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MSc in Corporate Finance and Banking – Project Finance

Project Finance - Lectures 1. Structure, players and contracts What are the main differences between Project Finance and regular Corporate Finance (“plain vanilla”)? Project Finance To finance a “ring-fenced” asset =Limited scope / parameter of lending that is the SPV (all equity and debt) -> Expected cash-flow financing Special Purpose Company (SPC) serves as a borrowing vehicle to undertake the project It is created as an empty shell incorporated in the consortium Non-recourse financing during operations (assets is being constructed -> Not generated any CF) Limited recourse to industrial sponsors possibly during construction Adequacy of the project’s cash flows to repay its debt thanks to its contractual structure and/or competitive position

Plain vanilla Finance To finance general purpose

Structure

Highly structured operation (legal and financing) and heavy documentation Full security package (easier to secure) Strict control over the borrower (use of cash, business decision, financing structure) Risk allocation complex between all the parties

Leverage and Tenor/term

Typically high leverage (up to 90/10 in Debt/Equity) and long tenor (maturity of debt often above 10 years, if not 15) In depth review of the project and its contractual and financing structure (due diligence process) High execution costs (due diligence, legal costs) and important management and coordination time. Several years can go by between mandate signing and credit closing (ie signature of the credit agreement) DSCR (Debt Service Cover Ratio); LTV is not used as the market is illiquid and there is a relative uniqueness of the project

Straight forward structure and documentation Usually unsecured General corporate covenant Balance sheet financing based on the historical (BS and P&L account) and existing assets of a designated company (or company’s affiliate) Shorter leverage and shorter tenor

Purpose

Borrower

Recourse to shareholders

Based on

Due-diligence

Implementation (costs and duration)

Ratios

Asset finance Finance shifts, aircrafts …

Company itself

Non-limited recourse / Full recourse

The creditworthiness of the whole company

Cash flow of the ships but also on the asset itself

Nor or limited due-diligence

Lower costs and faster implementation

More fees

Usual financial ratios (leverage, gearing, ROA, ROCE…)

LTV (loan to value): commercial financial value of the asset at time T (market very liquid and uniqueness of the project)

Non-recourse: lenders secure themselves purely on the SPV. If there is a problem, the cash flow is lower; this default risk will be the risk of the lenders Drawbacks PF: time-consuming structuring, high costs, negative CF with uncertain positive CF, high commercial spreads (LIBOR+100-300bps vs + 20bps for plain vanilla) In the case study, show the parties involved (name), their function in the transaction, the contract signed and the cash flows (exam 2014, 2016) Parties Contract signed Cash flow involved Sponsor Sponsor - SPV receives equity from sponsor agreement - Sponsor receives dividends from SPV Lenders Loan agreement - SPV receives debt cash from lenders - Lenders receives interest + principal repayments from SPV Host country Concession - Grantor receives taxes and royalties Constructor EPC contract - Constructor receives cash from SPV O&M O&M contract - O&M receives cash from SPV Offtaker Offtake contract - SPV receives cash from offtaker In which case would it be a rating agency involved? Project bond issuance in the SPV; project bonds are likely to be “investment-graded” (at least BBB-)

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MSc in Corporate Finance and Banking – Project Finance

What is a PPP? (Exam 2016, 2017)  PPP: Public Private Partnership (PFI: Private Finance Initiative in the UK)  Private sector partners (constructors, facilities management providers) join in a consortium and register the SPV. The SPV bears any costs overruns in respect of the construction and maintenance of the asset and the provision of services  Public sector is the end-user / the tenant who pays a rent for using the infrastructure  The PPP constitutes an important asset for the public sector with low construction risk and a high degree of revenue stability but it is also a highly leveraged financial structure with weak debt protection  There are 2 potential PPP revenues: o “User-pay”: users pay directly for the service; public sector needs to subsidise the service o “Authority-pay”: Authority makes the payment; assessment of affordability; service fee (rent) represent LT commitments

Differences between ECA’s and MLA’s in (1) shareholding (2) mission (3) policy instruments (exam 2014, 2016) ECA (Export Credit Agencies) MLA (Multilateral Agencies) Shareholding National shareholding Always publicly sovereign held Private or state owned Mission Encourage foreign investment and support Promote economic development on a given national exporters to cover both political and continent commercial (credit risk on the offtaker) risks Policy - Provides guarantees - Insure instruments - Political risk insurances - Guarantee to the buyer and buyer’s bank - Long term equity provider in SPV - Finance directly Often offer PRI (private insurer, political risk - Debt provider insurance) - Project bond issue and rating Work under common guidelines fixed by OECD - Financial and technical assistance to host (Consensus) countries World Bank (IBRD, IFC (International Finance Examples Coface (French), EGCD (Export Credit Guarantee Dpt, UK), EDC (Export Development Corp), MIGA), EIB (European Investment Bank), EBRD (European Bank for Reconstruction and Corporation, Canada), Euler/Hermes Development), ADB (Asian Development Bank) (Germany), EFIC (Export Finance Insurance Corporation, Australia), SACE (Italian) Coface country rating: business climate, economic / financial / economic prospects, companies’ payment behaviour What is Miga (function, mission, shareholding)? (Exam 2014)  MIGA (Multilateral Investment Guarantee Agency) is the PRI arm of the World Bank Group. As a AAA rated MLA, it supports investments that are developmentally sound and meet high social and environmental standards.  Its mission is to promote FDI into developing countries to help support economic growth, reduce poverty and improve people’s lives. It does this by providing political risk insurance (guarantees) to the private sector  MIGAS’s 5 main political cover instruments: - Currency inconvertibility and transfer restriction - Expropriation (from the foreign investor’s local assets) thru outright nationalization and confiscation or “creeping” expropriation - War, terrorism, civil disturbance - Breach of contract – protects against losses arising from the government

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MSc in Corporate Finance and Banking – Project Finance

- Non-honoring of sovereign financial obligations

What is EBRD?  EBRD (European Bank for Reconstruction and Development) is an international developmental investment bank, MLA to help Eastern Europe, ex-Soviet and Northern Africa countries to nurture a new private sector in a democratic environment  Its mission is to provide PF for banks, industries and businesses, and supporting reconstructions and privatisations  Policy instruments: - Guarantees on political risk - Direct loans - Equity participations - Leasing facilities and financing of projects As a PF analyst, which institution could you approach for to access…? (Exam 2014, 2017)  The level of country / political risk on a certain country: Euromoney, AON, Marsh (PR reports and maps) + Coface  The business environment of a specific country where your bank is due diligencing a project financing: Business environment index (Economic Intelligence Unit, The Economist) + Doing Business Index (World Bank)  The corruption level of a specific country/market: Transparency International (Corruption perception index)  The sovereign rating of a specific country: S&P, Moody’s, Fitch Assuming that you are the CFO of a European engineering company involved in constructing and operating international projects, which institution would you approach to: (Exam 2014; 2017) Co-finance a project in Chile (2014); Kenya (2017): CAF (Latin America Development Bank), ABD (African Development Bank) Finance a long term (>15 years) infrastructure project in Spain: MLA’s, commercial banks, bonds investors Take equity in a toll road project in France (2014); Germany (2017): Infrastructure, PE, Pension, Sovereign funds… Guarantee Political risk for one of your projects in Cambodia: ECA (like Coface for a French company) Ensure bond issuance in Belgium (2017): Local MLA à vérifier

2. Due diligence and risks What are the three key contractual documents in project finance (for lending check-out)? Which 3 key contracts do lenders want to review before writing the term sheet? (Exam 2016) Name of document

Concession agreement

Construction contract / EPC

Offtake contract (Take and pay vs. Take or Pay)

Purpose. Why key? Permits – Licenses, land plot, fiscal & legal regime… Commitment of the host country where the project is to be constructed. Specifies in all details the country’s fiscal, accounting and construction commitments of this country towards the project company. Check the duration as, upon termination of the property of the project will usually be handed over to the country either for free or at a pre-agreed price. Key contract for Build-Operate-Transfer (B.O.T.) and other privately funded infrastructure projects. The state of the host country grants a concession by which the relevant infrastructure/project is built, operated and timely transferred to the State at the end of the period. Fixes all contractual obligations of the host country towards the project (infrastructure, energy and land procurement, royalties policy, tax treatment etc…) Agree the terms of the construction: duration, technical specificities, costs and on the responsibility of the construction company. Check if it is a “turnkey” (ie with recourse on the project company in case of nonconformity) contract or not. The construction of the project is to meet a standard (tested via the completion test) whereby it is ready to produce and yield a certain volume of cash flow. These contracts usually have Liquidated Damages (LD’s) payable for delays and sub-standard performance under a construction, equipment supply or O&M contract. Agree upon the volume and tariffs of the project’s output -> Key to determine the cash flows of the project. Check (1) the take-and-pay of take-or-pay clauses; (2) the creditworthiness of the offtaker

Signatory parties

Risk impacted

Host State (Governmen t / Ministry; Concession grantor) and SPC

Country / Political risk; Infrastructure risk

Project SPC and construction company (often the main industrial sponsor) Project SPC and the client buying the project’s output (“offtaker”), usually a public/ stateowned utility company for electricity or water projects. Usually CPI

Completion risk

Market risk

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MSc in Corporate Finance and Banking – Project Finance

indexed and possibly hedged on the commodity markets

Other contracts of importance include the shareholder’s agreement, O&M contract and key suppliers’ contracts. There is not the term sheet as it is signed when the 3 contracts above have been audited Assuming you are an investment bank approached by the sponsors to provide financing. Carry out the Due Diligence of this project. Show in the table below the 5 main risks, where the risk lies and their mitigates (exam 2014, 2016, 2017) Main risks

Country / Political

Construction / Completion

Where the risk lies / Subcomponents CIT (Currency inconvertibility & transfer) NCE (Nationalisation & creeping Expropriation) Expropriation (tax, regulation, access or change in law) PVFM (Political violence & force majeure) War & insurrection Terrorism Sovereign downgrade Cost-overrun (budget explode) Late delivery (or no delivery at all) Inability to pass completion test !! Not relevant for an existing toll road that us being refinanced !!

Mitigants

ECA, MLA, PRI (Private insurers, political risk insurance), Insurers

Turnkey contract (construction company is committed to meet performance criteria materialized by a completion test at a certain time otherwise it pays penalties), more particularly if lump-sum (fixed price commitment) A turnkey contract provides completion support via liquidated damages (LDs), retentions, performance bonds and delay-in-startup (DIS) insurances Secured and indexed sale contracts with creditworthy offtakers (CPI indexation) Take-or-pay possible (in the event the project output is not taken, payment must be made whether or not the output is deliverable) Penalties / LD’s in case of change of shareholding State guaranty Possible buyback clauses FOB / Ex-works sale contracts (Free On Board) -> Incoterms

Market / Offtake

Offtake often a State-owned entity High risk in transport infrastructures (complex and uncertain traffic forecasts)

E&S

Environmental: Wasting natural resources Environmental activism Fauna & Flora, pollution Social: Local communities displacement

Sponsor guarantee for greenfield projects Government commitment (via concession agreement) for brownfield projects MLA’s governance Equator principles (risk management framework)

Deficiencies in design or engineering

Proven technology (ie patented technology) (unproven technology is uncovered -> Increase DSCR) Completion guarantee issued by bank or manufacturer Corporate guarantee issued by manufacturer Insurers => Design & Construction contract signed with technically viable and creditworthy contractors

Engineering / design

Funding & Forex (Currency)

Hedging (FX swaps, IR swaps)

Infrastructure / Transportation

Loss due to insufficient infrastructure in the area to complete the project or transport a good

Operating

Cost, technology and management components that impact Opex and project output. Includes inflation

Participant / Sponsor Structuring & Syndication Legal Supply

Raw materials or input to a project change from those projected

Government commitments (via concession agreement) Sponsor + Insurance (reputed and good track record) Sponsor + LD’s & penalties (possibly via turnkey lump sum EPC contract) Reputed and creditworthy O&M contractor JVA Contract industry track – record of sponsors Underwriting agreement Skilled syndication agent Good lawyers Supply warranty Alternative supply sourcing (when available)

Who provide political risk insurance? Main PRI/PRG providers:  Export Credit Agencies (ECA)  MLA’s (e.g. MIGA, IFC for the World Bank)  OPIC (Overseas Private Investment Corporations)

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MSc in Corporate Finance and Banking – Project Finance

 Private PRI/PRG (Political Risk Insurer / Guarantor) providers (e.g. Lloyd’s) What are the IFC performance standards? IFC is the private sector’s financing arm of the World Bank. It provides financing for private sector investments and raises capital for large projects in the global capital markets and supports sustainable economic growth in developing countries by making renewable energy and clean technology projects a priority. The IFC has established its Performance Standards on Environmental and Social Sustainability, which it applies when evaluating (due Diligence) the viability of financing one specific project: It must be technically viable, economically viable, and beneficial to the local economy. Viability of renewable energy projects? Renewable energy comes from natural resources that are naturally and continuously replenished, such as hydropower, wind power, solar energy, tides, geothermal heat, biomass and biofuel. These projects have benefited from strong subsidies from their respective governments Renewables provide currently some 20% of global energy worldwide, with hydropower accounting for the majority. Renewables can be especially suitable for developing economies. In 2016, renewables was the most attractive sector  Distinct stages of information gathering and decision-making  Unproven technology  Subsidized  As a compensation, the host country might require the sponsors to agree to license the technology

What is YieldCo’s? It is a new financing structure capturing the uncertainty during the development stage of renewable energy projects (but tend to produce low-risk cash flows once they are operating). A Yieldco is a dividend growth-oriented public company, created by a parent company (a RE developer - sponsor), that bundles renewable long-term contracted operating assets (ie brownfield projects) in order to generate predictable cash flows. YieldCos ensure tax optimization for the parent company by creating a kind of pass-through structure and avoiding double-taxation.

What is the P50-P90 methodology to forecast production level? It is defined as the exceedance probability (50% or 90%) that a certain value (predefined production level) will be exceeded. For example, a P50 (or P90) value of 10,000 kWh for the annual output of a solar power system means that there is a 50 % (90%) likelihood that the system’s output will be greater than 10,000 kWh.

3. Financial modelling What is a cash sweep? A cash sweep clause is often inserted in the loan agreement to monitor the project’s cash waterfall and secure the debt repayment. It is the mandatory excess free cash flows to pay down outstanding debt rather than distribute it to shareholders. It forces the project’s SPV (borrower) to pay at least a portion of all excess cash flows. It minimizes the credit risk. Why should lenders beware of manipulated IRRs?  Aggressive revenue forecasts presented in the sponsor’s business plan  No adjustment for sovereign/political risks in the cash flows (ie no MLA involvement which high risk, no PRI/PRG costs, etc.)  Tax-exempt structures which increases the cash flows (when tax is paid at sponsor level rather than SPC level)  Low equity structures  Early dividend payments favouring an early equity divestment of certain sponsors >> A high equity IRR is not synonymous of value creation >> Due to manipulated IRR, lenders should rather have a look to the NPV What are the key project finance ratios?  DSCR (Debt Service Cover Ratio)  LLCR (Loan Life Cover Ratio): NPV (CFADS over loan life) / Debt  NPV (Net Present Value): PV of cash inflows less PV of cash outflows  IRR (Internal Rate of Return): discount rate which would give a NPV of 0; the higher the IRR, the greater the incentives fir sponsors

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MSc in Corporate Finance and Banking – Project Finance



ICR (Interest Cover Ratio)

Which level of DSCR covenant would you fix for a financing to secure your lending position and why? (Exam 2014)  DSCR = Debt Service Cover Ratio = FCF / Total debt - FCF (of the project SPV) is EBIT + D&A – Tax – Change in WC - Capex - Total debt: principal + interest + fees (fees are paid upfront)  Often used as a key financial covenant in the project finance offer (credit agreement), it measures the amount of debt that the project can fully service during the loan repayment period  The DSCR should never go under +/- 1.15 value in order to ensure a sufficient cash flow buffer along the whole debt amortization. Level of DSCR per industry - Power: 1.2x - 1.4x - Resources (Oil & gas, mining): 1.5x – 1.6x - Telecoms: 1.4x – 1.6x - Infrastructure: 1.2x – 1.5x  The DSCR level is a reflection of the overall risk profil...