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Transcript of project financing
← A COMPARATIVE ANALYSIS OF MUTUAL
FUNDS WITH SPECIAL EMPHASIS ON SIP AND
LUMPSUM INVESTMENTS
←← A PROJECT REPORT
←← Submitted by
←
← SAKET AGARWAL
←← in partial fulfillment for the award of the degree
←← of
←← BACHELOR OF COMMERCE
←← In
←← FINANCE
←← ST. XAVIERS COLLEGE (AUTONOMOUS),KOLKATA
←
1
← MARCH, 2010
←
← ST. XAVIER’S COLLEGE(AUTONOMOUS),
KOLKATA
←
←← BONAFIDE CERTIFICATE
← Certified that this project report “A COMPARATIVE ANALYSIS OF
MUTUAL FUNDS WITH SPECIAL EMPHASIS ON SIP & LUMPSUM
INVESTMENTS” is the bonafide work of “SAKET AGARWAL” who carried
out the project work under my supervision.
←
←
← SIGNATURE SIGNATURE
←
← HEAD OF THE DEPARTMENT SUPERVISOR
←
DEPT. OF COMMERCE (EVE.) DEPT. OF
COMMERCE (EVE.)
←
← 30 MOTHER TERESA SARANI 30 MOTHER TERESA
SARANI
←
← KOLKATA 700 016 KOLKATA 700 016
2
←
3
ACKNOWLEDGEMENT
←←← First and foremost, I would like to extend my deepest gratitude to
my guide Professor Kaushik Chatterjee for his support. His constant
encouragement motivated me to perform to the best of my ability.
←← I am sincerely thankful to my teachers, without whose supervision
and guidance this project would not have been completed.
← Also, I would like to convey my gratitude to Mr. Sanjay Saraf of
SSEI Ltd. Who gave me valuable knowledge on the subject.
←← Also, I would like to speacially thank Mr. Basant Maheshwari,
Director of www.theequitydesk.com for providing and guiding me on
the various regulations governing the stock market.
4
ABSTRACT
←← Finance is the lifeblood of business. Finance is indispensable, it is
rightly said that finance is the lifeblood of an enterprise. This is because in
modern money oriented economy, finance is one of the basic foundations of
all kinds of economic activities. It is needed to convert ideas into reality.
It may be arranged in many ways – and project finance is one such way. It is
the raising of funds on a limited recourse or non-recourse basis to finance an
economically separable capital investment project in which the providers of
the funds look primarily to the cash flow from the project as the source of
funds to service their loans and provide a return on their equity invested in
the project.
As an effective alternative to conventional direct financing, project financing
has become one of the hottest topics in corporate financing. It’s being used
more and more frequently on a wide variety of high profile corporate
projects.
Through this project I have highlighted on the rationale of project finance,
the characteristics and scheme of project finance, and the security
arrangements, project structure, project risks and its mitigation. Financial
modelling calculations are also shown and the various sources of project
funds have also been highlighted.
The presented case study involves a peep into Enron scandal and the way it
has impacted project finance, as after Enron project finance was widely
criticized.
5
Table of Contents PAGE NO.
1. INTRODUCTION
1.1 Rationale of Project Finance 1-2
1.2 Characteristics of Project Finance 3
1.3 Basic Scheme of Project Finance 4-5
2. LITERATURE REVIEW
2.1 Definition of Project Finance 6-7
2.2 Project Financing Arrangements 8-9
2.2.1 Build Own Operate Transfer
2.2.2 Build Own Operate Structure
2.2.3 Build Lease Transfer Structure
2.3 Project Viability and Financial Modelling 10-23
2.3.1 Technical Feasibility
2.3.2 Project Construction Cost
2.3.3 Economic Viability
2.3.4 Adequacy of Raw Material Supplies
2.3.5 Creditworthiness
2.3.6 Financial Modelling
2.4 Project Finance Risk 24-34
2.4.1 Risk Minimization Review
2.4.2 Types Of Risks
2.5 Security Arrangements 35-39
2.5.1 Security Arrangements Covering Completion of Project
2.5.2 Direct Security Interest in Project’s Facilities
2.5.3 Security Covering Debt Service
2.5.4 Purchase And Sale Contract
2.5.5 Raw Material Supply Agreement
2.5.6 Supplemental Credit Support
6
2.5.7 Financial Support Agreement
2.5.8 Cash Deficiency Agreement
2.5.9 Escrow Fund
2.5.10 Insurance
2.6 Legal Structure 40-44
2.6.1 Undivided Joint Interest
2.6.2 Corporations
2.6.3 Partnerships
2.7 Sources Of Funds 45-49
3. CASE STUDY: HOW ENRON HAS AFFECTED PROJECT FINANCE
3.1 The Enron Story 50-51
3.2 Caution among Lenders and Investors 52-53
3.3 Project Finance And Enron Factor 53-64
3.3.1 Effect on Traditional Project Finance
3.3.2 Effect in Structured Project Finance
3.3.3 Sources of Free Cash Flow
3.3.4 Security Interests
3.3.5 How Companies Have Responded
3.3.6 Increased Transparency and Disclosure
3.3.7 Regulatory Issues
3.4 Other Lessons Learned 65-66
4. CONCLUSION 67
BIBLIOGRAPHY 68
7
←←←
8
9
10
←←← CONTENTS
← PARTICULARS PAGE NO.
←← 1. INTRODUCTION 4
←← 2. LITERATURE REVIEW 6
←← 3. METHODOLOGY 17
←← 4. HYPOTHESIS 26
←← 5. RESULTS 27
←← 6. CONCLUSION 28
←← 7. EXECUTIVE SUMMARY 30
←← ANNEXURE
← BIBLIOGRAPHY
←←←←←←←←←←
11
←
← 1.
INTRODUCTION
←
← 1.1 Rationale of Project Financing
←
← There is a growing realization in many developing countries of the
limitations of governments in managing and financing economic activities,
particularly large infrastructure projects, Provision of infrastructure
facilities, traditionally in the government domain, is now being offered for
private sectors investments and management. This trend has been
reinforced by the resource crunch faced by many governments.
Infrastructure projects are usually characterized by large investments, long
gestation periods, and very specific domestic markets.
← In project financing the project, its assets, contracts, inherent
economic and cash flows are separated from their promoters or sponsors in
order to permit credit appraisal and loan to the project, independent of the
sponsors. The assets of the specific project serve as a collateral for the
loan, and all loan repayments are made out of the cash of the project. In
this sense, the loan is said to be of non-resource to the sponsor.
12
←
←
13
← Thus, project financing may be defined as the scheme of ‘financing
of a particular economic unit in which l lender is satisfied in looking at the
cash flows and the earnings of that economic unit as a source of funds,
from which a loan can be repaid, and to the assets of the economic unit as a
collateral for the loan. In the past, project financing was mostly used in oil
exploration and other mineral extraction through joint ventures with
foreign firms. The most recent use of project financing can be found in
infrastructure projects, particularly in power and telecommunication
projects. Project financing is made possible by combining undertakings and
various kinds of guarantees by parties who are interested in a project. It is
built in such a way that no one party alone has to assume the full credit
responsibility of the project. When all the undertakings are combined and
reviewed together, it results in an equivalent of the satisfactory credit risk
for the lenders. It is often suggested that the project financing enables a
parent company to obtain inexpensive loans without having to bear all the
risks of the project. This is not true, in practice, the parent company is
affected by the actual plight of the project, and the interests on the project
loan depend on the parents stake in the project. The traditional form of
financing is the corporate financing or the balance sheet financing. In this
case, although financing is apparently for a project, the lender looks at the
cash flows and assets of the whole company in order to service the debt and
provide security.
←
14
←
← 1.2 Characteristics of Project Finance
←
← The following are the characteristics of project financing:
← • A separate project entity is created that receives loans from lenders
and equity from sponsors.
← • The component of debt is very high in project financing. Thus,
project financing is a highly leveraged financing.
← • The project funding and all it’s other cash flows are separated from
the parent company’s balance sheet.
← • Debt services and repayments entirely depend on the project’s cash
flows. Project assets are used as collateral for loan repayments.
← • Project financers’ risks are not entirely covered by the sponsor’s
guarantees.
← • Third parties like suppliers, customers, government and sponsors
commit to share the risk of the project.
← Project financing is most appropriate for those projects, which
require large amount of capital expenditure and involve high risk. It is
used by companies to reduce their own risk by allocating the risk to a
number of parties.
← It allows sponsors to :
← • Finance large projects than the company’s credit and financial
capability would permit.
15
← • Insulate the company’s balance sheet from the impact of the
project.
← • Use high degree of leverage to benefit the equity owners.
← 1.3 Basic Scheme of Project Finance
←
The basic scheme of project finance has been explained with an example:
← Acme Coal Co. imports coal. Energen Inc. supplies energy to
consumers. The two companies agree to build a power plant to accomplish
their respective goals. Typically, the first step would be to sign a
memorandum of understanding to set out the intentions of the two parties.
This would be followed by an agreement to form a joint venture.
← Acme Coal and Energen form an SPV (Special Purpose Vehicle)
called Power Holdings Inc. and divide the shares between them according to
their contributions. Acme Coal, being more established, contributes more
capital and takes 70% of the shares. Energen is a smaller company and takes
the remaining 30%. The new company has no assets.
← Power Holdings then signs a construction contract with Acme
Construction to build a power plant. Acme Construction is an affiliate of
Acme Coal and the only company with the know-how to construct a power
plant in accordance with Acme's delivery specification.
16
← A power plant can cost hundreds of millions of dollars. To pay Acme
Construction, Power Holdings receives financing from a development bank
and a commercial bank. These banks provide a guarantee to Acme
Construction's financier that the company can pay for the completion of
construction. Payment for construction is generally paid as such: 10% up
front, 10% midway through construction, 10% shortly before completion,
and 70% upon transfer of title to Power Holdings, which becomes the owner
of the power plant.
← Acme Coal and Energen form Power Manage Inc., another SPV, to
manage the facility. The ultimate purpose of the two SPVs (Power Holding
and Power Manage) is primarily to protect Acme Coal and Energen. If a
disaster happens at the plant, prospective plaintiffs cannot sue Acme Coal or
Energen and target their assets because neither company owns or operates
the plant.
A Sale and Purchase Agreement (SPA) between Power Manage and Acme
Coal supplies raw materials to the power plant. Electricity is then delivered
to Energen using a wholesale delivery contract. The cash flow of both Acme
Coal and Energen from this transaction will be used to repay the financiers.
FIGURE - I
17
2. LITERATURE REVIEW
←
←
← 2.1 Definition of Project Finance
←
18
There is no single agreed upon definition for project finance.
For example, Finnerty defines project finance as:
The raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.
While Nevitt and Fabozzi defines it as:
A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.
And the International Project Finance Association (IPFA) defines project finance as:
The financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project.
Although none of these definitions uses the term “nonrecourse debt” explicitly (i.e., debt repayment comes from the project company only rather than from any other entity), they all recognize that it is an essential feature of project finance.[1]
The following definition, albeit slightly more cumbersome, allows one to distinguish project finance from other financing vehicles, something the previous two definitions cannot do:
Project finance involves the creation of a legally and 19
economically independent project company financed with nonrecourse debt (and equity from one or more corporate sponsors) for the purpose of financing a single purpose, capital asset usually with a limited life.
--------------------------------------------------------------------------------------------
[1] Limited recourse debt—debt that carries a repayment guarantee for a defined period of time, for a fraction of the total principal, or until a certain milestone is achieved (e.g., until construction is complete or the project achieves a minimum level of output)—is a subset of nonrecourse debt. The distinguishing feature is that at least some portion of the debt becomes nonrecourse at some point in time.
20
2.2 Project Financing Arrangements
←
← The project financing arrangements may range from simple
conventional type of loans to more complex arrangements like the build-
own-operate-transfer (BOOT).
← The typical arrangements include:
← 2.2.1 ‘The build-own-operate-transfer (BOOT) structure
← 2.2.2 The build-own-operate (BOO) structure
← 2.2.3 The build-lease-transfer (BLT) structure
←
←
← 2.2.1 ‘The build-own-operate-transfer (BOOT) structure
← It is a special financing scheme, which is designed to attract private
participation in financing constructing and operating infrastructure projects.
In BOOT scheme, a private project company builds a project, operates it for
a sufficient period of time to earn an adequate return on investment, and then
transfers it to the host government or its agency. Quite often, the value of
efficiency gain from private participation can outweigh the extra cost of
borrowing through a BOOT project, relative to direct government
borrowing. The private group usually consists of international construction
contractors, heavy equipment suppliers, and plant and system operators
along with local partners.
←
←
21
← 2.2.2 The Build-Own-Operate (BOO) Arrangement
← The issue of “transfer”(the T in BOOT projects) is ambiguous because
most of the BOOT projects under operation or consideration have the
transfer dates quite far away and, therefore, they are not a real concern as
yet. One problem with the transfer provision is the likelihood of the capital
stock of the project being run down as the date of transfer draws bearer.
←
←
← 2.2.3 Build-Lease-Transfer arrangement
← In the build lease transfer arrangement, the control of the project is
transferred from the project owners to a lease. The shareholders retain the
full ownership of the project, but, for operation purposes, they lease it to a
lessee. The host government agrees with the lessee to buy the output or
service of the project. The lesser receives the lease rental guaranteed by the
host government.
←
←
←
←
←
←
←
←
←
22
← 2.3 PROJECT VIABILITY AND FINANCIAL MODELLING
←
← Investors are concerned about all the risks a project involves, who will
bear each of them, and whether their returns will be adequate to compensate
them for the risks they are being asked to bear. Both the sponsors and their
adviser must be thoroughly familiar with the technical aspects of the project
and the risks involved, and they must independently evaluate a projects
economics and its ability to service project related borrowings.
←
←
← 2.3.1.Technical Feasibility:
← Prior to the start of construction, the project sponsors must undertake
extensive engineering work to verify the technological processes and design
of the proposed facility. If the project requires new or unproven technology,
test facilities or a pilot plant will normally have to be constructed to test the
feasibility of the process involved and to optimize the design of full scale
facilities. A well-executed design will accommodate future expansion of the
project; often, expansion beyond the initial operating capacity is planned at
the outset. The impact of project expansion on operating efficiency is then
reflected in the original design specifications and financial projections.
←
←
←
←23
← 2.3.2 Project Construction Cost:
← The detailed engineering and design work provides the basis for
estimating the construction costs for the project. Construction costs should
include the cost of all facilities necessary for the project’s operation as a
freestanding entity. Construction costs should include contingency factor
adequate to cover possible design errors or unforeseen costs. Project
sponsors or their advisers generally prepare a time schedule detailing the
activities that must be accomplished before and during the construction
period. A quarterly breakdown of capital expenditures normally
accompanies the time schedule.
← The time schedule specifies
← (1) Time expected to be required to obtain regulatory or
environmental approvals and permits for construction.
← (2) The procurement lead time anticipated for major pieces of
equipment and
← (3) The time expected to be required from pre-construction activities-
performing detailed design work, ordering the equipment and building
materials, preparing the site and hiring the necessary manpower.
← The project sponsor examines the critical path of the construction
schedule to determine where the risk of delay is greatest and then assesses
the potential financial impact of any projected delay.
24
2.3.3 Economic Viability:
← The critical issue concerning economic viability is whether the
project’s expected net present value is positive. It will be positive only if the
expected present value of the future free cash flows exceeds the expected
present value of the project’s construction costs. All the factors that can
affect project cash flows are important in making this determination.
Assuming that the project is completed on schedule and within budget, its
economic viability will depend primarily on the marketability of the projects
output (price and volume). To evaluate marketability, the sponsors arrange
for a study of projected supply and demand conditions over the expected life
of the project. The marketing study is designed to confirm that, under a
reasonable set of economic assumptions, demand will be sufficient to absorb
the planned output of the project at a price that will cover the full cost of
production, enable the project to service its debt, and provide an acceptable
rate of return to equity investors.
← The marketing study generally includes:
← 1) A review of competitive products and their relative cost of
production;
← 2) An analysis of the expected life cycle for project output, expected
sales volume, and projected prices; and
← 3) An analysis of the potential impact of technological obsolescence.
25
← An independent firm of experts usually performs the study. If the
project will operate within a regulated industry, the potential impact of
regulatory decisions on production levels and prices—and, ultimately, on the
profitability of the project –must also be considered. The cost of production
will affect the pricing of the project output. Projections of operating costs are
prepared after project design work has been completed. Each cost element,
such as raw materials, labor, overhead, taxes, royalties, and maintenance
expense, must be identified and quantified. Typically, this estimation is
accomplished by dividing the cost element into fixed and variable cost
components and estimating each category separately. Each operating cost
element should be escalated over the term of the projections at a rate that
reflects the anticipated rate of inflation. From a financing standpoint, it is
important to assess the reasonableness of the cost estimates and the extent to
which the pricing, and hence the marketability, of the project output is likely
to be affected by estimated cost inflation rates. In addition to operating costs,
the project’s cost of capital must be determined. The financial adviser
typically is responsible for this task. He develops and tests various
financing plans for the project in order to arrive at an optimal financing plan
that is consistent with the business objectives of the project sponsor.
←
←
← 2.3.4 Adequacy of raw material supplies:
26
← The project should have sufficient supplies of raw materials to enable
it to operate at design capacity over the term of the debt. Independent
consultants may be summoned to evaluate the quantity, grade, and rate of
extraction that the mineral reserves available to the project are capable of
supporting. The project should have the ability to access the raw materials
through contractual agreements like direct ownership, lease, purchase
agreement etc.
← 2.3.5 Creditworthiness:
← A project has no operating history at the time of its initial debt
financing. Consequently, the amount of debt the project can raise is a
function of the project’s expected capacity to service debt from project cash
flow- or more simply, its credit strength.
← A project’s credit strength derives from
← (1) The inherent value of the assets included in the project,
← (2) The expected profitability of the project,
← (3) The amount of equity project sponsors have at risk,
← (4) The pledges of creditworthy third parties or sponsors involved in
the project.
Thus,
27
← To arrange financing for a stand-alone project, prospective lenders
must be convinced that the project is technically feasible and economically
viable and that the project will be sufficiently creditworthy if financed.
Establishing technical feasibility requires demonstrating that the
construction can be completed on schedule and within budget and that the
project will be able to operate at its design capacity following completion.
Establishing economic viability requires demonstrating that the project will
be able to generate sufficient cash flow so as to cover its overall cost of
capital. Creditworthiness will be established by demonstrating that even
under reasonably pessimistic circumstances, the project will be able to
generate sufficient revenue to cover all operating costs and to service project
debt in a timely manner. The loan terms have an impact on how much debt
the project can incur and still remain creditworthy.
2.3.6 Financial Modelling
EXAMPLE: To illustrate how financial modeling is done a 50MW power
plants calculation is shown below:
28
2.4 PROJECT FINANCE RISK
2.4.1 Risk Minimization Process
Financiers are concerned with minimizing the dangers of any events that
could have a negative impact on the financial performance of the project, in
particular, events that 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.
29
The minimization 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 minimized, the financiers will need to build it into the interest rate margin for the loan.
STEP 1 - Risk identification and analysis
30
← 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 analyzed 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.
←
← STEP 2 - Risk allocation
← Once the risks are identified and analyzed, 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.
←
31
← STEP 3 - Risk management
← Risks must be also managed in order to minimize the possibility of the
risk event occurring and to minimize 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.
←
←
← 2.4.2 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 minimizing them.
However, it is helpful to categorize the risks according to the phases of the project within which they may arise:
(i) The design and construction phase;
(ii) The operation phase; or
(iii) Risks common to both construction and operational phases.
32
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.
(i) Construction phase risk –
33
← 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 jeopardize contracts for the sale of
the project's output and supply contacts for raw materials.
← Commonly employed mechanisms for minimizing 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;
← (d) Obtaining independent experts' reports on the design and
construction of the project.
34
← Completion risk is managed during the loan period by methods such
as making pre-completion phase drawdown’s of further funds conditional on
certificates being issued by independent experts to confirm that the
construction is progressing as planned.
←
←
← (ii) 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 minimized 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);
35
← (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.
← Operating risk
← 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. The usual way for minimizing 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.
←
Market / off-take risk
36
← 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 minimizing market risk before lending
takes place is an acceptable forward sales contact entered into with a
financially sound purchaser.
←
← (iii) 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 that may arise. Of course, credit risk is also important
for the sponsors' completion guarantees. To minimize 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.
←
← Technical risk
37
← This is the risk of technical difficulties in the construction and
operation of the project's plant and equipment, including latent defects.
Financiers usually minimize this risk by preferring tried and tested
technologies to new unproven technologies. Technical risk is also minimized
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 risk
← 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 minimizing currency risk 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.
←
38
← Regulatory / 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.
←
←
←
←
← Political risk
← This is the danger of political or financial instability in the host
country caused by events such as insurrections, strikes, and suspension of
foreign exchange, creeping expropriation and outright nationalization. It also
includes the risk that a government may be able to avoid its contractual
obligations through sovereign immunity doctrines. Common mechanisms for
minimizing 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); 39
← (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.
←
← Force majeure risk
← 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 minimizing 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.
←
← Country Risk
← Country risk includes risks of currency transfer, expropriation, war
and civil disturbances, and breach of contract by the host government. The
multilateral Investment guarantee Agency (MIGA) of the World Bank
provides guarantee against country risk for an appropriate premium. Export
credit agencies also provide such guarantees but they usually seek counter-
guarantees from the host government.
40
←
← Sector Risk
← Sector risk refers to the risk in certain sectors because of the role of
government agencies in those sectors. For example, in the power sector, the
buyer is usually a government utility agency that transmits and distributes
power. The solvency of the utility is critical for the ‘take or pay’ power
purchase agreement to have any value. For selected power projects, the
Indian government has agreed in principle to give counter guarantees to back
up state guarantees for the State Electricity Boards (SEBs), payment
obligations to private generating companies, on a specific request to the state
government concerned and subject to the state government agreeing to
certain terms and conditions. For toll roads, government support may be
necessary to enforce toll collections. Similarly, in the case of municipal
services such as water supply and solid-state disposal, the support of
municipal authorities is important. In each case, the government may
guarantee contract compliance of the respective agencies.
FIGURE 2: TYPES OF RISK
41
2.5 Security Arrangements
←
42
← Arranging sufficient credit support for project debt securities is a
necessary precondition to arranging debt financing for any project. Lenders
to a project will require that security arrangements be put in place to protect
them from various risks. The contractual security arrangements apportion
the risks among the project sponsors, the purchasers of the project output,
and the other parties involved in the project. They represent a means of
conveying the credit strength of going-concern entities to support project
debt.
← 2.5.1 Security arrangements covering completion of project:
The security arrangements covering completion typically involves an
obligation to bring the project to completion or else repay all project debt.
Lenders normally require that the sponsors or creditworthy parties provide
an unconditional undertaking to furnish any funds needed to complete the
project in accordance with the design specifications and place it into service
by a specified date. The specified completion date normally allows for
reasonable delays. If the project is not completed by the specified date, or if
the project is abandoned prior to completion, the completion agreement
typically requires the sponsors or other designated parties to repay all project
debt. The obligations of the parties providing the completion undertaking
terminates when completion of the project is achieved.
←
←
43
←
← 2.5.2 Direct security interest in project facilities:
Lenders require a direct security interest in project facilities, usually in the
form of a first mortgage lien on all project facilities. This security interest is
often of limited value prior to project completion. Following completion of
the project, the first lien provides added security for project loans. The lien
gives lenders the ability to seize the assets and sell them if the project
defaults on its debt obligations. It thus affords a second possible source of
debt repayment apart from cash flows of the project.
←
←
← 2.5.3 Security covering debt service:
After the project commences operations, contracts for the purchase and sale
of the project’s output or utilization of the project’s services normally
constitute the principal security arrangements for project debt. Such
contracts are intended ensure that the project will receive revenues that are
sufficient to cover operating costs fully and meet debt service obligations in
a timely manner.
←
←
←
←
←
←
44
←
← 2.5.4 Purchase and Sale Contracts:
It is of the following types:
← (a)Take-if-offered contract :
← Such a contract obligates the purchaser of the project’s output or
services to accept delivery and pay for the output and services that the
project is able to deliver. It does not require the purchaser to pay if the
project is unable to deliver the product. That is the contract protects the
lenders only if the project is operating at a level that enables it to service its
debt. Lenders would therefore require additional credit support or security
arrangements in order to provide against unforeseen events.
(b) Take-or-pay contract:
A Take-or-pay contract is similar to a Take-if-offered contract; it gives the
buyer the option to make cash payment in lieu of taking delivery, whereas
the take-if-offered contract requires the buyer to accept deliveries. Cash
payments are usually credited against charges for future deliveries. Like the
take-if-offered contract, a take-or-pay contract does not require the
purchaser to pay if the project is unable to deliver the output or services.
← (c) Hell-or-high water contract :
← This is similar to a take-or-pay contract except that there are no ‘outs’
even when adverse circumstances are beyond the control of the purchaser.
The purchaser must pay in all events, regardless of whether any output is
delivered. It therefore provides lenders with tighter security than other
contracts.45
← Step-up provisions:
The strength of these various agreements can be enhanced in situations
where there are multiple purchasers of the output. A step-up provision is
often included in the purchase and sale contracts. It obligates all the other
purchasers to increase their respective participation in case one of the
purchasers goes into default.
←
← 2.5.5 Raw material supply agreements:
A raw material supply agreement represents a contract to fulfill the project’s
raw material requirements. The contract specifies certain remedies when
deliveries are not made. Often both purchase and supply contracts are made
to provide credit support for a project. A supply-or-pay contract obligates
the raw material supplier to furnish the requisite amounts of the raw material
specified in the contract or else make payments to the project entity that are
sufficient to cover the project’s debt service.
←
← 2.5.6 Supplemental credit support:
← Depending on the structure of a project’s completion agreement and
the purchase and sale contracts, it may be necessary to provide supplemental
credit support through additional security arrangements. These arrangements
will operate in the event the completion undertaking or the purchase and sale
contracts fail to provide the cash to enable the project entity to meet its debt
service obligations.
←46
←
←
← 2.5.7 Financial support agreement:
← A financial support agreement can take the form of a letter of credit or
similar guarantee provided by the project sponsors. Payments made under
the letter of credit or similar guarantee are treated as subordinated loans to
the project company. In some cases it is advantageous to purchase the
guarantee of a financially able party to provide credit support for the
obligations of a project company
←
← 2.5.8 Cash deficiency agreement:
← It is designed to cover any cash shortfalls that would impair the
project company’s ability to meet its debt service requirements. The obligor
makes a cash payment sufficient t cover the cash deficiency. Payments made
under a cash deficiency agreement are usually credited as cash advances
toward payment for future services or product from the project.
←
← 2.5.9 Escrow Fund
In certain instances lenders may require the project to establish an escrow
fund that typically contains between 12 and 18 month’s debt service. A
trustee can draw money from the escrow fund if the project’s cash flow from
operations proves insufficient to cover the project’s debt service obligations.
←
←47
←
←
← 2.5.10 Insurance:
Lenders typically require that insurance betaken out to protect against
certain risks of force majeure. The insurance will provide funds to restore
the project in the event of force majeure, thereby ensuring that the project
remains a viable entity. The project sponsors normally purchase commercial
insurance to cover the cost of damage caused by natural disasters. They may
also secure business interruption insurance to cover certain other risks. In
addition lenders may require the sponsors to agree contractually to provide
additional funds to the project to the extent insurance proceeds are
insufficient to restore the operations.
←
←
←
←
48
2.6 LEGAL STRUCTURE
Sponsors of projects adopt many different legal forms for the ownership of
the project. The specific form adopted for any particular project will depend
upon many factors, including:
The amount of equity required for the project
The concern with management of the project
The availability of tax benefits associated with the project
The need to allocate tax benefits in a specific manner among the
project company investors.
One of the most critical questions project sponsors need to address is
whether a legally distinct “ project financing entity” should be employed and
how it should be organized.
2.6.1 Undivided Joint interest:
Projects are often owned directly by the participants as tenants in common.
Under the undivided joint interest ownership, each participant owns an
undivided interest in the real and personal property constituting the project
and shares in the benefits and risks of the project in direct proportion to the
ownership percentage. The ownership interests relate to the entire assets of
the project; no participant is entitled to any particular portion of the property.
49
When the project is organized, the participants choose someone in their
ranks to serve as the project operator. This arrangement is particularly
suitable when one of the owners already has operations in the same industry
that are of a similar nature, or otherwise has qualified employees available.
The duties of the operator and obligations of all other parties are specified in
an operating statement. The joint venture will require each participant to
assume responsibility for raising its share of the project’s external financing
requirements. Each sponsor will be free to do so by whatever means are
most appropriate to its circumstances.
Thus for example,
if a sponsor owns 25 percent of the project, it will be required to provide,
from its resources, 25 percent of the funds necessary to construct the project.
The undivided joint interest has particular appeal when firms of widely
differing credit strength are sponsoring the project. By financing
independently, the higher-rated credits can borrow at a cost that is lower
than the cost at which the project entity can borrow based on its composite
credit. Depending on the sponsor’s ability to take immediate advantage of
the tax benefits of ownership arising out of the project, direct co-ownership
may also provide the project sponsors with immediate cash flow to fund
their equity investments.
50
2.6.2 Corporation
The form of organization most frequently chosen for a project is the
corporation. A new corporation is formed to construct, own, and operate the
project. This corporation, which is typically owned by the project sponsors,
raises funds through the sponsors’ equity contributions and through the sale
of senior debt securities issued by the corporation. The senior debt
securities typically take the form of either first mortgage bonds or
debentures containing a negative pledge covenant that protects their senior
status. The negative pledge prohibits the project corporation from granting a
lien on project assets in favour of other lenders unless the debentures are
secured rate able. The corporate form permits creation of other types of
securities, such as junior debt (second mortgage, unsecured, or subordinated
debt), preferred stock, or convertible securities. The corporate form of
organization offers the advantages of limited liability and an issuing vehicle.
Nevertheless, the corporate form has disadvantages that must be considered.
The sponsors usually do not receive immediate tax benefits from any
Investment Tax Credit (ITC) the project entity can claim or from
construction period losses of the project. Also, the ability of a sponsor to
invest in the project corporation may be limited by provisions contained in
the sponsor’s bond indentures or loan agreements. In particular, the
51
provisions restricting “investments” either by amount or by type may impose
such limitations.
2.6.3 Partnership:
The partnership of organization is frequently used in structuring joint
venture projects. Each project sponsor, either directly or through a
subsidiary, becomes a partner in a partnership that is formed to own and
operate the project. The partnership issues securities (either directly or
through a corporate borrowing vehicle) to finance construction. Under the
terms of a partnership agreement, the partnership hires its own operating
personnel and provides for a management structure and decision-making
process. A partnership is particularly attractive for so-called “cost
companies”; a profit is not realized at the project level but instead is earned
further downstream in the sale of the project’s output. The Uniform
Partnership Act imposes joint and several liabilities on all the general
partners for all obligations of the partnership. They are also jointly and
severally liable for certain other project-related obligations any of the
general partners incurs in the ordinary course of business or within the scope
of a general partner’s apparent authority. A partnership can also have any
number of limited partners. They are not exposed to unlimited liability.
However, there must be at least one general partner who does have such
exposure.
52
FIGURE 3: A PARTNERSHIP STRUCTURE IN PROJECT FINANCE
53
54
100% OWNERSHIP AND PERFORMANCE GUARANTEE
100% OWNERSHIP AND PERFORMANCE GUARANTEE
100% OWNERSHIP AND PERFORMANCE GUARANTEE
X OWNER
SHIP PERCEN
Y OWNER
SHIP PERCEN
Z OWNER
SHIP PERCEN
100%
OWNERSHIP
2.7 SOURCES OF FUNDS
Financing options i.e the various sources of finance are equity, debt, Indian
and international financial institutions, multilateral institutions, export credit
agencies, GDR’s and external commercial borrowings.
(a) Equity finance
Government policy allow a debt equity ratio of 8:2, however lending
institutions advocate a gearing ratio up to 7:3 as a prudent measure of
lending. Specialized infrastructure and mutual funds have come up to bridge
the equity gap in mega projects such as Global Power investment of GE
Caps, the AIG Asian Infrastructure Fund, and the Asian Infrastructure Fund
of Peregrine Capital Ltd. And ICICI.
(b) Debt Financing
In raising debt or financing the power sector projects the list of funds should
be the lowest so that the ultimate cost of electricity will be the lowest for the
end consumer. The decision of the promoter to go in for equity or debt
financing depends on various factors like go guidelines for power projects,
incentives available and return on equity as also the cost of debt vis-a vis
equity.
55
Domestic Capital market Bonds are issued by the Central / State
Government and Publish/private Ltd. Companies t augment the resources of
the power sector in the capital market. Presently, internal rates are regulated
and credit rating is mandatory if the maturity of the instruments exceeds 18
months. NCDs with an option of buy back, debentures with equity warrants,
floating rate bonds and deep discount bonds are some of the innovative
instruments offered in the market.
(c) Indian Financial Institutions
The area of project financing in the Indian context is mainly limited to the
Indian Term Lending Institutions. In addition a large number of state level
institutions, finance projects of smaller size commercial banks also
participate in the term loans to a limited extent, besides meeting the working
capital requirements. As no individual FI can feed to the power sector
because of the huge funds requirements and the long gestation period of the
projects. The concept of loan syndication amongst the FIs is gaining
momentum. This also helps in sharing the risk among the FIs apart from
saving o the efforts and the cost because of the appraisal done by the leading
institution.
56
(d) Sources of international finance
Due to the domestic finance viable for the power projects, the need to tap
international markets has become inevitable which is characterized by the
long tenure of maturities and availability of various modes of finance.
(e) Multilateral Institutions
Institutions like the World Bank, IFC, and ADB etc. Have traditionallybeen
financing infrastructure in developing countries. The financing comer with
restrictive covenants affordable costs, long tenure and in an assured manner.
The co-financing facility extended by some of the multilateral institutions is
gaining popularity. In many of these loans, sovereign guarantee is required.
(f) Export Credit Agencies
ECAs are a common source of bilateral funding. Credit is provided by ECAs
such as the US Exim Bank, Exim Japan, etc. ECAs have a long history of
providing finance for all types of power generation equipment. There are
certain limitations in ECA financing like exposure limits, exchange risk,
transfer to IPP guarantee requirements and cost of insurance etc.
57
(g) External commercial borrowings
These include Yankee bonds, Dragon bonds, Euro Currencysyndicated
loans, US144A private placements, Global Registered Notes, Global Bonds
etc. (J) Syndicated loans The special features of syndicated loans are that
they are for medium to longer period; specific to the requirements of the
borrowers to suite their projects and availability of floating rate of interest.
Most of the investors are Asian/European Banks, FIs, Insurance Companies
and pension funds.
(h) Global Depository receipts (GDRs)
GDRs present an attractive avenue of funds for the Indian companies. Indian
Companies can collect a large volume of funds in foreign currency in Euro
issues. GDRs are usually listed in Luxembourg and are traded in London in
the OTC market or among a restricted group such as Qualified Institutional
Buyers (QIBs) in the USA. The GDRs do not have a voting right; there is no
fear of management control.
58
FIGURE4: SOURCES OF FUNDS
59
60
3. CASE STUDY :
HOW ENRON HAS AFFECTED PROJECT FINANCE
3.1 The Enron Story
Enron Corporation (former NYSE ticker symbol ENE) was an American
energy company based in Houston, Texas. Before its bankruptcy in late
2001, Enron employed approximately 22,000 staff and was one of the
world's leading electricity, natural gas, communications and pulp and paper
companies, with claimed revenues of nearly $101 billion in 2000. Fortune
named Enron "America's Most Innovative Company" for six consecutive
years.
Enron traded in more than 30 different products, including the following:
Products traded on Enron Online
Petrochemicals
Plastics
Power
Pulp and paper
Steel
Weather Risk Management
Oil& LNG Transportation
Broadband
Principal Investments
Risk Management for Commodities
61
Shipping / Freight
Streaming MediaWater and Wastewater
At the end of 2001 it was revealed that its reported financial condition was sustained substantially by institutionalized, systematic, and creatively planned accounting fraud, known as the "Enron scandal". Enron has since become a popular symbol of willful corporate fraud and corruption. The scandal also brought into question the accounting practices of many corporations throughout the United States and was a factor in the creation of the Sarbanes–Oxley Act of 2002. The scandal also caused the dissolution of the Arthur Andersen accounting firm, affecting the wider business world.
Enron filed for bankruptcy protection in the Southern District of New York in late 2001 and selected Weil, Gotshal & Manges as its bankruptcy counsel. It emerged from bankruptcy in November 2004, pursuant to a court-approved plan of reorganization, after one of the biggest and most complex bankruptcy cases in U.S. history. A new board of directors changed the name of Enron to Enron Creditors Recovery Corp and focused on reorganizing and liquidating certain operations and assets of the pre-bankruptcy Enron. On September 7, 2006, Enron sold Prisma Energy International Inc., its last remaining business, to Ashmore Energy International Ltd. (now AEI).
62
3.2 CAUTION AMONG LENDERS AND INVESTORS
← Because lenders may have been stung by PG&E or Enron an because
of other recent market factors such as declining power prices and emerging-
market problems, lenders and investors in early 2002 were approaching all
energy and power companies with increased caution. They were scrutinizing
merchant power and trading businesses with particular care. They were
doing deals mainly with prime names that have proven staying power.
← At the same time, rating agencies were downgrading hitherto fast-
growing independent power companies or requiring them to reduce their
leverage to maintain a given rating. Among the agencies’ concerned in the
current market environment are the exposure of these companies’ merchant
plants to fluctuating fuel and electricity prices and the companies’ reduced
access to equity capital. Of course, having been criticized for not
downgrading Enron soon enough, the rating agencies are particularly
sensitive toward the energy and power sectors. But, it is important to
remember that the fast-growing power companies using innovative
revolving credits to finance the construction of new power plants are single
sponsors with fully disclosed on-balance- sheet debt. Even though Enron is
one of the factors that have discouraged banks from increasing their industry
exposure, most of the restrictions the markets are placing on the growth of
independent power companies are related to other market factors discussed
above that were evident before the Enron bankruptcy.
63
← Similar to lenders and investors, companies that trade with each other
are becoming more concerned with counterparty credit risk. In evaluating
the creditworthiness of a given counterparty, they are looking at the whole
portfolio to see if one risky business such as merchant power or energy
trading—diversification benefits aside— could drag down the others.
← For example, a company with primarily merchant plants is more
vulnerable to an overbuild scenario than one with mainly power purchase
agreements.
3.3 PROJECT FINANCE AND ENRON FACTOR
←
64
← The Enron bankruptcy and related events have changed neither the
nature nor the usefulness of traditional project finance, but they have led to a
slowing down of some of the more innovative forms of structured project
finance. Among the other direct and indirect effects of Enron have been
increased caution among lenders and investors toward the energy and power
sectors; increased scrutiny of off-balance sheet transactions, increased
emphasis on counterparty credit risk particularly with regard to companies
involved in merchant power and trading and deeper analysis of how
companies generate cash flow. There is increased emphasis on transparency
and disclosure even tough disclosure in traditional project finance has been
more robust than in most types of corporate finance. In the current market
environment, for reasons that extend beyond Enron, some power companies
have been cancelling projects and selling assets to reduce leverage and
resorting to on balance financing to fortify liquidity.
←
← The immediate cause of the Enron bankruptcy was a loss of
confidence among investors caused by the company’s restatement of
earnings and inadequate, misleading disclosure of off-balance-sheet entities
and related debt. However, because Enron was a highly visible power and
gas marketer (not to mention far-flung activities from overseas power plants
to making a market in broadband capacity), its failure brought more scrutiny
to all aspects of the energy and power business, particularly the growing
sectors of merchant power and trading.
65
←
← Even before the Enron bankruptcy, the confidence of many power and
gas companies was shaken by other devastating events during 2001
including the California power crisis, the related Pacific Gas and Electric
Company bankruptcy, failing spot power prices in U.S. markets, and the
collapse of Argentina Economy and financial system. The California power
crisis is evidence of a flawed deregulation structure, which caused a global
setback to power deregulation and paralyzed U.S. BANK, markets for much
of the first half of 2001. The falling spot power prices were caused primarily
by overbuilding of new projects for the near term (though probably not for
the longer term), mild weather is most of the United States, and
overdependence on the spot market
← The combination of these events in 2001, accentuated at the end of the
year by the Enron bankruptcy, caused a dramatic change in the perception of
risk among investors, lenders, and rating agencies. In particular, these parties
began to perceive independent power producers (IPPs) riskier than they ever
had before.
66
← They considered trading businesses difficult to evaluate; they
suspected earnings manipulation through the marking to market of power
contracts and off-balance-sheet vehicles; they feared sustained low power
prices in the U.S. market. After problems in countries such as Argentina,
Brazil, India and Indonesia, emerging market IPP projects began to seem
more like a danger than an opportunity. Investors and lenders began to
perceive earnings in the IPP and trading business to be less predictable and
sustainable than they had thought before. They discounted the growth
prospects of these companies and focused on liquidity and leverage in light
of higher perceived risk.
←
← They have bad exposures in foreign markets that have collapsed; they
have had to cancel advance purchase orders for turbines because of a
slowing U.S. power market; their stock prices are tumbling as a result of
reduced growth prospects; and they are facing a credit crunch from lenders,
some of which are gun-shy from recent losses related to PG&E or Enron. So,
as we look at today’s energy and power market, we see some direct effects
of the Enron bankruptcy and other situations caused by a combination of all
the factors discussed above.
← But before going further, let’s look at how Enron has affected pure,
traditional project finance.
← 3.3.1 EFFECT ON TRADITIONAL PROJECT FINANCE
67
←
← “Traditional” project finance is cash flow based; asset-based finance
that has little in common with Enron’s heavily criticized off- balance-sheet
partnerships. The historic elements of project finance are firmness of cash
flow, counterparty creditworthiness, ability to deal over a long time frame,
and confidence in the legal system. It is a method for monetizing cash flows,
enhancing security, and sharing or transferring risks. The Enron transactions
in question generally did not have these characteristics. They were an
attempt to unduly benefit from accounting, tax, and disclosure requirements
and definitions.
← Traditional project finance is based on transparency, as opposed to the
Enron partnerships, where outside investors did not have the opportunity to
do the due diligence upon which any competent project finance investor or
lender would have insisted. Those parties are interested in all the details that
give rise to cash flows. As a result, there is a lot more disclosure in project
finance than there is in most corporate deals.
← In traditional project finance, investors and rating agencies do not
have a problem with current disclosure standards; it is not hidden and it
never has been. First, they know project financing is either with or without
recourse and either on or off the balance sheet.
68
← For example, in the case of Joint venture where a company owns 50%
of a project or less, the equity method of accounting is used for off balance-
sheet treatment. On the income statement, the company’s share of earnings
from the project is included below the line in the equity investment in
unconsolidated subsidiaries.
← When a company owns more than 50% of a project, its debt is
consolidated on the balance sheet and its dividends are included in income.
The minority interest is backed out. The point to remember is that whether a
project is financed on or off the balance sheet, analysts know where to look.
← Also off-balance-sheet treatment may not be the principal reason for
most project financing. It usually is motivated more by considerations such
as risk transfer or providing a way for parties with different credit rating to
jointly finance a project – whereas if all of those parties providing the
financing on their own balance sheets, they would be providing unequal
amounts of capital by virtue of their different borrowing costs. None of these
considerations have anything to do with the Enron partnerships, where 3 %
equity participation from a financial player with nothing at risk was used as
a gimmick to get assets and related debt off the balance sheet.
3.3.2 EFFECT ON STRUCTURED PROJECT FINANCE
←
69
← Even though traditional project finance has not been affected very
much by Enron, there certainly has been a slowing of activity in the more
innovative types of structured finance such as synthetic leasing, structured
partnerships, and equity share trusts – at least for the time being.
Synthetic leases are a mature product, understood by rating agencies and
accountants, in which billions of dollars of deals have been done.
← Even though synthetic lease are transparent and well understood, they
have an off-balance sheet element that creates headlines in today’s
environment, more of them maybe done in a year or two.
← The investor market has overreacted to anything that sounds “like
Enron”. Structured and project financing techniques have been developed
for sound risk management reasons and, in my opinion, must be defended
vigorously on those grounds. I believe a prejudice against such financial
structures could have a real economic and financial cost. However if
sponsors fear that the wider market will punish them for using complex
structures, they will stop using them.
← At the time of Enron scandal several companies had already made
public vows not to use any off – balance sheet structures.
← But, rather than pandering to uninformed sentiment, one should make
greater efforts to clearly delineate the difference between legitimate non-
recourse debt and the Enron structures.
←
←
← 3.3.3 SOURCES OF FREE CASH FLOW70
←
← Immediately after Enron filed for bankruptcy protection, some
questioned whether project and structured finance would survive in its form.
And indeed, some corporations with large amounts of off- balance sheet
financing were subjected to increased scrutiny and sharply red valuations for
both their equity and their debt. In response those companies have expanded
their liquidity and reduced their debt to the extent possible. But, as time
progresses, the main fallout from Enron and the other recent market shocks
have not been so much of a turning away from project finance but rather a
greater stress on bottom-up evaluation of how companies generate recurring
free cash flow and what might affect it over time. In this process, project as
well as structured finance probably will continue to play an important role.
The change, has been that the focus has shifted from not only the project
structures, but also on how they may affect corporate level cash flow and
credit profiles, for example through springing guarantees and potential debt
acceleration, through contingent indemnification and performance
guarantees, and through the potential for joint-venture and partnership
dissolutions to create sudden changes in cash flows.
←
←
← 3.3.4 SECURITY INTERESTS
←
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← Power business, in part, has shifted from a contract-based business to
a trading, cash flow- based kind of business where the counterparty becomes
critical to the viability of a transaction. The security in the transaction is less
than the asset itself and more what the trading counterparty does with the
asset. That asset has an option value in the hands of a counterparty, but a far
different value if a bask has to foreclose on it—a value you would rather not
find out.
← Enron’s alleged tendency to set its own rules for marking gas,
electricity and various other newer, thinly traded derivative contacts to
market raises some questions about collateral and security. Historically, the
security in a power plant financing has consisted of contracts, counterparty
arrangements and assets. But if a lender’s security depends on marking
certain contracts to market and there is some question as to the objectivity of
the counterparty that is marking them to market, that raises additional
questions as to what is an adequate sale, what is adequate collateral, how a
lender takes an adequate security interest, how a lender monitors the value of
its security interest, and what needs to be done to establish a sufficient prior
lien in the cash flow associated with the transaction. In the case of a
structured project finance transaction, the key question remains just as it
always has been: whether the security is real and whether you can get rely
on it.
←
←
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← 3.3.5 HOW COMPANIES HAVE RESPONDED
←
← Affected companies respond to the current market environment
rapidly and decisively to strengthen their liquidity through issuing new
equity, canceling projects, selling assets, either unwinding structured finance
deals or putting them on the balance sheet, and increased transparency and
disclosure (discussed further below). During this past December and J alone
five power companies raised $4 billion in equity. During the first quarter of
2002, power projects adding up to 58,000 megawatts of capacity were either
deferred or canceled.
← Some power companies have set up massive credit facilities for doing
so based on their overall corporate cash flow and creditworthiness. Another
option for a company is to borrow against a basket of power projects,
allowing the lenders to diversify their risks, but such a facility is still largely
based on the credit fundamentals of the corporation. But project financing on
an individual plant basis can be preferable to either of these approaches for
both project sponsors and lenders.
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← For example, say a company is financing ten projects and three run
into trouble. The company can make a rational economic decision as to
which of those projects are salvageable and which ones do not merit
throwing in good money after bad. It might let one go into foreclosure and
be restructured and sold. But if a company is financing ten projects together,
its management may feel compelled to artificially bolster some of its
projects so that the failure of one project does not bring the entire credit
facility down. Making such an uneconomic decision for the near term would
not be in the company’s long-term interests.
←
←
←
←
←
← 3.3.6 INCREASED TRANSPARENCY AND DISCLOSURE
←
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← The major players generally are releasing much more information
than before about their businesses and financing arrangements. Similarly, an
overriding aura of conservatism in disclosure has been seen, for example, in
conference room discussions while drafting prospectuses for project finance
deals. Bankers are making extra efforts to confirm that details are being
disclosed and explained the right way. Given the current tarnishing of the
merchant power sector, they might explain further than in the past that a
company’s trading is not speculative and that it is using accepted risk
management measures such as value-at-risk (VAR). They also might break
out the percentage of sales from power sales and from “marketing”—a team
that sounds better than trading in today’ environment
← Also strong management actions are needed to restore belief in
honesty of numbers. A company’s management needs to demonstrate the
same passion for integrity as it had for growth in the past. It needs to get rid
of gimmicks and consistently communicate and execute a simple, clear
strategic vision. This involves cleaning up the balance sheet. Transactions
that have significant recourse to the sponsor should be put back on the
balance sheet. Only true non-recourse deals should be left off the balance
sheet. To convey an accurate, fair picture of the business, companies need to
communicate—to the point of obsession —information and assumptions
about how earnings are recognized, including mark-to-market transactions.
← Managing earnings is out and managing cash flow is in—and, that’s
what the rating agencies are looking at anyway.
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← Companies may need to reexamine their strengths and weaknesses
and refocus and simplify their basic business strategies. Their boards of
directors might become more helpful in this process with the addition of
non-executive members who understand the business.
3.3.7 REGULATORY ISSUES
←
← One of the reasons Enron was left to its own devices in valuing gas,
electricity, and other types of contracts was that it became, in effect the
largest unregulated bank in the world. It was able to avoid regulation of its
activities by the Commodity Futures Trading Commission (CFTC). Partly as
a result of its own lobbying efforts, and the Federal Energy Regulation
Commission (FERC) declined to get involved as well. Therefore, it was able
to duck some of the scrutiny that regulators have directed toward
commercial and investment banks dealing in derivatives. Of course,
securities analysis had long complained about Enron’s opaque financial
reporting, only to be told in return that they just didn’t understand the
business.
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← FERC will have to become more involved in trading than it has in the
past. FERC’s current emphasis is to avoid the abuse of market power in the
electricity business But today, a power company might have market power
in trading completely unrelated to market power in asset ownership. Enron
proved that they are two different things. A company can dominate trading
market without dominating the asset-ownership market. So regulatory lesson
to be learned from Enron is that today’s electricity market needs more
sophisticated oversight of both the trading function and market power.
←
← Also Sarbanes-Oxley Act was implemented to protect investors by
improving the accuracy and reliability of corporate disclosures made
pursuant to the securities laws, and for other purposes. The Sarbanes-Oxley
Act created new standards for corporate accountability as well as new
penalties for acts of wrongdoing. It changes how corporate boards and
executives must interact with each other and with corporate auditors. It
removes the defense of "I wasn't aware of financial issues" from CEOs and
CFOs, holding them accountable for the accuracy of financial statements.
The Act specifies new financial reporting responsibilities, including
adherence to new internal controls and procedures designed to ensure the
validity of their financial records.
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3.4 OTHER LESSONS LEARNED
← Among the more general lessonsfrom Enron that go beyond the realm
of structured and project finance are:
← • It is risky to over-invest in businesses sectors such as broadband and
water
← • A power trading business, though potentially profitable, is highly
vulnerable to liquidity crisis and has a low liquidation value.
← •Trading to hedge a power company’s inherent physical position in
power or gas should not be regarded as a suspect business per se, but it can
involve the risk of sudden liquidity crisis—especially for triple-B-minus-
rated companies that don’t want to slip below investment-grade status.
← • Mark-to-market accounting rules can mislead investors, lenders, and
analysts as to the extent of non-recurring earnings, even in the absence of
fraud.
← Among the lessons more directly related to project and structured
finance are the following:
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← • The transfer of assets, intangible and otherwise, into non-
consolidating vehicles controlled by a sponsor may mislead investors as to
the extent of non-recurring earnings or deferred losses even in the absence of
fraud.
← • There is a risk of low recovery rates on structured transactions
secured by intangible assets (investments, contracts, company stock) or by
tangible assets whose values are net established on an arm’s length basis.
← • Having been badly burned by the Enron bankruptcy, banks and
investors in its structured and project financings, and in the energy sector
generally, will be especially conservative, and this will limit credit and
capital access for many clients in the sector, creating a genera liquidity issue
for these customers.
←
←
← Several recommendations concerning accounting treatment and
disclosure:
←
← • An effort must be made by all in the project finance industry (and
investor relations) to underscore the distinction between true non-recourse
structures and Enron’s activities
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← • The terms “non-recourse” and “off balance sheet should remain
synonyms. Liabilities that truly have no recourse to a company’s
shareholders can justly be treated as off balance sheet. Enron appears to have
violated this principle since the undisclosed liabilities in the off- balance
sheet partnerships actually had significant recourse to Enron shareholders
through share marketing mechanisms.
← • Many project finance structures are “limited” rather than “non”
recourse, and thus there is a potential grey area in which accounting rules
allow off-balance sheet treatment but there is nonetheless some contingent
liability to the parent company shareholders. Full disclosure of any potential
shareholder recourse was advisable pre-Enron and is absolutely necessary
now.
←
← 4.
CONCLUSION
←
← Two basic tenets of project finance:
← I) The financing of hard assets that have ongoing value through
economic cycles and
← 2) The high level of sponsor expertise and commitment required.
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← As Enron grew and expanded, it seemed more interested in businesses
or transactions that would generate a certain return than it was in whether or
not those ventures would complement its core businesses. As such, Enron
got into a number of businesses in which it did not have any expertise and
then was not committed to those businesses when expectations were not met.
← To conclude, project finance is alive and well. We just need to remind
a few people of its basic fundamentals. Neither project finance nor sensible
in innovations in structured finance with sound, well explained business
reasons have been shaken by Enron.
← The principle lessons learned from the Enron debacle have to do with
transparency and disclosure. When some of your businesses or your finance
structures become hard to explain, you may begin to question whether they
make sense in the first place.
BIBLIOGRAPHY
Finnerty, J.D., 1996, Project Financing: Asset-Based Financial Engineering. New York, NY: John Wiley & Sons.
Hoffman, Scott L., The Law and Business Of International Project Finance, Kluwer Law International, 2008.
Nevitt, P.K., and F.J. Fabozzi, 2000, Project Financing, 7th edition, Euromoney Books (London, U.K.).
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Brealey, R., and S.Myers, Principles of Corporate Finance, McGraw Hill
Standard & Poor's Corporation, 2003, Project Finance Summary Debt Rating Criteria, by P. Rigby and J. Penrose, in 2003-2004 Project & Infrastructure Finance Review: Criteria and Commentary, October.
Wikepedia.com - (http://en.wikipedia.org/wiki/Project_finance) (en.wikipedia.org/wiki/Enron)
www.projectfinancemagazine.com/
www.people.hbs.edu/besty/projfinportal/
www.pfie.com
www.projectfinancereview .com
www.time.com/time/2002/enron
www.enronfraud.com/
www.uow.edu.au/~bmartin/dissent/documents/.../citienron.html
←
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