Project Finance

Table of content

1. Introduction

2. Basic definitions and characteristics

3. Applications

4. Stages of Project finance
4.1 Planning stage
4.2 Construction stage
4.3 Run - up stage
4.4 Operating stage
4.5 Divestment stage

5. Identifying and Managing Project Risks
5.1 Identifying Project Risks
5.2 Managing Project Risks
5.2.1 Static methods
5.2.2 Dynamic methods
5.3 The influence of the Basel II Accord on Project finance

6. Examples of project finance

7. Conclusion

1. Introduction

The topic of this essay is project finance. Although it is considered to be a relatively new method of finance, its roots go back to the late 1920's when it was invented to initially provide American wildcatters with longer - term production finance. During the 1930's and 1940's improved engineering techniques were developed, which improved to ability to forecast recovery of oil reserves. banks, which also employed some technical staff applied these techniques, and were thus able to give oil production loans in excess of three years. Or, in other words, they accepted the risk that revenues from oil production would enable the borrower to repay the loan only out of the cash generated by this project. The creditworthiness of the borrower was irrelevant. Nowadays, project finance is not only limited to the petroleum sector, although this sector and other natural resource industries still remain leading users of project finance. A significant part of the project finance market is accounted for by power and other private infrastructure projects. Another significant feature of project finance is, that project finance has nowadays nothing to do with capital constraints, for major international mining, energy or power projects are developed by some of the world's largest companies. Risk management aspects which speak in favour of using project finance are gaining importance. (Compare: Pollio, Page 87)

Concerning the structure of this essay, it will start off by giving some basic definitions and characteristic features of project finance. This chapter will be followed by a description of possible applications of project finance. After that, stages of project finance will be outlined. As this essay mainly concentrates on risks and problems that can occur when investments are project financed the following chapter will deal with that. Besides, special problems concerning the Basel II accord will be outlined, and methods how to judge upon risks and minimize the project's risk exposure will be explained. In the last chapter, some examples of project financed investments will be outlined.

2. Basic definitions and characteristics

Project finance is described in many books and there is no single There is no single agreed upon definition for project finance. For example, Megginson (1997, p. 429) defines project finance as:

...a specialized method of allocating financial risk among creditors, borrowers and investors, whose distinguishing method is the creation of a vehicle company, legally separate from the borrowers, that arranges limited or non - recourse construction fincancing, and then operates the project and pays off its debt after completion.

while Eitemann, Stonehill and Moffett (1998, p.606) define project finance as:

..method that refers to the arrangement of financing for long - term capital projects, large in scale, long in life and generally high in risk".

Another general definition, which summarizes the two definitions mentioned above, describes project finance, as

...the financing of the construction and operation of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt used to finance the project are paid back from the cashflow generated by the project. In other words, project financing is a loan structure that relies primarily on the project's cash flow for repayment, with the project's assets, rights, and interests held as secondary security or collateral.

(Compare: http://www.investopedia.com/terms/p/projectfinance.asp)

The term cash flow will be explained in detail in chapter five.
Non - recourse or limited recourse in this respect means, that lenders base credit risk on the asset value and projected revenues from the facility combined with limited sponsor support, rather than the general assets or credit worthiness of the sponsor.

(Compare: http://www.lexpert.ca/directory/pa.php?area=P7)

Project finance is increasingly becoming popular, as private companies, which are often better equipped and more efficient than governments, are involved in the construction and operation of public infrastructure. Project financing has been used on many large-scale projects, including Euro Disneyland and the Eurotunnel. Increasingly, project financing is emerging as the preferred alternative to conventional methods of financing projects worldwide.

(Compare: http://www.finansbank.nl/finansbank/netherlands/english/corporate_banking/structured_project_finance/definition/)

However, although non general definition for project finance exists, there are four basic characteristics, which are crucial to the success of project finance:

- Separability of the project from its investors

The project is established as a separate legal entity. On the one hand, this protects the assets of the investors, on the other hand it enables the creditors to judge upon the project risks, to assess the ability of the project to service debt and to be assured that debt service payments will be created by the project itself.

- Long - lived capital intensive projects

The project must be large in proportion to the financial resources of its owners and its business lines must be singular, as far as construction, operation and size are concerned. Size is an important factor which is set at the planning stage of the project and is rarely, if ever, changed over the lifetime of the project.

- Cash flow predictability

As repayment of debt is guaranteed through the cash flow, generated by the project, it is important predict those cash flows and thus judge whether the project is able to generate a sufficient cash flow. Oil fields or power plant plants for instance produce homogenous outputs which are relatively easy to predict, as several experts are asked for their opinion in advance of the project. In addition to cash flow predictability, long term project have to be taken into account as well, usually through long - term supplier contracts with price adjustments measured on predicted inflation rates. For instance, a windpark project should always consider a yearly amount of money which is used for maintenance and repair. This amount is normally expressed as percentage value of the purchase price of a windmill. Those contracts will then limit the project company's exposure to business risk, and thus the bank's exposure to credit default risk.

- Finite projects with finite lives

Even for longer term investments it is crucial that projects have a finite point at which all debt have been paid. Contrary to other investments, where cash flows are used for reinvestment for growth and other investment alternatives, project cash flows go directly into debt service.

(Compare: Compare: Eitemann, Stonehill, Moffett; Page 607)

Another important aspect of project finance, which has to be mentioned in this context, stresses that project finance is an important element in the overall corporate risk management. Risks are shared with lending banks and other parties, which participate at the project.

Such a company is defined a Special Purpose Vehicle (SPV), whose only task it is to bring the facilities to readiness of operation and later on manage the production. Sponsors provide this SPV with equity, in return for which they will receive dividends, if the project is successful. The SPV enters into separate agreements with the lending banks, with contractors, that are responsible for building the project, with potential purchasers of the project output and with insurances.

(Compare: Pollio, Page 88 f.)

The Management company is a company that will operate the new facility.

The supplier enter into contracts with the Project company which assures it long-term delivery of raw and operating materials.

Purchasers or Users usually have long-term contracts with the Project company as well, as this is the base of the cash flow predicted.

The capital providers is normally a large bank consortium, but in some cases private investors and state owned and supranational organizations (e.g. the World Bank) are involved in financing projects as well.

Other parties include insurances and governmental institutions.

The following diagram shows the interconnections of the parties involved:^[1]

illustration not visible in this excerpt

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^[1] Figure 1 - Compare: gastvortrag_boeger-projektfinanzierung-grundbegriffe_ anwendungsmoeglichkeiten_ beispiele-23[1].06.2004.pdf