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Concepts of Project Finance

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Published: Thu, 01 Mar 2018

Introduction

Project Finance.

Origins of project finance

Project financing is generally sought for infrastructure related projects. Its linkages to the economy are mutiple and complex, because it affects production and consumption directly, creates negative and positive externalities, and involves large flow of expenditure.

Prior to World War I, private entrepreneurs built major infrastructure projects all over the world. During the 19th century ambitious projects such as the suez canal and the Trans-Siberian Railway were constructed, financed and owned by private companies. However the private sector entrepreneur disappeared after world War I and as colonial powers lost control, new governments financed infrastructure projects through public sector borrowing. The state and the public utility organizations became the main clients in the commissioning of public works, which were then paid for out of general taxation. After World War II, most infrastructure projects in industrialized countries were built under the supervision of the state and were funded from the respective budgetary resources of sovereign borrowings.

This traditional approach of government in identifying needs, setting policy and procuring infrastructure was by and large followed by developing countries, with the public finance being supported by bond instruments or direct sovereign loans by such organizations as the world Bank, the Asian Development Bank and the International Monetary Fund.

Development In the early 1980s

  • The convergence of a number of factors by the early 1980s led to the search for alternative ways to develop and finance infrastructure projects around the world. These factors include:
  • Continued population and economic growth meant that the need for additional infrastructure- roads, power plants, and water-treatment plants-continued to grow.
  • The debt crisis meant that many countries had less borrowing capacity and fewer budgetary resources to finance badly needed projects; compelling them to look to the private sector for investors for projects which in the past would have been constructed and operated in the public sector
  • Major international contracting firms, which in the mid-1970s had been kept busy, particularly in the oil rich Middle East, were, by the early 1980s, facing a significant downturn in business and looking for creative ways to promote additional projects.
  • Competition for global markets among major equipment suppliers and operators led them to become promoters of projects to enable them to sell their products or services.
  • Outright privatization was not acceptable in some countries or appropriate in some sectors for political or strategic reasons and governments were reluctant to relinquish total control of what maybe regarded as state assets.

During the 1980s, as a number of governments, as well as international lending institutions, became increasingly interested in promoting the development for the private sector, and the discipline imposed by its profit motive, to enhance the efficiency and productivity of what had previously been considered public sector services. It is now increasingly recognized that private sector can play a dynamic role in accelerating growth and development. Many countries are encouraging direct private sector involvement and making strong efforts to attract new money through new project financing techniques.

Such encouragement is not borne solely out of the need for additional financing, but it has been recognized that the private sector involvement can bring with it the ability to implement projects in a shorter time, the expectation of more efficient operation, better management and higher technical capability and, in some cases, the introduction of an element of competition into monopolistic structures.

However, the private sector, driven by commercial objectives, would not want to take up any project whose returns are not consumerate with the risks. Infrastructure projects typically have a long gestation period and returns are uncertain. What then are the incentives of private capital providers to participate in infrastructure projects, which are fraught with huge risks? Project finance provides satisfactory answers to these questions.

Project finance is typically defined as limited or non-recourse financing of a new project through separate incorporation of vehicle or Project Company. Project financing involves non-recourse financing of the development and construction of a particular project in which the lender looks principally to the revenues expected to be generated by the project for the repayment of its loan and to the assets of the project as collateral for its loan rather than to the general credit of the project sponsor.

In other words the lenders finance the project looking at the creditworthiness of the project, not the creditworthiness of the borrowing party. Project Financing discipline includes understanding the rationale for project financing, how to prepare the financial plan, assess the risk, design the financing mix, and raise the funds.

A knowledge base is required regarding the design of contractual arrangements to support project financing; issues fior the host government legislative provisions, public/private infrastructure partnerships, public/private financing structures; credit requirements of lenders, and how to determine the projects borrowing capacity; how to prepare cash flow projections and use them to measure expected rates of return; tax and accounting considerations; and analytical techniques to validate the projects feasibility.

Traditional finance is corporate finance, where the primary source of repayment for investor and creditors is the sponsoring company, backed by its entire balance sheet, not the project alone. Although creditors will usually still seek to assure themselves of economic viability of the project being financed so that it is not a drain on the corporate sponsors existing pool of assets, an important influence on their credit decision is the overall strength of the sponsors balance sheet, as well as their business reputation. If the project fails, lenders do not necessarily suffer, as long as the company owning the project remains financially viable.

Corporate finance is often used for shorter, less capital-intensive projects that do not warrant outside financing. The company borrows funds to construct a new facility and guarantees to repay the lenders from its available operating income and its base of assets. However private companies avoid this option, as it strains their balance sheets and capacity, and limits their potential participation in future projects. Project financing is different from traditional forms of finance because the financier principally looks to the assets and revenue of the project in order to secure and service the loan.

In project finance a team or consortium of private firms establishes a new project company to build, own and operate a separate infrastructure project. The new project company to build own and operate a separate infrastructure project. The new project company is capitalized with equity contributions from each of the sponsors. In contrast to an ordinary borrowing situation, in a project financing the financier usually has little or no recourse to the non-project assets of the borrower or the sponsors of the project. The project is not reflected in the sponsors’ balance sheets.

Extent of recourse

Recourse refers to the right to claim a refund from another party, which has handled a bill at an earlier stage. The extent of recourse refers to the range of reliance on sponsors and other project participants for enhancement to protect against certain projects risks. In project financing there is limited or no recourse. Non-recourse project finance is an arrangement under which investors and credit financing the project do not have any direct recourse to the sponsors.

In other words, the lender is not permitted to request repayment from the parent company if borrower fails to meet its payment obligation. Although creditors security will include the assets being financed, lenders rely on the operating cash flow generated from those assets for repayment.

When the project has assured cash flows in the form of a reliable off taker and well-allocated construction and operating risks, the lenders are comfortable with non-recourse financing. Lenders prefer limited recourse when the project has significantly higher risks. Limited recourse project finance permits creditors and investors some recourse to the sponsors.

This frequently takes the form of a precompletion guarantee during a projects construction period, or other assurance of some form of support for the project. In most developing market projects and in other projects with significant construction risk, project finance is generally of the limited recourse type.

Merits and Demerits of Project Financing:

Project financing is continuously used as a financing method in capital-intensive industries for projects requiring large investments of funds, such as the construction of power plants, pipelines, transportation systems, mining facilities, industrial facilities and heavy manufacturing plants. The sponsors of such projects frequently are not sufficiently creditworthy ot obtain tr5aditional financing or unwilling to take the risk and assume the debt obligation associated with traditional financing. Project financing permits the risk associated with such projects to be allocated among number of parties at levels acceptable to each party.

The advantages of project financing are as follows:

1.

Non-recourse:

The typical project financing involves a loan to enable the sponsor to construct a project where the loan is completely “Non-recourse” to the s[sponsor i.e. the sponsor has no obligation to make payments on the project loan if revenues generated by the project are insufficient to cover the principle and interest payable on the loan. This safeguards the assets of sponsors. The risks of new projects remain separate from the existing business.

2.

Maximizes leverage:

In project financing. The sponsors typically seek to finance the cost of development and construction of project on highly leverage basis. Frequently such costs are financed using 80 to 100 percent debt. High leverage in an non recourse financing permits a sponsor to put less in funds at risk, permits a sponsor to finance a project without diluting its equity investment in the project and in certain circumstances, also may permit reduction in cost of capital by substituting lower cost, tax deductible interest for higher cost, taxable return on equity.

3.

Off balance sheet treatment:

Depending upon the structure of project financing the project sponsors may not be required to report any of the project debt on its balance sheet because such debt is non recourse or of limited recourse to the sponsor. Off balance sheet treatment can have the added practical benefit of helping the sponsor comply with convenient and restrictions related to the board. Borrowings funds contain in other indentures and credit agreements to which the sponsor is a party.

4.

Maximizes tax benefits:

Project finance is generally structured to maximize tax benefit and to assure that all available tax benefit are used by the sponsors or transferred to the extent possible to another party through a partnership, lease or vehicle.

5.

Diversifies risk:

By allocating the risk and financing need of the projects among a group of interested parties or sponsors, project financing makes it possible to undertake project that would be too large or would pose too great a risk for one party ion its own.

Demerits:

1.

Complexity of risk allocation:

Project financing is complex transaction involving many participants with diverse interest. If a project is to be successful risk must be allocated among the participants in an economically efficient way. However, there is necessary tension between the participants. For e.g between the lender and the sponsor regarding the degree of recourse, between the sponsor and contractor regarding the nature of guarantees., etc which may slow down the realization of the project.

2.

Increase transaction cost:

It involves higher transaction costs compared to other types of transactions, because it requires an expensive and time-consuming due diligence conducted by the lenders lawyer, the independent engineers etc., since the documentation is usually complex and lengthy.

3.

Higher interest rates and fees:

The interest rates and fees charged in project financing are higher than on direct loan made to the project sponsor since the lender takes on more risk.

4.

Lender supervision:

In accordance with a higher risk taken in project financing the lender imposes a greater supervion on the mangement and operation of the project to make sure that the project success is not impaired. The degree of lender supervision will usually result into higher costs which will typically have to be borne by the sponsor.

Whether expanding manufacturing facilities, implementing new processing capabilities, or leveraging existing assets in new markets, innovative financing is often at the core of long-term projects to transform a company’s operations. Akin to the underlying corporate transformation, the challenge with innovative financial structures such as project finance is that the investment is made upfront while the anticipated benefits of the initiative are realized years later.

There has been a rise in number of companies that need innovative financing to satisfy their capital needs, in a significant number of instances they have viable goals but find that traditional lenders are unable to understand their initiatives. And so the need emerged for project finance.

Project financing is a specialized form of financing that may offer some cost advantages when very large amounts of capital are involved It can be tricky to structure, and is usually limited to projects where a good cash flow is anticipated. Project finance can be defined as: financing of an industrial (or infrastructure) project with myriad capital needs, usually based on non-recourse or limited recourse structures, where project debt and equity (and potentially leases) used to finance the project are paid back from the cash flow generated by the project, with the project’s assets, rights and interests held as collateral. In other words, it’s an incredibly flexible and comprehensive financing solution that demands a long-term lending approach not typical in today’s market place.

Whether expanding manufacturing facilities, implementing new processing capabilities, or leveraging existing assets in new markets, innovative financing is often at the core of long-term projects to transform a company’s operations. Akin to the underlying corporate transformation, the challenge with innovative financial structures such as project finance is that the investment is made upfront while the anticipated benefits of the initiative are realized years later.

Infrastructure is the backbone of any economy and the key to achieving rapid sustainable rate of economic development and competitive advantage. Realizing its importance governments commit substantial portions of their resources for development of the infrastructure sector. As more projects emerge getting them financed will continue to require a balance between equity and debt. With infrastructure stocks and bonds being traded in the markets around the world, the traditionalist face change. A country on the crest of change is India. Unlike many developing countries India has developed judicial framework of trust laws, company laws and contract laws necessary for project finance to flourish.

Types of Project Finance

  • Build Operate Transfer (BOT)
  • Build Own Operate Transfer (BOOT)
  • Build Own Operate (BOO)

Build Operate Transfer

Build operate transfer is a project financing and operating approach that has found an application in recent years primarily in the area of infrastructure privatization in the developing countries. It enables direct private sector investment in large scale infrastructure projects.

In BOT the private contractor constructs and operates the facility for a specified period. The public agency pays the contractor a fee, which may be a fixed sum, linked to output or, more likely, a combination of the two. The fee will cover the operators fixed and variable costs, including recovery of the capital invested by the contractor. In this case, ownership of the facility rests with the public agency.

The theory of BOT is as follows:-

BUILD –

A private company (or consortium) agrees with a government to invest in a public infrastructure project. The company then secures their own financing to construct the project.

Operate –

The private developer then operates, maintains, and manages the facility for a agreed concession period and recoups their investment through charges or tolls.

Transfer-

After the concessionary period the company transfers ownership and operation of the facility to the government or relevant state authority.

In a BOT arrangement, the private sector designs and builds the infrastructure, finances its construction and operates and maintains it over a period, often as long as 20 or 30 years. This period is referred to as the “concession” period. In short, under a BOT structure, a government typically grants a concession to a project company under which the project company has the right to build and operate a facility. The project company borrows from the lending institutions in order to finance the construction of the facility. The loans are repaid from “tariffs” paid by the government under the off take agreement during the life of the concession. At the end of the concession period the facility is usually transferred back to the government.

Advantages

  • The Government gets the benefit of the private sector to mobilize finance and to use the best management skills in the construction, operation and maintenance of the project.
  • The private participation also ensures efficiency and quality by using the best equipment.
  • BOT provides a mechanism and incentives for enterprises to improve efficiency through performance-based contracts and output-oriented targets
  • The projects are conducted in a fully competitive bidding situation and are thus completed at the lowest possible cost.
  • The risks of the project are shared by the private sector

Disadvantages

  • There is a profit element in the equity portion of the financing, which is higher than the debt cost. This is the price paid for passing of the risk to the private sector
  • It may take a long time and considerable up front expenses to prepare and close a BOT financing deal as it involves multiple entities and requires a relatively complicated legal and institutional framework. There the BOT may not be suitable for small projects
  • It may take time to develop the necessary institutional capacity to ensure that the full benefits of BOT are realized, such as development and enforcement of transparent and fair bidding and evaluation procedures and the resolution of potential disputes during implementation.

Build Own Operate Transfer (BOOT)

A BOOT funding model involves a single organization, or consortium (BOOT provider) who designs, builds, funds, owns and operates the scheme for a defined period of time and then transfers this ownership across to a agreed party. BOOT projects are a way for governments to bundle together the design and construction, finance, operations and maintenance and potentially marketing and customer interface aspects of a project and let these as a package to a single private sector service provider. The asset is transferred back to the government after the concession period at little or no cost.

The Components of BOOT.

B for Build

The concession grants the promoter the right to design, construct, and finance the project. A construction contract will be required between the promoter and a contractor. The contract is often among the most difficult to negotiate in a BOOT project because of the conflict that increasingly arises between the promoter, the contractor responsible for building the facility and those financing its construction.

Banks and other providers of funds want to be sure that the commercial terms of the construction contract are reasonable and that the construction risk is placed as far as possible on the contractors. The contractor undertakes responsibility for constructing the asset and is expected to build the project on time, within budget and according to a clear specification and to warrant that the asset will perform its design function. Typically this is done by way of a lump-sum turnkey contract.

O for Own

The concession from the state provides concessionaire to own, or at least possess, the assets that are to be built and to operate them for a period of time: the life of the concession. The concession agreement between the state and the concessionaire will define the extent to which ownership, and its associated attributes of possession and control, of the assets lies with the concessionaire.

O for Operate

An operator assumes the responsibility for maintaining the facility’s assets and the operating them on the basis that maximizes the profit or minimizes the cost on behalf of the concessionaire and, like the contractor undertaking construction and be a shareholder in the project company. The operator is s often an independent through the promoter company.

T for Transfer

This relates to a change in ownership of the assets that occurs at the end of the concession period, when the concession assets revert to the government grantor. The transfer may be at book value or no value and may occur earlier in the event of failure of concessionaire.

Stages of Boot Project

Build

  • Design
  • Manage project implementation
  • Carry out procurement
  • Finance
  • Construct

Own

  • Hold in interest under concession

Operates

  • Mange and operate facility
  • Carry out maintenance
  • Deliver products/services
  • Receive payment for product/ service

Transfer

  • Hand over project in operating condition at the end of concession period

Advantages

  • The majority of construction and long term risk can be transferred onto the BOOT provider.
  • The BOOT operator can claim depreciation on the facility constructed and depreciation being a tax-deductible expense shareholder returns are maximized.
  • Using an output based purchasing model, the tender process will encourage maximum innovations allowing the most efficient designs to be explored for the scheme. This process may also be built into more traditional tendering processes.
  • Accountability for the asset design, construction and service delivery is very high given that if the performance targets are not met, the operator stands to lose a portion of capital expenditure, capital profit, operating expenditure and operating profit.
  • Boot operators are experienced with management and operation of infrastructure assets and bring these skills to scheme.
  • Corporate structuring issues and costs are minimal within a BOOT model, as project funding, ownership and operation are the responsibility of the BOOT operator. These costs will however be built into the BOOT project pricing.

Disadvantages

  • Boot is likely to result in higher cost of the product/ service for the end user. This is a result of the BOOT provider incurring the risks associated with 100 percnet financing of the scheme and the acceptance of the ongoing maintenance liabilities.
  • Users may have a negative reaction to private sector involvement in the scheme, particularly if the private sector is an overseas owned company
  • Management and monitoring of the service level agreement with the BOOT operators can be time consuming and resource hungry. Procedures need to be in place to allow users to assess service performance and penalize the BOOT operator where necessary.
  • A rigorous selection process is required when selecting a boot partner. Users need to be confident that the BOOT operator is financially secure and sufficiently committed to the market prior to considering their bid.

Build Own Operate

In BOO, the concessionaire constructs the facility and then operates it on behalf of the public agency. The initial operating period {over which the capital cost will be recovered} is defined. Legal title to the facility remains in the private sector, and there is no obligation for the public sector to purchase the facility or take title. The private sector partner owns the project outright and retains the operating revenue risk and all of the surplus operating revenue in perpetuity. As an alternative to transfer, a further operating contract {at a lower cost} may be negotiated.

Design Build Finance Operate (DBFO):

Under this approach, the responsibilities fro designing, building, financing and operating are bundled together and transferred to private sector partners. They are also often supplemented by public sector grants in the from of money or contributions in kind, such as right of way. In certain cases, private partners may be required to make equity investments as well. DBFO shifts a great deal of the responsibility for developing and operating to private sector partners, the public agency sponsoring a project would retain full ownership over the project.

Others:

    • Build Transfer Operate (BTO)

The BTO model is similar to BOT model except that the transfer to the public owner takes place at the time that construction is completed, rather than at the end of the franchise period. The concessionary builds and transfers a facility to the owner but exclusively operates the facility on behalf of the owner by means of management contract.

  • Buy Build Operate (BBO)

 

A BBO is a form of asset sale that includes a rehabilitation or expansion of an existing facility. The government sells the asset to the private sector entity, which then makes the improvements necessary to operate the facility in a profitable manner.

 

  • Lease Own Operate (LOO)

 

This approach is similar to a BOO project but an existing asset is leased from the government for a specified time. the asset may require refurbishment or expansion.

 

  • Build Lease Transfer (BLT)

 

The concessionaire builds a facility, lease out the operating portion of the contract, and on completion of the contract, returns the facility to the owner.

 

  • Build Own Lease Transfer (BOLT)

 

BOLT is a financing scheme in which the asset is owned by the asset provider and is then leased to the public agency, during which the owner receives lease rentals. On completion of the contract the asset is transferred to the public agency.

    • Build Lease Operate Transfer (BLOT)

The private sector designs finance and construct a new facility on public land under a long term lease and operate the facility during the term of the lease. the private owner transfers the new facility to the public sector at the end of the lease term.

    • Design Build (DB)

A DB is when the private partner provides both design and construction of a project to the public agency. This type of partnership can reduce time, save money, provide stronger guarantees and allocate additional project risk to the private sector. It also reduces conflict by having a single entity responsible to the public owner for the design and construction. The public sector partner owns the assets and has the responsibility for the operation and maintenance.

    • Design Bid Build (DBB)

Design bid build is the traditional project delivery approach, which segregates design and construction responsibilities by awarding them to an independent private engineer and a separate private contractor. By doing so, design bid build separates the delivery process in to the three liner phases: Design, Bid and Construction. The public sector retains responsibility for financing, operating and maintaining infrastructure procured using the traditional design bid build approach.

  • Design Build Maintain (DBM)

    A DBM is similar to a DB except the maintenance of the facility for the some period of time becomes the responsibility of the private sector partner. The benefits are similar to the DB with maintenance risk being allocated to the private sector partner and the guarantee expanded to include maintenance. The public sector partner owns and operates the assets.

  • Design Build Operate (DBO)

    A single contract is awarded for the design, construction and operation of a capital improvement. Title to the facility remains with the public sector unless the project is a designbuildoperatetransfer or designbuildownoperate project. The DBO method of contracting is contrary to the separated and sequential approach ordinarily used in the United States by both the public and private sectors. This method involves one contract for design with an architect or engineer, followed by a different contract with a builder for project construction, followed by the owner’s taking over the project and operating it.

    A simple design build approach credits a single point of responsibility for design and construction and can speed project completion by facilitating the overlap of the design and construction phases of the project. On a public project, the operations phase is normally handled by the public sector under a separate operations and maintenance agreement. Combining all three phases in to a DBO approach maintains the continuity of private sector involvement and can facilitate private sector financing of public projects supported by user fees generated during the operations phase.

  • Lease Develop Operate (LDO) or Build Develop Operate (BDO)
  • Under these partnerships arrangements, the private party leases or buys an existing facility from a public agency invests its own capital to renovate modernize, and expand the facility, and then operates it under a contract with the public agency. A number of different types of municipal transit facilities have been leased and developed under LDO and BDO arrangements.

Theoretical Perspective

Project Finance Strategic Business Unit

A one-stop-shop of financial services for new projects as well as expansion, diversification and modernization of existing projects in infrastructure and non -infrastructure sectors

Since its inception in 1995 the Project Finance SBU has built-up a strong reputation for it’s in-depth understanding of the infrastructure sector as well as non-infrastructure sector in India and they have the ability to provide tailor made financial solutions to meet the growing & diversified requirement for different levels of the project. The recent transactions undertaken by PF-


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