CHAPTER 13
Structuring Project Finance
How Everything Comes Together

The structuring of project financing is a framework in which ownership structure, project structure, risk structure, and financial structure decisions are made and tied together in the project's legal structure which, in turn, forms a foundation for funding the project on a limited recourse basis. The ownership structure is how the special purpose company (SPC) is organized; that is, as a corporation, unincorporated joint venture, limited liability partnership, etc. Project structure on the other hand refers to the agreements defining responsibilities and transfer of rights and/or ownership of the SPC such as build, operate, and transfer of ownership (BOT), build, own, operate, and transfer (BOOT), build, lease, and transfer (BLT), etc.

Risk structure is the prioritization and mitigation of risks after the identification, assessment, and allocation process is completed. The project's legal structure is the web of contracts and agreements negotiated to make financing possible. Financial structure refers to the mix of financing used to fund a project, which includes equity, short‐ and long‐term loans, bonds, trade credits, etc. and the cash flows to equity providers and the lenders.

An example of a financing structure is presented in Figure 13.1, which is a simplified version of a plant project financing structure. Its key elements are the participants, the agreements that hold it together, and the money flows indicated by arrows. The structuring of project financing is done in a recursive manner, in a fluid environment, and in the context of decision interrelationships, which require skills and experience to arrive at a balanced solution that satisfies all project stakeholders. Many of the processes, evaluations, and decisions made in public–private partnership (PPP) or private finance initiative (PFI) projects are the same as those performed in all private project finance deals around the world. The differences of entirely private‐sector funded projects are the following:

Flowchart illustration of simplified typical project finance structure.

Figure 13.1 Simplified typical project finance structure

Source: Adapted from Merna, Chu, and Al‐Thani (2010).

  1. The absence of a host government as a project stakeholder
  2. No multilateral agency involvement or funding by regional development banks
  3. Reliance not on offtake agreements for project success but on a well‐functioning marketplace
  4. Less emphasis on contracts and more on evaluation of project economics, risk management, and project due diligence

In the sections that follow we examine equity and debt investor requirements, structuring and financing options, the contractual basis, determinants of project financing, and how all the pieces are fused together in the project financing plan to direct choices in order to arrive at a successful financing close. Section 13.1 touches on the prerequisites and the various elements involved in the financing structure while the perspectives and expectations of equity investors, lenders, and other funding sources are examined in Section 13.2.

The project financing structuring framework, the decisions that must be made, and the process of advancing the project from the formation of the SPC to the financial structure phase are discussed in Section 13.3. The determining factors of project financing are presented one more time in Section 13.4. The integration of all the processes and evaluations are discussed in Section 13.5, which is a summary of how sustainable and efficient project financing comes together in the project financing plan.

13.1 ELEMENTS OF PROJECT FINANCING STRUCTURING

The purpose of project financing structuring is to identify the parties involved in funding, assess the financing options open to a project, and determine specific shares of funding and contracts and agreements needed. Hence, the components of financing structure are not only decisions that need to be made but, also, the selection of financing techniques and options to fund a project.

To begin with, for PPP deals, a common financing technique of host governments is land‐financing variants, such as land contribution to build project facilities, sale of development rights, and betterment levies, which are a one‐time tax on the increased value of property due to the project. Another PPP financing option is the one where a private sponsor is awarded a concession agreement and then uses it to raise funds to build and operate a project for the duration of the agreement.

The most common form of project financing is obtaining loans though the backing of contractual commitments of the offtaker to purchase the output produced. This, in essence, makes the offtaker a guarantor of revenue streams. For resource extraction projects, a production payments' scheme is created, whereby funds are advanced to build a project based on assigning a proportion of interest in oil and gas or mineral reserves to the sponsor. Another option is the advance payment technique, which involves the expansion of funds by a sponsor for project output to be developed and a sponsor agreement to purchase the output upon beginning of production. Lease financing is also used in some cases to have a project facility financed while it is owned by investors not related to the sponsor, who get tax benefits and then lease the facility back to the project company on a nonrecourse basis.

Decisions that have to do with equity structuring evolve around organizing and capitalizing the project company, management and control of its operations, and transfer of ownership rights at the end of the project company lifecycle. Other decisions include bringing in additional equity investors and how to resolve disputes between sponsors and other equity investors. On the debt‐structuring side, a larger number of issues have to be considered to arrive at the right debt financing solution. Some of the lender considerations involve decisions about the country of sourcing of equipment and services, involvement of development agencies, local currency debt, use of government grants and loans, commercial loans for construction, and refinancing with long‐term loans to cover operations. A summary view of project financing structuring components and considerations is displayed in Figure 13.1.1 above.

Flowchart illustration of the elements of financing structuring.

Figure 13.1.1 Elements of Financing Structuring

Project financing is to a good measure a risk‐management method where a system is created to allocate risks to different project participants and minimize the volatility of project‐company cash flows. The nature of the negotiated implementation or concession agreements narrows down the financing options and available financing techniques. It is those agreements that hold the project structure together and the development of a sound financing plan that make it implementable.

13.2 EQUITY AND DEBT INVESTOR REQUIREMENTS

The starting point of financing structuring is getting a good understanding of the objectives of equity participants and debt investors and what it takes to reconcile their diverse requirements. A key element of successful financing structuring is the financing strategy that lays out how the SPC will be financed optimally and consistent with the consensus of project stakeholder objectives. The financing strategy outlines the sponsor's process and steps to select funding sources and options to ensure adequate funding past construction completion and well into the operational phase. It also defines financing‐related roles and responsibilities for project stakeholders in sufficient detail and clarity to make it effective.

Financial structuring is not only about the mix of different funding instruments but, also, about the drawdown schedule, the debt repayment profile and equity distributions, and the credit support and security packages required by debt and equity investors. For private sector sponsors, the financing strategy's success is judged by the adequacy of project internal rate of return (IRR), net present value (NPV), debt ratios, and short payback periods. For public sector stakeholders, financing strategy success is judged by getting the best value for money, which consists of least‐cost funding, efficient project development, effective project outcomes for the money spent, and balanced distribution of project benefits.

What equity investors typically pay attention to in the analyses for financial structuring is a set of parameters coming out of the financial model that includes adequate return on investment measured by:

  1. IRR, which is the discount rate that makes the project flows' NPV equal zero
  2. Project NPV or risk‐adjusted NPV, which is project NPV adjusted by the likelihood of occurrence in each period of operations
  3. Payback period, which is the time required for an investment to be paid back from the project's cash flow
  4. Profit investment ratio or profitability index, which is the present value of cash flows divided by the initial investment
  5. Debt cover ratios that measure the project company's ability to generate cash flows to meet all its debt obligations
  6. Debt service profiles, which is the repayment schedule of principal and interest amounts

In addition to sufficient upfront equity and commitment for future equity amounts to make a project bankable, project lenders closely examine the financial structuring parameters and look for and prefer the following:

  1. Experienced sponsor company and project company management teams and a skilled and competent project team
  2. Fixed completion date and contact price with appropriate guarantees and insurance and no technology risk and security from the engineering, procurement, and construction (EPC) contractor
  3. Liquidated damages for delays, and performance and project company output guarantees
  4. Interest rate and foreign exchange hedging contracts for significant operating cost items
  5. Competitive project company output pricing, host government subsidies, and barriers to discourage new competitor entry
  6. Strong and enforceable offtake and supply contracts and adverse regulatory noninterference
  7. Adequacy of risk mitigation and a security package acceptable to all stakeholders

Because different stakeholders define success differently, a balance of private and public interests and objectives must be achieved. What sponsors look for in financial structuring needs to be consistent with lender requirements that, other things being equal, determine project bankability. Also, there are some preconditions to project financeability that apply to all projects and that are examined and monitored closely through all stages of project financing and include factors such as:

  1. The host country's political and social stability and ability to deliver on contribution obligations
  2. Identifiable project risks and the ability to mitigate them through contracts and agreements
  3. Validation of project economic viability judged by the outputs of the project financial model
  4. Accessible local and international debt financing and ECA and multilateral institution support

13.3 DECISIONS FROM SPC OWNERSHIP TO FINANCING STRUCTURE

The structure of project financing is the set of decisions needed to arrive at financial close. The key process elements of the financing structuring framework are shown in Figure 13.3.1. The project stakeholders are the sponsors, the host government authority, debt and equity investors other than the sponsors, and the ECAs and multilateral institutions involved in the project. The major decisions involve the SPC structure; the project structure, the risk structure, the contract structure, and the financing structure once relevant corresponding considerations are taken into account.

Flowchart illustration of project finance structuring framework.

Figure 13.3.1 Project Finance Structuring Framework

Having made those decisions, structuring project financing becomes the process of identifying the right funding channels, drafting and negotiating appropriate contracts and agreements, and selecting the best‐suited financing instruments among several options. The result of these undertakings is the project financing plan, an illustration of whose development is presented in Figure 13.3.2, that directs the activities for both construction financing and long‐term financing. The structuring process activities outlined in Figure 13.3.2 are a complement of the project financing‐structuring framework, and the four major categories of activities involved are:

  1. The financing structuring activities
  2. The sourcing of finance undertakings
  3. The evaluation of financing selected and negotiations
  4. The financial closing steps
Flowchart illustration of financing structuring process activities.

Figure 13.3.2 Financing Structuring Process Activities

Source: Adapted from Yescombe (2014).

A. Ownership Decisions

The project ownership‐structure decision is made after evaluations and conclusions about the effects of the following:

  1. Strategic, financial, competitive, and other objectives the sponsors expect to achieve from investing in the project
  2. Upfront investment requirements and future investment contributions as well as the tax treatment of the SPC and benefits to be obtained in the host country
  3. Constraints or conditions of the legal and regulatory requirements of the host country
  4. Nature of the project, expected obligations, and control and management of the SPC

B. Project Structure Decisions

The project structure decision is also based on the life span of the project company operations, its responsibilities and obligations, and the terms and conditions of the ownership of its assets. However, the project structure to be negotiated has feedback effects on the ownership decision which, in turn, impacts the project structure. Once the SPC ownership structure and the project structure decisions are made and implemented, the project risk structure comes into focus after the feasibility study is completed and demonstrates the economic viability of the project which is, of course, conditioned by its risk structure.

The decisions on how to manage the project risk structure take place after the following process steps are completed:

  1. Project risks and their root causes are identified and categorized as controllable and uncontrollable
  2. Controllable risks are evaluated in terms of likelihood of occurrence and potential adverse impacts
  3. Allocation of risks to the party best able to handle is made or sharing of risks in proportion to the benefits obtained by the project
  4. Risk‐avoidance efforts are made to minimize or eliminate the number of risks
  5. Making provisions to absorb the risks that are uninsurable or have a low probability of occurrence
  6. Obtaining guarantees from the parties where risks emanate from and insurance, credit support, and enhancements from the host government, ECAs, and multilateral institutions
  7. Developing contingency plans to address unknown, uncontrollable, and black swan risks

C. Contract Structure Decisions

The project contract structure requires the weaving of enforceable contracts and agreements to make the project bankable and provide adequate protection of shareholder interests. In cases where a host government authority participates in the project, the implementation or ceding agreements are a key part of the legal framework. These agreements involve decisions in every area they cover and when negotiated, they define the following:

  1. The duration of the project life, licenses and permits required, and termination clauses
  2. The roles and responsibilities of the parties involved
  3. The project implementation arrangements that include bidding and procurement qualifications and project specifications
  4. The host government's financial and in‐kind contributions, grants, guarantees, and other kinds of support
  5. The governing law and funding provisions and conditions precedent
  6. The value of the project company assets at the end of the project agreement

Other elements of the project contract structure include several important parts, each of which entails decisions about acceptable levels of desired outcomes. Namely:

  1. An EPC contract with an appropriate completion date, price, performance guarantees, and liquidated damages for delays and nonperformance
  2. A sound offtake contract with quantity targets and price increases to offset inflation, equipment upgrades, and changes in tax treatment or tax‐rate increases
  3. Wide‐ranging supply contracts for production inputs, supplies, and power and other utilities with price stability and quality clauses
  4. Private and ECA and multilateral institution insurance contracts for risks not allocated or absorbed and third‐party insurance policies
  5. Credit support agreements, guarantees, counter‐guarantees, hedging contracts, and other credit enhancements
  6. A decent O&M agreement with performance, output, and quality clauses

D. Operational Decisions

The operational factors that play a role in financing structure decisions have to do with the term of the contract, the project cost and revenue forecasts, and the tax treatment of the project cash flows. Other operational factors impacting financing are the expected prices of the project company's output, inflation expectations, and the interest rate environment and financing costs. Factors influencing decisions about the sources of financing and funding instruments evolve around the following:

  1. Project stakeholder equity contributions and their timing
  2. Equity returns measured by the projects NPV or the investors' IRR
  3. The debt service profile and debt ratios
  4. Sponsor and other project stakeholder guarantees
  5. Security on loans to the project company

Conclusions about the best choice of sources of funding and financing instruments are arrived at after operating and funding parameters are well considered and decisions are made on respective factors.

E. Financing Structure Decisions

The project financing structure is based on the results of analyses and assessments of the feasibility study results, the due diligence report, and judgments and decisions made concerning the structures mentioned earlier. Project financing structuring considers these factors and attempts to balance interests, costs, and benefits to arrive at an optimal structure; that is, the best possible outcome to be achieved that is acceptable to the stakeholders involved. The last factors considered are operational elements, funding parameters obtained from the project financial model output, and the sources and types of financing.

In project financing transactions, sponsor or developer equity is a prerequisite before other investors are brought into the project and commercial loans may be obtained. Equity and preferred equity decisions are influenced by evaluations on how the SPC is organized and planned to be capitalized, management and control of the SPC, how disputes between equity participants will be resolved, and the terms and conditions of the SPC's termination of operations. On the other hand, debt‐financing decisions involve evaluations of sources of funding and availability, terms and conditions, compliance requirements, guarantees, insurance, and costs, advantages and disadvantages of different debt‐funding options.

For projects in emerging countries, the first source of funding could be multilateral or regional development banks, followed by the host government's in‐kind contributions. In most developing country projects, grants from the host government that provide initial funding are usually in local currency contributions. In both instances, government subsidies, tax relief, land and resource contributions, and government guarantees and counter‐guarantees add to the basket of money flows to fund a project. Also, as a precondition to participate in a project, EPC contractors and technology and equipment providers are enticed to provide equity or debt to the project at costs comparable to those in financial markets.

Funding from host government subsidies is low on the list of sources of funding because, for the most part, it is indirect funding and usually involves dealing with bureaucratic processes. However, substantial benefits can be derived from funding via host government subsidies, which can take many different forms, such as:

  1. Project company tax concessions, reduced tax rates, and tax holidays
  2. Accelerated depreciation allowances and exemptions from import duties and export subsidies
  3. In‐kind subsidies such as land contributions, subsidized housing, utilities, etc.
  4. Creation of free‐trade zones and production subsidies
  5. Cash grants, subsidized loans, loan guarantees, government insurance at reduced rates, credit subsidies and tax‐free bonds

Senior commercial bank loans are used for different purposes, such as construction and operations, and different maturities; that is, short term and permanent (long term) financing. In many cases, commercial paper backed by the SPC's assets is used to fund ongoing operational expenses. Mezzanine loans are used in instances when equity investments and senior debt are not sufficient to cover all project costs. Junior bank loans are unsecured or subordinated loans, usually with no collateral behind the debt, and involve substantially higher interest rates. These loans are used for contingency funding purposes such as construction cost overruns. Project bonds are long‐term financing instruments via public offerings or private placements and are used in large financings. Project bonds involve substantial costs to obtain a credit rating, preparing the bond placement information, and legal and marketing costs. Also, insurance to protect against the default of bonds is required for bond ratings BB or below as well as for loans.

Export credit finance and political insurance are integral parts of international project finance and play a major role in the project financing structure. Export trade finance is provided by the ECAs of the countries where equipment, technology, and services are sourced. They take the form of credit to suppliers or loans to buyers of equipment, technology, and services from the country the ECA provides credit insurance and financial guarantees. Also, political insurance from OPIC provides comprehensive coverage for losses to assets, investment value, or loss of earnings.

13.4 DETERMINANTS OF PROJECT FINANCING

An illustration of project financing's determining set of factors is shown in Figure 13.4. The first determinant is adequate equity investment by sponsors and the involvement of private and public stakeholders in the project, but with no or limited recourse to the owners of the SPC.

Flowchart illustration of determinants of project financing.

Figure 13.4 Determinants of Project Financing

Once the primary determinants are satisfied, another set of factors defines an effective project financing structure and entails the following:

  1. Economic and political state of the host country, the size of the project, and the funding needs
  2. Updated sponsor and other investor analysis, and evaluation and equity contributions consistent with other project stakeholder expectations
  3. Verification of continuity of stakeholder objectives and alignment consistent with updated sponsor objectives
  4. Reasonableness of cost and revenue forecasts established by scrutinizing and testing the assumptions and underlying scenarios
  5. Sound project‐management processes and safeguards and the ability to integrate decisions effectively in the project financing plan
  6. Project economic viability validated by a sound, independent, and critical assessment and supported by the findings in the due diligence report
  7. Reassessment of project risk mitigation through allocation to parties best able to handle, insurance contracts, and counter‐guarantees
  8. Validation and verification of the due diligence findings by professionals engaged by the lenders' group
  9. Verification of the adequacy of EPC, offtake, supply, hedging, and O&M contracts along with guarantees, financing support, and enhancements
  10. Strong host government political support and enforceable offtaker and supplier contracts
  11. Sponsor contacts, relationships, alliances, and understanding of processes and requirements of potential debt and equity sources
  12. Availability of suitable cost of financing, support in local and hard currency, and interest rate and exchange rate hedging contracts
  13. Participation of, support, and enhancements by ECAs and multilateral institutions
  14. Satisfactory debt ratios tested though simulations of alternative plausible scenarios
  15. Proper management of project company accounts according to lender covenants and restrictions

13.5 AMALGAMATION OF FINANCING

In previous sections we discussed elements of financing structuring, debt and equity investor requirements, the many decisions made in the project development stage, and the determinants of project financing. Following the process from creation of project objectives to financing decisions leads to creation of a project financing plan. A very important element missing from the discussion is the integration of different financing process components that are necessary to develop the project financing plan. The discussion of how all the different pieces and decisions come together to affect project financing is the topic of this section. It is aided by Figure 13.5.1, which is a summary illustration of how the integration of the project team's processes and work activities take place.

Flowchart illustration of integration of project financing decisions.

Figure 13.5.1 Integration of Project Financing Decisions

Once project evaluations and risk profiling and mitigation are completed, they form the basis of the project contracts and agreements and the due diligence report is where these pieces are integrated and summarized. Updating the financial model place takes place by integrating data, inputs, and parameters from the project characteristics, attributes of the project company, host government attributes, funding considerations, and validation from the due diligence report. Based on these updates, the financial model yields estimates of the debt‐cover ratios, IRR, and NPV. Those estimates are further refined by inclusion in the model details about:

  1. Equity investor motivations
  2. Lenders' requirements
  3. Tax and accounting treatment of debt
  4. Loan particulars
  5. Credit enhancements and support
  6. Project specific considerations

The refined financial model outputs determine the project's ability to generate sufficient cash flow to repay debt incurred, satisfy equity‐investor requirements, and serve as a guide to the project's capital structure. At this junction, an interim project financing plan is created and an illustration of it is shown in Figure 13.5.2 above. But, this is not the end. In addition to upfront sponsor equity contributions and timing, additional funding and contingency financing needs are included and other equity sources and instruments are considered and evaluated.

Flowchart illustration of  Illustration of development of the financing plan.

Figure 13.5.2 Illustration of Development of the Financing Plan

Various equity and debt sources and facilities are assessed and the repayment schedule and loan fees are updated and input to the financial model. Only then can an optimized capital structure be determined and acted on to bring financing closure. The manner in which the integration of the parts needs to take place to create a competitive advantage demonstrates the significance of superior project management skills, capabilities, and experiences in structuring financing effectively. In large projects, however, the help and guidance of an experienced external financing advisor is valuable to facilitate the process and ensure smooth closing.

Figure 13.5.2 shows the series of elements needed to optimize the structuring of construction and long‐term financing. Final decisions are made based on annual coverage ratios and tests and, if inadequate, the process is iterated until optimization is achieved. The project financing plan is a major milestone not only because it guides the financing structuring process but, also because it provides crucial support for creating a respectable information memorandum. The crucial importance of the project financial model lies with reaching a financing structure acceptable to both equity and debt investors and for that the reason the next chapter is focused entirely on that discussion.

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset
3.23.103.112