Project and Infrastructure Finance Slides Module1_Ver3

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MODULE - 1

BASICS OF PROJECT FINANCE

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BASICS OF PROJECT FINANCE

• Investment - Investor, IRR, NPV (Land, Working

capital)

• Project Finance – Process of raising finance for

gross root projects.

• How Bankers look at project for financing.

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Project Finance Objectives1. Identify key risks in the project through due

diligence and develop risk mitigate structures 2. Risk allocation to the various participants who are

best capable of handling it through structured contracts – This depends upon negotiating power and risk premiums (lower tariff for offtake contract) – Risk trade off skills; No point in allocating risk to a party who cannot sustain the financial consequences.

3. (a) Quantifying and considering the acceptability of the residual risks that remains with the company / lenders (Mitigation, Impact). Transferring all risk – not possible(b) Increasing interest rate is not risk mitigation

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4. Development of security structures to protect lenders’ interest.

5. Financial Modelling6. The project should be structured for risk and

priced and pricing should not be on risk alone7. Security and Documentation

Project Finance Objectives

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Why Risk is important

• Huge upfront cost / Earnings back ended over long term.

• No recourse to promoters • No adequate tangible / saleable security• If we de-risk the project, raising funds

from banks is not difficult.

Invt. Bankers,

Technical & Legal

Advisers

Concession/Licence

Agreement

Insurance

Companies

O&M

Operator

EPC

Contractor

Government

Sponsors

Invt. Bankers,

Technical & Legal

Advisers

Financial

Investors

Users

TRA/Escrow

Agent

Lenders

Project SPV

Advisers

Insurance Policies

O&M

Contract

EPC Contract

Equity

Equity/

Sub-debt

Offtake

contracts

TRA/Escrow

Agreement

Debt

Substitution

Agreement

(Assignment of interests, rights etc.)

AdvisersFuel Supply

Advisers/Experts

Rating agency

Deal Diagram

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RAS LAFFAN LIQUIFIED NATURAL GAS COMPANY LTD (RASGAS)

Risk Case Study

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1. 25 year take or pay agreement with Korea Gas2. Mobil to guarantee minimum price of LNG linked to crude

oil price of $10.40 per barrel3. Maximum liability of Mobil $200 million4. Maximum period of guarantee – 2009 (10 years)

Risks - Price

Qatar Govt. Mobil Itochu Nissho Iwai

66.5% 26.5% 4% 3%

Equity

LNG project

Security Trustee

Bond Trustee

Exim facilities

Bond holders

Offshore contractorOnshore contractorDrilling contractor

Offtake agreement

Minimum price guarantee

Trustee agreement

Project coordination agreement

Korea Gas

RAS LAFFAN LNG

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Project

Production of 10 million tonnes of LNG from North field which is world’s largest non associated gas field – 9% of world gas reserves

Project Cost $ millionDrilling 239Offshore facilities 453Onshore facilities 1670Interest during construction 593Other costs 380

-------3335-------

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Project (cont’d)

Financial PlanEquity $ millionQatar Petroleum Company 651 (19.9%)Mobil 260 ( 8.0%)Itochu 39 ( 1.2%)Nisso Iwai 29 ( 0.9%)

979 30%DebtCommercial Banks 382 (11.7%)ECA (US Exim, UKECGD Italy-Sace) guaranteed loans 703 (21.5%)Bonds redeemable in 2006 400 (12.3%)Bonds redeemable in 2013 800 (24.5%)

2285 70% 3264 100%

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• Korean Gas, offtaker has an option to take 5% equity- Bonds were considered because of long duration debt

and long moratorium requirement (6-8 years)Long term bond yield - 8.294% (U.S. Treasury + 1.875%)

- International investors 20%- US Investors 80%

- Lead manager – Goldman Sachs

Project (cont’d)

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Project detailsRAS LAFFAN LIQUIFIED NATURAL GAS COMPANY LTD

(RASGAS)

State of Qatar

Mobil Corporati

on

Itochu/ Nisso Iwai

Facility agent

Bond Trustee

Qatar Petroleu

m Corporati

on

Mobil QM Gas Inc

Banks ECA

Bonds

Ras GasRepublic of Korea

Korea Electric Power

Corporation

Regional Governmen

ts

Korea Gas Corporation

(Kogas)

Korea Electric Power Corporation

(Kepco)

100% 100%

71% 29%

Equity 28%

Equity 2%

Debt 70%

Offshore Trust Account (Industrial

Bank of Japan)

Kogas, Kepco enjoy Korea sovereign rating – AADefault probability – 1.07%

LNG Supply

50% 34.7% 15.3%

47.4% 52.6%

Operating Cost

Other LNG Buyers

Condensate Buyers

Royalt

ies &

ta

xes

Div

iden

ds

Deb

t serv

ice

LNG

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a) Offtaker: Korea Gas (Kogas) offtakes 75% of gas and supplies to Korea Electric Power Corporation (Kepco)

b) Shareholding of Kogas - Republic of Korea 50.0%- Kepco 34.7%- Regional Governments 15.3% ----------- 100.00% -----------

Kogas and Kepco enjoy Korea Sovereign rating AA according to Standard and Poor

Project details (cont’d)

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c) Risks in the projectAssets are of little value because of dedicated use and

location- Spot sales of LNG world over forms only 2% of sales- Heavy front end investment in dedicated facilities- Lack of transportation capacity / lack of alternative

markets- Demand risk for power (Kogas reduced offtake by 22%

during Asian crisis in 1998)- Price risks- Quantity risks

Credit spread depends on firm specific contractual structure.


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d) Management of risks (credit enhancement / contracts)

i) Long term take or pay agreement (25 years) between Rasgas and Kogas for 75% of production with LNG price linked to a basket of crude oil

ii) Debt contract between Rasgas and Lendersiii) Credit enhancement agreement by Mobil to

lenders. Unsecured subordinated revolving loan to meet shortage of funds for debt service.- Maximum liability $200M- Maximum period of guarantee 1999-2009- Mobil’s guarantee to be activated if crude

oil price falls below $10.4 per barrel. At 75% production level and $10.4 per barrel linked price the revenues would cover operating expenses, royalties and taxes and debt service. The oil prices in 1998 fluctuated between $12 to 14 per barrel.


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e) Priority of fund utilisation from offshore account

Royalties and taxes to Qatar Government(20% of revenue)

Operating Cost

Debt Service

Dividends


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f) Standard and Poor estimates the average crude price to be $10.15 per barrel through the project life

g) Rasgas input / output flow matrix

Assets a) Take or pay contract proceeds net of costs at NPV

b) NPV of other short term sales of products

c) Contingent debt service guarantee by Mobil

Liabilities a) NPV of royalties and taxesb) Public debt : Bondsc) Private debt : Debt from banks and

ECAsd) Equity - Private


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h) Unmanaged risks

Quantity - counter party risk (Kogas / Kepco)Price - Brent crude oil priceMobil guarantee - Mobil Stock priceKepco offtake risk - Kepco credit spread / rating

- Kepco stock price- High oil / LNG prices*

$ / won exchange - Kepco’s revenues in Won but debt servicing in $ risk (fixed exchange rate transformation to floating)Korea country risk - Country rating(Demand for power) - Korea composite stock price index (KOSPI)Competition - Russian exportsEmerging market risks - Kepco was downgraded from AA to B+ during

Asian crisis but subsequently upgraded to BBB**Financial risk - There is a probability that the defaults may be

over $200 million, occur after 10 years* While higher oil prices favour Rasgas it could

affect Kepco. Breakeven price for Kepco is $23 per barrel. Above this, Kepco will default (Dabhol)

** Default probability: AA – 1.07%; BBB – 4.48%


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Types of Financing

Finance

Corporate/Balance

sheet financing

Assets based

financing

Project

financing

(Based on company’s

financial position)

(Based on value of

Assets [Real Estate])

(Value of cash flows)

Why companies promote separate companies for large projects?

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Project Financing versus Corporate Finance

Project Financing Corporate Financing

a) Financial Plan Important; Difficult to change during the loan tenure as it is governed by contracts

Generally assumed to be independent. Can be changed at any time during the tenure of the loan

b) Repayment risk

The repayment only out of cash flows of the project. No sponsor support. The financing is off balance sheet.

Repayment out of company’s overall earnings. Sponsor support is possible

c) Security The security would include intangible assets such as rights, assets and interests.(Overbridge, Airports, Toll Road)

Normally either unsecured or security of tangible assets

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Project Financing Corporate Financing

d) Quantum and tenure of assistance

Usually large8-10 years

Variable

e) Risk levels High, because of uncertainty of project cash flows

Low as the company’s working data is available

f) Risk mitigation Through structured financing and contractual commitments

-

g) Participants Project developers, Governments Engineers, Contractors, Equipment suppliers, Fuel suppliers, Product offtakers

Only lenders and CEO

Project Financing versus Corporate Finance

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Characteristics of Project Finance

• Project is a separate legal entity / special purpose vehicle – Ring fenced

• Sometimes a Special Purpose Vehicle (SPV), where each sponsor takes his share of rewards and meets his share of expenses and project funding is availed by sponsors – Oil SPVs

• Project revenue, the only source of loan servicing, equity return – limited recourse.

• No sponsor credit support; sponsors shift debt servicing to the project

• Lenders to have a high degree of confidence in the project cash flows

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• Financial package is custom built• Risk is allocated to the party that can handle

it better with negotiated rewards (through contracts), its credit worthiness, its role in the project

• Debt is of long term tenure• Financial plan takes into account taxation,

exchange controls, enforceability of claims etc.

• The borrowing structure is enforceable contract driven with covenants


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• Credit enhancement through contracts (offtake agreement, contingent guarantees)

• High cost of syndication;Syndicated loans

• Private – public partnerships / FDI• Large size loans to be viable• High leverage


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a) Competition resulting in - Price erosion- Lowering of security

requirements- Not checking enforceability of

conditions / contracts- Extension of maturities- Higher credit risk

b) Competition is not - Skill developmentadequately resulting in - Appointment of consultant

c) Increasingly becoming like corporate finance

Problems in Project Finance

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d) Higher NPA will block future project financing, lead to risk averseness as lenders’ leverage is high

e) Lenders have only downside and no upsidef) i) Syndication groups – aggressive price – no risk

perceptionii) Relationship groups – a cost & service centre; Pursuesa deal aggressivelyiii) Structured finance groups – comes with futuristic structuresignoring the core of the deal

iv) Risk groups

Departments in Project Finance

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• Blockbuster deals • Pioneer deals • Why left behind deal / take it away from

him• Market Image deal• Relationship deal

Various Deals

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Growth of Project Finance

1. Privatisation / Private Public Partnership (Private sector participation – Japan, Australia, Portugal, Italy, UK)

2. Deregulation3. Internationalization of Investments4. Growth in Power, Telecom, Infrastructure, Oil and

Roads (Portugal), Natural Resources (Mining), Gas (Brazil)

5. Project Finance is not necessarily• Privatisation• Structured financing• Securitization• Leveraged buyout• Acquisition finance

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Advantages of Project Finance (sponsors / company)

Why existing companies implement large projects in separate companies availing project finance?

a) Sponsor company can insulate itself from the credit risks of the project with only equity at risk. Even if sponsor credit support is required, it could be limited to completion guarantee, ceiling of guarantee amount, removal of guarantee in case of satisfactory D/E or DSCR

b) Project loan is off the balance sheet of the promotor company and hence doesn’t affect rating of sponsor

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c) From the lender’s angle, the project is insulated from promotor bankruptcy. This is important for lenders, suppliers and offtakers. If there is a proper contract structure, the rating of the new project could be better than the parent and can raise low interest loans.

d) The sponsor could invite equity participation from other strategic investors like product offtakers, input suppliers, technology suppliers to strengthen the project rating but at the same time without diluting their controlling interest in the sponsor company.

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e) In a similar way, the sponsors could promote larger projects by inviting public participation in equity without dilution of their control in the promoting company.i) Sponsor contribution 100

Debt 200300

ii) Sponsor contribution 100Public equity 100Debt 400

600

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f) The promotors company avoids restrictive covenants of the project lenders such as cross defaults, dividend declaration, nominee director etc.

g) Debt could be large and of long tenureh) The sponsor after ascertaining performance of

the project can always merge it into the sponsor company at a time of his choice or sell it away

i) The incorporation of a separate company may also be due to different wage levels, regulatory issues environmental issues.

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j) In many cases like power, fertilizers etc., there is a need to segment the cost of the project/operational cost for regulatory purposes. Hence there is a need for a separate entity.

k) Sharing of risks by several parties who are in a better position to handle them. For instance a good offtake contract from a buyer more creditworthy than sponsor improves project rating.

l) Limiting security to the project’s assets.

While no party assumes responsibility for the entire credit risk, a combination of guarantees and undertakings which then viewed together constitutes a bankable credit risk.

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Disadvantages of Project Finance (sponsors / company)

1. Delay due to due diligence for lenders, protracted negotiations and time for finalise risk allocation.

2. Higher risks for lenders – projected cash flow3. Generally higher fees and interest rates on non recourse

financing4. Complying with the lenders’ reporting requirements covenants,

and the reimbursement of the cost of lenders’ supervision (lenders’ engineers’ fees) could add to the cost.

5. The non recourse loans have made the sponsors totally very aggressive risk takers

6. Risk allocation leads to higher risk premium and increases cost.7. High legal bills8. Cumbersome documentation9. Lenders have a large number of covenants

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Choosing a Bank

- Cost of project vis a vis the bank size- Cost of funds of the bank and hence

pricing- Bank’s experience in project finance /

flexibility / realism- Complexity of documentation- Decentralisation of decision making

(time factor)

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Components of a Project Appraisal

1. Promotor Evaluation2. Management Aspects3. Project Details

Location Technical Implementation Raw material availability Labour issues Environmental aspects

4. Cost of Project5. Means of financing6. Profitability analysis7. Risk Evaluation8. Conditions

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Infrastructure Project TypesBOT - Build, Operate and Transfer The assets are owned by (Roads, Power, Sewage treatment) Government agency which will

take back assets after concession period

BOOT - Build, Own, Operate and TransferSame as BOT except that assetownership is with the operator andsold to the Government for either a

nominal/ preagreed fixed sum / market value with a cap

BOO - Build, Own, Operate Same as BOOT except that asset

is perpetually owned by theoperator

BOOST - Build, Own, Operate, Share and Same as BOOT except that Transfer during the concession period

revenue is shared with theGovernment agency

BOLT - Build, Own, Lease and Transfer Subleased to other tenants afterbuilding in a leased land – IT ParkTransfer to the government agencyafter concession period.

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DBFO - Design, Build, Finance and Operate Designed, financed and

operated perpetually.BTO - Build, Transfer, Operate Private operator transfers to

Government and leases it backcollects revenues.

BBO - Buy, Build, Operate Buy an existing facility,modernise, operate and collectuser fees (Old Mumbai-Pune road)

OMT - Operate, Maintain and Transfer Operated during the concession

period and transferred back tothe government agency.

Infrastructure Project Types

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Characteristics of Infrastructure Projectsa) Capital Intensive – Fixed charges form a

major part of the expenditureb) Mainly dedicated use – market analysis

is important as product has specific use at specific time and cannot be stored.

c) Cash flow is the only source of funds for loan repayment. Asset utilisation is more important than asset value

d) Usually implemented as Special Purpose Vehicles (SPV).

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e) Offtake Agreements – Long Term Agreements to purchase a minimum amount of end product at an agreed price.

f) There are different classes of investors with varying risk return characteristics.

g) Contingent funds – Equity/Debt with some commitment charges

h) Loans are usually are of long term nature – 15 to 20 years.

Characteristics of Infrastructure Projects

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Contingent Equity / Debt

- The project should be capable of repaying the debt as otherwise it cannot function.

- The quantum of loans depends on the cash flow (not profit) and volatility of cash flow (steel, cement, fashion wear, power projects).

- What should be the cash flow for a loan of Rs.100crores repayable equally over 5 years carrying 10% interest.

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Year 1 2 3 4 5

Repayment 20 20 20 20 20

Interest 9 7 5 3 1

Total 29 27 25 23 21

(Rs. in Crore)

Minimum cash – Rs.29 croresTotal cash flow – Rs.125 croresWith 60% margin = 125 x 1.6 =

Rs.200 crores(50 to 100% = Rs.40 cores / year(DSCR 1.5 – 2.0)(i.e. 40% of the total loan amount).

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Possible Scenarios

(Rs. Crores)

Contingent Equity I II

Project 100.0 110.0

Cash flow 30.0 25.0

Loan 250% of cash flow 75.0 62.5

Equity 25.0 47.5Contingent Equity = Escalation (Rs.10 crores)

Plus Shortfall (Rs.22.5 crores) in cash flow (Rs.12.5 crores)

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Contingent Debt I II

Equity 25.0 25.0

Contingent equity 22.5 12.5

Debt 62.5 62.5

Contingent debt* -- 10.0

Total 110.0 110.0

(Rs. Crores)

* Subordinated/quasi equity debt

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i) Stronger Security Structure:• Charge/assignment on assets including

intangibles, revenues, receivables, company’s rights under project documents, contracts, licenses, permits, approvals, consents and insurance polices

• Step in rights• Trust and Retention account• Pledge of equity of Promoters• L/c opening by customer for 1 to 3 month’s

estimated receivables• Debt Service Recovery Account• State Government Guarantee• Central Government Guarantee• Contingent Promoter's Support


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j) Restrictions due to contractual obligations• Recall rights if rating falls below a grade.

k) Water fall Mechanism.


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AgreementsConcession - Rights to the company to recover Agreement project costs and operating costs

through levy of fees; Fees indexing (Ports, Flyovers, Airports) / support / tax incentives

Throughput - Obligation on the part of the buyer Agreement / to pay for the quantity of product Take or Pay whether he lifts or not (LNG)

Long term pricing/Limited market (oil, toll road)Put or Pay - Supplier indemnifies the project Supply contracts company for excess cost incurred

in securing supplies from third parties for revenue cost.

Long term sales - Quantity fixed but the price at the prevailing rates

agreement (oil , minerals) with a floor price (LNG)

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Cash deficiency - Overrun undertaking / cash loss financing by sponsors

Capital Subscription - Equity AgreementIntercreditor Agreement - Between the creditorsShareholder Agreement - Agreement between

shareholders on rights/ obligations of each (Board/ Management)

Completion Agreement - Guarantees for the loan by sponsors till completion of

the project (guarantee to ensure project completion)

Agreements

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Finance ProvidersEquity - Private equity, Public, Banks, International Finance

Corporation, Customers, Contractors, Equipment suppliers, Operators, offtakers, Input (Fuel)

suppliers, Infrastructure funds (GE Capital, Asian infrastructure fund), Warrants

Underwriters - Investment Banks, Brokers, Banks, various mutual funds

Quasi equity - Subordinated loans from promotors- Interest free advance from customers (Oil)- Royalty based loans (Technology Development Board)- Convertibles (loans, preference shares)- Interact free loans from sponsors- Preference shares of long maturity

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ParticipantsDebt - Suppliers’ credit from equipment supplier

- Bonds subscribed by institutional investors Pension funds, Insurance companies etc., based on credit rating

- Loans, guarantees, insurance from export credit agencies (Exim Bank / OPIC)- Multilateral, bilateral credits, mixed credits (IBRD, KFW, ADB)- Senior debt / syndicated debt- Debentures- Bank loans- Securetised debt

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ParticipantsDebt - Secured / unsecured

- Fixed / floating interest rates- Foreign currency / local currency- Ballooning repayment schedules- Differential interest rates after

construction- Take o ut financing

Insurance - MIGA (Political insurance for equity / debt) (AIG, GIC etc)

Guarantees - Banks, IBRD- Letter of Credit (Banks)

Credit Enhancers - Offtake / supply agreementsRating Agencies - CRISIL, ICRA, FITCH etc.

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Interest of various participants in the project

Sponsorsa) Segregation of project risk from the existing

operationsb) Maximum leverage – Maximum debtc) Flexible loan covenantsd) Well negotiated risk sharinge) Exclusion of all assets other than that of the

project from securityf) Lenders willing to restructure loans rather than

recall in case of difficultiesg) Management controlh) Low interest / low transaction costi) High cash flow potential

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Lendersa) Good construction contract for timely

completion within the budgetb) Turnkey contracts with firm price, time

of completion, compatible with the regulatory network and performance of the project with respect of output

c) Completion guarantee / performance bonds


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d) Good inter-creditor agreementse) Financial closure – no more loans

required for completionf) Adequate contracts of economic valueg) Legally satisfactory contracts / structuresh) The entire risk is properly allocated to

suppliers, contractors and offtakersi) Proper assignment of contractsj) Good debt service coverage ratio (1.5 –

2.0)k) Project complying with all the regulations


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l) Good pricingm) Favourable covenantsn) Proper warranties / representationso) Collaterals viability funding / shadow toll

agreement / credit enhancement / completion guarantee

p) Right to appoint consultants to oversee projectq) Pari passu security for allr) No overrun / delays) Credit worthiness of all project participantst) Guarantees if project is abandoned


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Contractora) Minimum penalties for escalation/ late

deliveryb) Maximum price, bonusc) Credit worthiness of the sponsord) Satisfactory financial tie upOperatora) Limiting the price risk penalties


Project and Infrastructure Finance Slides Module1_Ver3

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