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FINANCIAL RISKS AND MITIGATION Author – LEELA TABLE OF CONTENTS Abstract………………………………………………………………………………………4 Introduction…………………………………………………………………………………..4 Project Finance: Meaning & Definition…..………………………………………………….5 Difference between Project Finance and Traditional Finance……………………………….6 Financi...

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FINANCIAL RISKS AND MITIGATION Author – LEELA TABLE OF CONTENTS Abstract………………………………………………………………………………………4 Introduction…………………………………………………………………………………..4 Project Finance: Meaning & Definition…..………………………………………………….5 Difference between Project Finance and Traditional Finance……………………………….6 Financing mechanisms under Project Finance………………………………………………..7


Equity…………………………………………………………………………………7




Debt……………………………………………………………………………………8




Leasing………………………………………………………………………………...9

Risks………………………………………………………………………………………….10 Risks Associated With Project Finance……………………………………………………...10


Commercial Risks……………………………………………………………………11




Currency Risk………………………………………………………………………...11




Demand Risks………………………………………………………………………...12




Political Risks………………………………………………………………………...12




Legal Risks…………………………………………………………………………...13




Construction, Operation, And Technical Risks………………………………………13

Financial Risks and Mitigation……………………………………………………………….14


Interest Rate Risk…………………………………………………………………….15




Exchange Rate Risk…………………………………………………………………..15




Inflation Rate Risks…………………………………………………………………..16




Liquidity Risk………………………………………………………………………...17

FINANCIAL RISKS AND MITIGATION


Refinance Risk or Credit Risk………………………………………………………..17

Risk Mitigation……………………………………………………………………………….18 Mitigating Risk with Guarantees……………………………………………………………..19 Conclusion……………………………………………………………………………………20

FINANCIAL RISKS AND MITIGATION

ABSTRACT Project finance is the preferred financing mechanism for large infrastructure projects that are essential for developing countries, emerging economies, and developed countries alike. For decades, project finance has been the preferred form of financing for large scale infrastructure projects worldwide. Several studies have emphasized its critical importance, especially for emerging economies, focusing on the link between infrastructure investment and economic growth. Over the last few years, however, episodes of financial turmoil in emerging markets, the difficulties encountered by the telecommunications and energy sectors and the financial failure of several high-profile projects2 have led many to rethink the risks involved in project financing. This research paper will define project finance and risks associated with project finance. It provides insight into the future of project finance.

INTRODUCTION While riding on a metro train in India, high-speed bullet train Europe, or Taiwan, a passenger may see massive wind turbines scattered throughout the countryside. Marveled by the landscape, the passenger may take a snapshot on her phone camera and send it to her family. Without realizing it, the passenger is likely to have benefitted from infrastructure projects that have been financed by a mechanism called ―project finance. The high-speed rail, the wind turbine, and the telecommunication towers are all large and complex infrastructure undertakings. Sometimes such projects are made possible by traditional financial methods; increasingly, however, infrastructure projects are financed by a mechanism that engages a multitude of participants including multilateral organizations, governments, regional banks, and private entities. In project finance, participants negotiate amongst themselves to spread risks associated with an undertaking, thereby increasing the chances for success in developing vital infrastructure projects for that country and its population. Project financing is well-established technique for large capital intensive projects. Its origin can be traced to the thirteenth century when the English Crown negotiated a loan from the Frescobaldi, one of the leading merchant bankers of the period, to develop the Devon silver mines. They crafted a loan arrangement much like what we would call a production payment loan today. It is a method of financing where the lender accepts future revenues from a project as a guarantee on a loan. In contrast, traditional method of financing is where the

FINANCIAL RISKS AND MITIGATION borrower promises to transfer to the lender a physical or economic entity (collateral) in the case of default. In practice, most projects are financed by a combination of both traditional methods as well as by guarantee-backed loans. While the name suggests that project finance refers to raising capital by any means to pay for any project, the term refers to a narrow but increasingly more prevalent method of financing capital- and risk-intensive projects across a broad array of industries.

PROJECT FINANACE: MEANING & DEFINITION The term “project finance” is used loosely by academics, bankers and journalists to describe a range of financing arrangements. Often bandied about in trade journals and industry conferences as a new financing technique, project finance is actually a centuries-old financing method that predates corporate finance. However with the explosive growth in privately financed infrastructure projects in the developing world, the technique is enjoying renewed attention. The purposes of this note are to contrast project finance with traditional corporate financing techniques; to highlight the advantages and disadvantages of project finance and; to propose that a single structure underlies every project finance transaction; to explain the myriad of risks involved in these transactions; and, to raise questions for future research. Project financing techniques date back to at least 1299 A.D. when the English Crown financed the exploration and the development of the Devon silver mines by repaying the Florentine merchant bank, Frescobaldi, with output from the mines. The Italian bankers held a one-year lease and mining concession, i.e., they were entitled to as much silver as they could mine during the year. In this example, the chief characteristic of the project financing is the use of the project’s output or assets to secure financing. Another form of project finance was used to fund sailing ship voyages until the 17th century. Investors would provide financing for trading expeditions on a voyage-byvoyage basis. Upon return, the cargo and ships would be liquidated and the proceeds of the voyage split amongst investors. An individual investor then could decide whether or not to invest in the sailing ship’s next voyage, or to put the capital to other uses. In this early example the essential aspect of project financing is the finite life of the enterprise. In corporate finance terms, we can also think of this mandatory liquidation as a fixed dividend policy. The idea of project finance predated the idea of permanent capital entrusted to a group of professional managers who would decide rather autonomously between paying dividends and reinvestment. Project financing has evolved through the centuries into primarily a vehicle for assembling a consortium of

FINANCIAL RISKS AND MITIGATION investors, lenders and other participants to undertake infrastructure projects that would be too large for individual investors to underwrite. The more recent prominent examples of project finance structures facilitating projects are the construction of the Trans-Alaskan pipeline and exploration and exploitation of the North Sea oil fields. In the late 1990s, the technique has become rather prevalent and is frequently used to finance independent power plants and other infrastructure projects around the world as governments face budgetary constraints. DIFFERENCE BETWEEN PROJECT FINANCE AND TRADITIONAL FINANCE In traditional or corporate financing, the sponsoring company (the company building the project) typically procures capital by demonstrating to lenders that it has sufficient assets on its balance sheets. That is, in the case of default, the lender will be able to foreclose on the sponsor company’s assets, sell them, and use the proceeds to recover its investment. In project finance, the repayment of debt is not based on the assets reflected on the sponsoring company’s balance sheet, but on the revenues that the project will generate once it is completed. The sponsoring company must consider several factors when determining whether to use a corporate or project finance structure. Such considerations include the amount of capital needed, the risks involved (political risks, currency risks, access to materials, environmental risks, etc.) and the identity of the participants (whether a government, multilateral institution, regional bank, bilateral institution, etc. will be involved). As the graph below demonstrates, corporate finance most often involves private investors who provide financing in return for ownership (equity) in a project company. The focus in project finance, however, is mostly on loans to the project company, with project revenues as the source of the return on the investment to lenders. Project finance greatly minimizes risk to the sponsoring company, as compared to traditional corporate finance, because the lender relies only on the project revenue to repay the loan and cannot pursue the sponsoring company’s assets in the case of a default. However, a sponsoring company can only use project finance where it can demonstrate that revenue streams from the completed project will be sufficient to repay the loan. In fact, lenders will often require that the sponsoring company demonstrate that it has agreements in place that will generate the required revenue (called ―off-take agreements‖). For example, in the case of power projects, the sponsoring company often signs contracts with distributors where the distributors agree to purchase electricity generated by the project.

FINANCIAL RISKS AND MITIGATION Therefore, project finance is most suitable for a project where there is a predictable revenue stream to support debt repayment. CORPORATE FINANCE MODEL V. PROJECT FINANCE MODEL

CORPORATE FINANCE

PROJCECT FINANACE

FINANCING MECHANISMS UNDER PROJECT FINANCE Similar to the traditional finance model, a project finance model allows an entity to use equity or debt financing. Most entities in search of investment funds prefer debt financing to equity financing because they retain full control over the project and earn a greater return through the use of debt financing. Debt financing refers to funding a project with a loan, where the SPV takes out a loan and no other investors are involved. In contrast, equity financing requires the project sponsors of the SPV to either contribute cash needed for the project or sell ownership in the SPV to raise capital. In addition to maintaining full control, debt financing is attractive because project sponsors do not have to contribute extra capital to the project.

FINANCIAL RISKS AND MITIGATION

EQUITY: Often host governments and debt lenders will require that the entity building the project obtain some equity funding in order to demonstrate project viability in the market and to offset initial costs. There are a number of factors that influence the level of equity in the SPV that will be made available by the sponsoring companies via equity funding and how much of the construction costs the SPV will solicit in the form of loans. Those factors include how the project is organized, who the players are, what the particular risks are in that country, and what legal requirements there may be in the host country. Typically, equity comprises a smaller share compared to debt (although equity-to-debt ratios range from 5% to 50% in project finance). DEBT: There are two main types of debt- Mezzanine and Senior Debt.  MEZZANINE DEBT: Mezzanine Debt is a special type of debt, which has priority over equity, but is subordinate to other types of loans. Recall the example above of the CBK hydropower station. The mezzanine debt lenders were providing capital in order for one project sponsoring company to purchase the existing project company. If the project fails, senior lenders who were lending to the SPV rather than to the new sponsor company will be paid off first. The important fact to bear in mind is that mezzanine debt refers to debt that is riskier, because there are other outstanding loans that have priority over the mezzanine loan in the case of a default.

FINANCIAL RISKS AND MITIGATION  SENIOR DEBT: As the name suggests, senior debt has seniority in the event of default. A lender may stipulate that it is a senior debt lender, as the World Bank does for example. This means that in the case of default, that lender will receive payment before other creditors of the project. There are several types of debt available to sponsoring companies:


Commercial Financing, (commercial banks, pension funds, insurance companies, and other financial institutions), where the lender requires the borrower’s promise of repayment to be collateralized (backed by some asset).




Subsidized Loans, where the interest rate is below the market rate. Development institutions, governments, and regional development banks (such as a loan from the African Development Bank) typically provide such subsidized loans.




Credit Enhancing Arrangement, from bilateral and multilateral organizations and regional banks, where those organizations provide a guarantee to the lender. If the SPV cannot make payments on its debt, then the guarantor will make payments to the lender on behalf of the SPV.




Bond Financing, where the bondholder provides capital in return for a promise by the SPV to repay the initial amount with interest.

LEASING: One other unique method of financing is lease financing where the SPV rents equipment relying on future revenue stream of the project to pay the lease. That is, the SPV does not make immediate payments on the leased equipment, but promises to pay for the equipment once the project begins to generate revenue. Because construction costs are significant, this sort of financing can play an important role in enabling a project to proceed. The company leasing the equipment has a security interest in the equipment and can repossess the equipment in the case of a default. In return for the financing, the SPV may be required to pay additional interest or pay a premium on the cost of renting the equipment.

RISKS Risk is a crucial factor in project finance since it is responsible for unexpected changes in the ability of the project to repay costs, debt service and dividends to shareholders. Cash flow can

FINANCIAL RISKS AND MITIGATION be affected by risk, and if the risk has not been anticipated and properly hedged it can generate a cash shortfall. If cash is not sufficient to pay creditors, the project is technically in default. Risk has been defined as “uncertainty in regard to cost, loss, or damage.” Uncertainty is the important aspects of the definition. RISKS ASSOCIATED WITH PROJECT FINANCE A successful project financing initiative is based on a careful analysis of all the risks the project will bear during its economic life. Such risks can arise either during the construction phase, when the project is not yet able to generate cash, or during the operating phase. One of the reasons that participants employ the project finance model as opposed to traditional finance is because infrastructure projects require large volumes of capital. With so many participants, risk can be allocated among the parties best able to bear it. Because project finance is a common financing mechanism for long-term, labor-intensive projects, risks are abundant and may surface at any one of the many stages in the project cycle. This next section will discuss the main risks inherent in project finance and how the various parties, in their agreements with each other, attempt to mitigate them. Financing infrastructure projects, especially in developing countries, entails a formidable set of risks. It is the role of the project finance advisor, the project sponsor and other participants to structure the financing in such a manner that mitigates these risks. Lenders and investors always are initially concerned about financing immobile assets in distant, politically-risky areas of the world. The project finance advisor’s role is to carve out the risks, assigning them to the party who is best suited to be responsible for controlling them. The purpose of this section is to provide a checklist of the risks that a project finance transaction faces. COMMERCIAL RISKS: In the larger scheme of commercial risks, there are two main types of financial risks: Interest rate risk and Currency risk. Like in traditional finance, changes to the interest rate may negatively affect the financier or the SPV, or both. Most projects are long-term so lenders charge floating rates (as opposed to predetermined, set rates) based on market conditions. Therefore, when interest rates rise, the costs of the project will increase and the SPV may find itself unable to meet its financial obligations. In order to mitigate this problem, when possible, it is best for the SPV to negotiate a either a fixed interest rate or a floating interest rate, but one that floats only within a fixed manageable

FINANCIAL RISKS AND MITIGATION range. Alternatively, the SPV may use interest-rate swaps to mitigate the risk that a floating rate will increase. The SPV may swap with another party, like a private bank, the floating interest rate for a fixed interest rate on the principal amount the SPV borrowed. CURRENCY RISK is also a serious financial risk to project finance, and one that is not easily mitigated. Currency risk occurs when revenues are generated in one currency while debts must be repaid in a different currency. This is called currency mismatch. In project finance, financing is typically received in the currency in which the lender operates and the lender expects to receive payment in the same currency—e.g., a U.S. bank lends in dollars and expects to be repaid in dollars. However, because currency exchange rates fluctuate, an SPV may find itself unable to pay its lenders if the domestic currency suddenly and significantly drops in value. For example, fluctuations in exchange rates may make repayment difficult if an SPV generates revenue in the Thai baht, but must pay back in dollars. If the baht drops in value with respect to the dollar, then the SPV will need to come up with more baht to pay back the loan because one baht now pays back less debt then before the devaluation. During the Asian Financial Crisis, many Asian countries’ currencies suffered significant depreciation; Indonesia’s Java Bali Power Grid project demonstrates the extreme effect of currency mismatch. The off-take purchaser (power purchaser in this case) bore the currency risk under the purchase agreement, and when the Indonesian rupiah fell 87% in 1996, the power purchaser’s rates to customers skyrocketed because of its obligations to pay for the debt in dollars. As a result, the power purchaser had to pay approximately 400% of the original price. Similar to interest rate swamps, the SPV may mitigate risks stemming from currency exchange-rate fluctuations by utilizing a currency swap, allowing the SPV to convert debt into a more stable currency. Also, a real exchange-rate liquidity (REX) facility may be used, which addresses the risk of a devaluation of the local currency. In the event of a specified devaluation, resulting in a cash flow shortfall, the facility provides liquidity to cover the debt payments. DEMAND RISKS Closely related to the currency mismatch are demand risks. Essentially, either through poor planning or because of some extraneous event like the Asian Financial Crisis, demand for the project-finance generated goods or service may drop, in which case the essential element of project finance—the revenue stream to pay back loans—is reduced. A drop in demand was the reason the Pigbilao Project failed in the Philippines. The project was

FINANCIAL RISKS AND MITI...