Please read the Project finance handout in the content area. There is basically very little on this important subject in 100 corporate finance textbooks surveyed by Fernandez. Pay attenetion to the case at the end of handout, as far as how the toll road was financed. I want you to discuss the implication of various risk factors on the required return to the providers of capital. Thanks to all of you and this is a great learning tool.

The hand out is pasted below:

Project Financing Definition

The International Project Finance Association defines Project finance as financing of long-term infrastructure, industrial projects, power plant, etc., where project debt and equity used to finance the project are paid back from the cash-flow generated by the project.

The two key aspects of project financing are: 1. The project revenues (cash flows) are expected to

service debt or equity interest taken by the providers of

capital. 2. The loans are secured by the project assets or, to

the extent security interests are restricted or have

limited value, are secured by contingent support from sponsors and other project participants.

SPV

Private companies use project finance as a means of financing a large project off-balance sheet through creation of SPV with limited equity invested by consortium of sponsors, thereby enabling the sponsors to maintain there level of book debt low as this project finance transaction are not treated as company debt.

Structure of project Finance

Sponsor Sponsor Sponsor

Concession Lenders Project Finance Co contract Government

Loan

Principal & Interest Pay

toll User

SPV

Construct

Electricity

Power Plant

Subcontractor design, build

Subcontractor operate

Subcontractor maintenance

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Types of PPP

Public Domain Public Private Privatization

DBFT (design, build, finance, transfer BOT (build, operate, transfer

DBFO (design, build, finance, operate BOO (build, own, operate)

Public procurement of services

Privately owned and publicly regulated

Phases of PPP

Identification Tender the project for bid by public sector Selecting the lowest bidder sponsor Construction Operation Transfer

Advantages of BOO/BOT

The BOO/BOT projects are conducted in a fully competitive bidding situation.

projects risk are transferred to the private sector through allocation of the appropriate risk to a party who can be able to mitigate its exposure.

The public sector get the benefits of private sectors ability to mobilize finances, and to use the management skills in the design, construction, and the operation of the project.

The public sector get the comparative advantage of the private sector in the latest technology, and typically the project is constructed faster and in timely fashion.

The public sector get the project Implementing efficiently albeit with higher cost.

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Economic incentives for PPP

Lack of public funding Increase efficiency in production of public

goods Introduce competition Poor infrastructure

Increase innovation in procurement of public projects for greater good

Privatization Improving the Economy

Public funds would no longer be channeled into non- profitable enterprises. Rather,revenues generated will be re- directed to the government through corporate taxes.

Consumers benefit from the improved quality and efficiency of services provided.

Privatization under the right structure will enable the government to focus on governance

privatization can widen and deepen the local capital market on i.e., improve liquidity, increased market capitalization, and transparency.

New projects embarked can be financed by local as well as foreign investment and debt

Why PPP

Sharing of risk between private and public sector. Accelerate construction of a key project with

positive externalities to the economy Changing the role of government from provider to

that of a facilitator and regulator. Innovation brought by private sector in procuring a

target out put. Skill transfer from private to the public sector. Complexity premium, Uk, carry high premium

than Spain.

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Project financing feasibility and rationale

Projectfeasibility

-financial and economic feasibility -legal framework for contractual and financial structuring - balance between tariff increases and value added for public

(service users)

Risk sharing - mitigate completion risk (costs/time/specification), operation risk

(demand/operating/performance/quality), financial risk (interest

rate/inflation/foreign exchange), legal, and political risk (force majeure) - distribute risks among project participants (contractors, sub- contractors, lenders, and other parties) based on who is best

positioned to efficiently manage and mitigate the risks

Revenue Sharing - for public services the main proceed is tariffs or tolls, therefore - tariff setting policies and securities for minimum tariffs are key

Financing

Cost of capital is usually higher for private provider than government raised finance, however competition in the financial market has increased tenor, resulting in narrowing of spread.

Any marginal higher cost of funding by private sector is more than offset by higher marginal savings on the project that is procured on time on budget and on the specification due to, diversification and transfer of construction risk to the private sector, increased efficiency and innovation in procuring a public project.

In a PFI project financing cost is usually 1/3 of the total cost. The PFI project in some countries must pass PSC test that compares

the cost of the PFI with the comparable project procured by traditional basis and demonstrate significant saving to the rate payers before being embarked in the UK.

A recent study by Arthur Anderson in UK found that PFI projects made and average of 17% project cost savings as compared to projects procured in traditional basis with over 1 billion pound savings to the tax payers.

Key Challenges for developing Economies on PPP

High risk region, Eastern Europe, Middle East, South America, Asia and Africa

Lack of legal framework

Promoting PPP through legislative mandate.

Central government commitment for promoting PPP.

Establishing necessary legislative changes Changes in tax laws that weigh against PPP

approach. Establishing working example of pilot PPP project

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Advantage of PFI

Synergies in design construction and operation Proper risk sharing and risk allocation Faster project completion Curtailing cost overrun

Encourages innovations Maintenance cost are accounted for adequately

Disadvantage of PFI

High tendering cost Lengthy and complex negotiation Difficulty in specifying quality of service resulting

in dispute Difficulty in pricing operation and maintenance

during the bidding phase Agency problem arising due to conflict of interest

between various parties

Small contractors are left out due to sheer size of the project

Revenue Risk

Theprovideriscompensatedinthreeways: 1. Direct payment, i.e., Toll, fees Risk, the amount of toll can be negotiated, however

the amount of traffic (demand for the out put) is

beyond the control of provider. 2. Indirect payment, i.e., shadow tolls on road Risk,paymenttotheproviderdependsonvolumeso

that the fees structured minimize the risk to the

provider. 3. Availability payment, the assets being available for

use. Risk,thisriskisunderproviderscontrol

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Sources of Funds

Funds for project financing comes from variety of sources: such as:

equity capital, governmental aids, loans, which can be export (Eurobonds,

private placement and commercial papers),

loans at favorable terms from development institutions such as the World Bank or the Agency for International Development,

loans from multilateral agencies (IFC, ADB), commercial bank term loans or loans backed by export credit guarantees.

Project Financing Risks

GENERAL RISK Completion Risk MARKET RISK FEEDSTOCK RISK POLITICAL RISK FORCE MAJEURE PERMITS

SPONSOR RISK LEGAL RISK ENVIRONMENTAL RISK Foreign exchange risk Interest rate risk

General risks

May be related to deficiencies in the feasibility studies: Too often preliminary studies fail to show upside potential and downside risk of the project.

Many developing countries, have spent time and money studying or constructing projects that turned out to be unfeasible. For example,

During the late 1970s and early 1980s, there were a substantial number of white elephant projects undertaken in developing countries for reasons relating more to national pride and other social considerations than to economic viability.

Projects that succeeded in the 2000s, are likely to be governed primarily by market driven considerations.

The World Bank and the European Bank for Reconstruction and Development will finance feasibility studies, as will the Overseas Private Investment Corporation (OPIC).

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Market Risk

Related to the assessment of whether market exists for the energy produced. This part of the feasibility study is therefore key to the success of the project.

Cash flow projections may be affected by a number of factors, such as economic and industry cycles, demand from the retail and whole sale end users driving request for electrical power.

Competition from other producers, albeit non-existant in the emerging markets.

Market risk could be mitigated to some extent by putting in place contractual assurances.

Two major types of agreement can be entered into, and these are: take or pay contracts or tolling agreements. Take or pay contracts are contracts (generally used for commodities like

electricity, oil and gas). In a typical take or pay contract structure, the contract is entered into between the project company and the buyers, but all payments arising from the contract are assigned by the project company to the lenders.

Production payment agreement (PPA). The financial effects of such contractual scheme are those of a financing arrangements (taking equity interest) through the purchase of a stake in the economical activity of the project. Such assignment guarantees the right to receive part of revenues generated from sales of electricity, up to retirement of the debt.

Tolling Agreement

Tolling agreements are agreements to put a specified amount of raw material per period through a particular processing facility. The toller, who is going to be the purchaser of electric energy (Dispatching), provides the toll processor (Power Plant owner) the natural gas for the production of electric energy and generally pays for transportation costs to the power plant. In this contractual scheme, therefore, both the fuel availability risk and the fuel supply risk are to be borne by the toller, while the toll processor is involved exclusively in the productive process.

The toller pays the toll processor a fee (called toll) Clearly, the tolling agreement is closer to a conversion contract (or a service contract)

than to a sale: the power plant does not sell energy, the toll processor is therefore a

servicer and not a seller. Usually, the toll processor shall: Generate electrical energy with the gas or oil supplied by the toller, Supply energy exclusively (optional) to the toller; Hold the gas in custody on the tollers behalf.

Usually, the toller shall: Supply natural gas and fuel oil; Absorb electric energy in the determined amount or (optional) in minimum

amounts (take or pay clause); Pay the toll processor for the energy supplied, which usually includes: a conversion fee (for the service);

a capacity availability fee; a fee for other services rendered by the toll processor connected to the energy generation.

Feedstock Risk

Related to the availability of feedstock (be it oil, natural gas, water etcetera).

Power plants require significant amounts of fuel to operate on ongoing basis, it is key to the success of the project to make sure that such fuel is available and will remain available during the operation of the plant.

In order to limit such the availability risk, lenders will normally require long-term supply contracts with the principal suppliers to ensure adequate supplies of the necessary volume and quality of feedstock at prices consistent with the financial projections for the project.

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Political Risk

Political risks may be considered a sub-category of force majeure events. Political risks represent a significant factor in structuring the financing of a developing country power project.

Such risk may include: Terrorism, war, civil war, rebellion, revolution; Prevention of, or delay in, the payment of external debt by the host

government or by that of a third country through which payment must

be made; Expropriation by the host government, either of equity debt interests or

assets, or even bank accounts; Cancellation or non-renewal of export licenses; Actions or failure to act by governments in breach of international law,

causing delay or stop in payments;

Destruction of all or part of the manufacturer's assets or debt servicing ability, or interruption of the manufacturer's operations.

Force Majeure

Force Majeure is a risk of a prolonged interruption of operations for period after a project finance project has been completed due to fire, flood, storm, or some other factor beyond the control of the projects sponsors.

Force majeure risks are circumstances that are not within the reasonable control of the parties. The acts beyond the control of the contractor, including acts of God, natural disasters, insurrections, civil disorder, strikes as well as political violence and other

political acts

Permits

Permits are usually the responsibility of the sponsors or contractors. In order to attract

lenders to the project, sponsors and contractors must be able to show that they have fully analyzed the regulatory structure of the host country and acquired, all necessary permits to get the project underway.

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Sponsor Risk

Lenders analyze in depth sponsors and other participants strengths and weaknesses. Such analysis usually focuses on the strict financial strengths of the sponsor, such as

Balance sheet strength, proforma and projected earnings performance, and managerial skills of its directors.

The analysis of the track record of the sponsors in similar projects, and focuses also on examining, last but not least, the political support for the project, which is paramount.

Legal Risk

The contract should be carefully drafted to include provisions of governing law and consent to foreign jurisdiction. In case the consent to foreign jurisdiction is agreed, it will be necessary to ascertain whether local government will enforce and recognize foreign decision, or will tend to retry the matter in the court.

In some developing countries issues of sovereign immunity arise. Sometimes sovereign nations refuse to acknowledge foreign jurisdictions. Usually a provision waiving sovereign immunity both as to the arbitration and the enforcement of the arbitral award is included in contracts. It would be desirable to insert arbitration provisions in the contract, even though lenders are usually not willing to derogate to court jurisdiction.

Sponsors will usually insist for negotiating an arbitration clause or by applying international conventions, such as the Convention on the Settlements of Investment Disputes Between States and Nationals of Other States (ICSID),

Environmental Risk

Projects In the past, were largely constructed with little regard to environmental issues or the adverse social impact of the project on local populations.

Lending institutions, host countries and sponsors are focusing much more attention on these issues today and in the future, particularly for projects that involve the production of significant hazardous waste.

As developing countries do not currently have a detailed codified body of environmental law, lenders will require project compliance with international environmental standard such as the World Bank guidelines or the standards from

environmentally advanced countries, such as the U.S.

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Case Study1: N4 toll road

The Trans African Concessions (Pty) Limited (TRAC) was awarded the 30-year build-operate- transfer (BOT) concession for the N4 toll road between Witbank, South Africa and Maputo, Mozambique.

More than one project company was established and the sponsors interests extend beyond their equity investment. The TRAC Consortium will own the assets for the life of the BOT, and the SBB Consortium, consisting of the primary TRAC Consortium construction companies (sponsors), is contracted to provide the construction and maintenance of the toll road.

Project finance structure

Three construction companies, Bouygues, Basil Read and Stocks & Stocks together own 40 per cent of

the TRAC Consortium and 100 per cent of

SBB. Although they are equity investors in the

project, their primary interest is in the earnings they will generate in constructing and maintaining the toll road. Recognizing this, the other equity and debt investors in the project require these sponsors to maintain their equity position in the TRAC Consortium for a minimum of four years.

TRAC financing structure

Equity

Sponsors R132 million (40 per cent of equity)

Non-sponsor equity holders R199 million (60 per cent of equity)

Debt

R331 million to be increased if required (20 per cent of total financing)

R 1324 million (80 per cent of total financing)

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Non-financing bank participation in issuance of TRAC equity

Lead arranger Future Bank Corporation Merchant Bank (South Africa) Co-arranger in Mozambique Banco Comercial e de Investimentos (Mozambique) Underwriters Investec (South Africa) Banco Comercial e de Investimentos (Mozambique) Future Bank Corporation Merchant Bank (South Africa) Development funding Commonwealth Development Corporation (United Kingdom) South African Infrastructure Fund (South Africa)

ount

469 illion

455 illion

200 illion

200 illion

Equity and debt investors in TRAC

The governments of South Africa and Mozambique jointly and

severally guarantee the debt of TRAC. Under certain conditions, the

Term Grace period Interest

governments also jointly and severally guarantee the TRAC equity.

on principal

Equity (Sponsors/construction companies)

15 years 4

2,125 per cent over the South African bank

Bouygues (France)

discount rate

Basil Read (South Africa)

6 per cent coupon Stocks & Stocks (Sosubjtehct Ato CfrPiIca)

20 years 4

Equity (Non-sponsors) indexation 2,125 per cent over

20 yeSaros uth Afric10an InfrthaesStoruuthcAtfruicarnebaFnkund (South Africa) discount rate

RMB Asset Management (South Africa)

3 per cent over the 15 yeCarsommonw5ealth Development Corporation (United Kingdom)

South African bank South African MutuadliscLoiufnet raAtessurance (South Africa)

175 illion

15 yeMarsetropolitan Life Limited (South Africa)

2,35 per cent over the Sanlam Asset ManSoaugtheAfmricaenbtan(kSouth Africa)

from draw 4 down

discount rate

SDCM (Mozambique) e warranted for the purchase of equity at original value ction with additional equity

Loan Am

Rand term

CPI -linked

DBSA

R m

R m

R m

Subordinated 1 R m

Standby 2 R m

1. Eight per cent of valu 2. Draw down in conjun

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Equity and debt investors in TRAC

Debt (excluding equity investors that are also debt investors)

ABSA Corporate and Merchant Bank (South Africa) Development Bank of South Africa Limited (South Africa) First National Bank (South Africa) Mine Employees and Officials Pension Funds (South Africa) Nedcor Bank (South Africa) Standard Corporate and Merchant Bank (South Africa)