8 - Project Finance Flashcards
Project Finance: definition/characteristics
Proj. Finance is a LARGER SCALE, sometimes, HIGHLY LEVERAGED, financing facility established for a SPECIFIC UNDERTAKING whose credit worthiness and economic justification is based primarily on that undertaking’s EXPECTED CASH FLOWS and ASSET COLLATERAL
-Lenders look initially to the project’s cash flow for repayment and its assets for collateral
Project Finance: definition/characteristics (2)
- Debt terms are not based on the sponsor’s credit support of the value of the physical assets of the project, but on the technical and economic factors
- Level of leverage is higher than for a normal project
Recourse vs non-recourse finance
- Recourse: lender can recover debt by selling OTHER assets of the sponsor
- Limited recourse: if project is nearly finished, lender has right to assets to finish the project
- Non recourse: lender has right ONLY to the CFs and assets of the project (not the company)
Completion test
-Companies often move from recourse to non-recourse throughout the project
-Based on expected CFs which is based on assumed technological details
-Details include design engineering and construction risks
Tests include: capacity, daily production rate, output specification, banks will have done sensitivity analyses
Financial consequences of recourse/non recourse
- Recourse is an important consideration, because it affects balance sheet ratios:
- Higher recourse causes D/E ratio to deteriorate
- Affects ratings
- Affects borrowing covenants
- Once a loan becomes non-recourse, interest costs/borrowing amounts become OBS (not included in ratios)
Financial convenants
- A range of financial ratios which must always be observed: e.g., current assets ratio (2:1), debt service ratios (1.5:1), debt/equity ratio (40/60)
- A breach of ratio can result in immediate payback of principal, and also cross-default clauses (default in one agreement = default in ALL agreements)
PF: greater economic efficiency
- Project financings are designed to avoid uncertainty
- Extensive feasibility/engineering/due diligence takes place so that CF projections can be relied upon
Types of risks: Development phase
- Developers and contractors usually take an equity position (i.e. become a partner in the project)
- Risks include: technology risk (assumed by sponsors through equity contribution), credit risk (often enhanced through letters of credit), bid risk (will the bid be successfully made)
Types of risks: Construction phase
- Completion risk: risk that project may never reach operating stage, contractors therefore allocate segments of completion risk to equipment and material suppliers; sponsors favour turnkey projects where engineering/construction contractors assume responsibility for completion
- Cost overrun risk: fixed price contracts may be difficult to obtain, may offset by including price escalation clauses
Types of risks: Construction phase (cont.)
- Sponsor’s performance risk: may not meet quality standards or deadlines by failing to provide specified goods or services on time; completion and performance guarantees help cover this risk
- Political risks: legislative and regulatory changes which occur during project construction
Types of risks: Operations phase
Project has been successfully completed, the following risks remain:
- Cost overrun risk: labour and materials used during operation may turn out to be more expensive than anticipated
- Off-take risk (marketing): risk that the project may not meet revenue projections because of price or demand changes (manage through fixed price agreements, or derivatives)
- take-or-pay: guarantee if company produces nothing, pay certain amount back (fixed costs)
- take-and-pay: if company can’t produce goods, will only pay back what has been delivered
Types of risks: Ongoing risks
- Equity resale risk: contractors and other sponsors may be unable to sell their share in a project upon completion because secondary market may be limited
- Ongoing risks: interest rate and FX risks
Ownership Structure: key aspects (3)
1) To avoid parent company direct involvement
2) Legal liability: due to size of most projects covered by project finance
3) Tax: timing of deductions for CAPEX, which affect deductions against taxable income and hence timing of tax payable and cash flow effects
Partnerships
- Direct access to write-offs
- Recourse limited to partnership assets
- BUT unlimited liability for partners
Corporations
- Special purpose company may be formed
- Will own the assets of the project, but not other assets
- If a single sponsor: access exists to initial tax write offs through the grouping provisions
- If dual sponsor: tax claims are deferred until the project generates taxable income
