this standard form permits calculation of the outputs for each type of work. We identify three ranges which define the risk-iness intervals under which the three types of work can be evaluated.

Figure 4. Risk Test


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Once the critical risks are identified, the sensitivity analysis provided by the model identifies the positive or negative variations that should be implemented in these factors, and their impact on the economic-financial indicators.

Table 4- Sensitivity analysis

ID Variation in costs Variation over time (+/-) 20% 2 years

(+/-) 10% 1 year

(+/-) 5% 6 months

(+/-) 0% none

At this point the analysis is repeated to identify the new values for the economic-financial indicators un-der the revised project, and thus the sustainability of the business plan.

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