THE CONCEPT OF PROJECT FINANCING-3(1) (1).pptx

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1. Dr. Kiplimo Sirma, PhD Kabarak University THE CONCEPT OF PROJECT FINANCING

2. Introduction This lecture introduces you to the study of project financing, its nature and purpose, the historical development thought of project financing, the importance of other forms of public financing in project management.

3. What is Project Financing? (Meaning of project finance) There is no a single agreed upon definition for project financing. For example, Finnety (1996) defines project financing as: “……the raising of funds to finance an economically separable capital investment project in which the providers of funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project: ”

4. What is Project Financing? (Meaning of project finance) cont….. Nevitt and Fabozzi (2000) define it as: financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan. International Project Finance Association (IPFA), defines project financing as the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where projects debt and equity used to finance the project are paid back from the cash flow generated by the project.

5. What is Project Financing? (Meaning of project finance) cont….. Standard and poor’s corporation (2003) defines a project company as: “….. a group of agreements and contracts between lenders, project sponsors, and other interested parties that creates a form of business organization that will issue a finite amount of debt on inception, will operate in focused line of business and will ask that lenders look only to a specific asset to generate cash flow as a sole source of principal and interest payments and collateral.’ Non-recourse debt – means debt – repayments come from the project company only rather than from any other entity.

6. What is Project Financing? (Meaning of project finance) cont….. Project financing is an innovative and timely financing technique that has been used on many high profile corporate projects such as large scale-natural resources projects, from pipelines and refineries and electricity generating facilities and hydro-electric projects. Project financing is emerging as the preferred alternative to conventional methods of financing infrastructure and other large scale projects worldwide.

7. The Focus of Project Financing The focus of project financing sets up the project to focus on the risks and gains related to the project that would be viably divided among all project parties (namely sponsors, shareholders, subscribers, suppliers or operators bearing a particular part of risk) and also financing subjects. Therefore, it is typical that when transactions of such type are realized, the owners of the project company are responsible for credit payment up to their share on equity, eventually, are responsible for project support in specific cases, which are clearly defined in advance.

8. The Focus of Project Financing cont…. From the forgoing it emerges that project financing focuses on the how (process) and the what (content ) of finance. The process takes many forms. Some will follow a structured format such the menu of financing; others will take the format of the SPV and others will take the unstructured format of third party financing. It should be clear to you that project financing is not project financial management. Project financing concerns itself with sourcing for the funds to finance project activities in a sustainable way. It is about decision making with regard to the different modes available for the projects. Project Financial Management is about the mechanics of accounting for the project finances.

9. The Focus of Project Financing cont…. Therefore, project financing is a responsibility of the project manager while project financial management is a responsibility of the project accountant.

10. Principal terms and criteria for project realizations. Principles of project financing can be applied for either small or large projects. However, in case of non-recourse principle or limited recourse principle towards investors it is necessary to carefully analyze technical, contractual and also financial attributes of the project, preferably in cooperation with qualified advisors in specific cases.  In order to arrange a self-financing project it is necessary to focus on the contractual relationships both with principal off-takers and suppliers on the Mutually Motivated basis. Emphasis on trust worthy agreement concerning project supply and construction is very important with respect to limited recourse principle, these

11. Principal terms and criteria for project realizations. Cont…. contracts should include conveniently arranged engagements supply and payment conditions respecting a fixed price and quality of supply. What must be considered is the capability of parties to fulfill commitments resulting from the agreements and also to bear potential sanctions. Thus, it is preferable that parties are appropriately financially strong.

12. Security focus Security is fundamental aspect of project financing. In projects which presume full recourse, security is an essential part of the conditions for accessing finance. In this case assets are provided and secured to guarantee for the financial resources. In projects in which there is non-recourse clause, security is given in the form of contracts that guarantees the access to funding which is the case for SPVs. In cases of pure project financing, the limited recourse principle is respected and therefore the security represented is usually by all assets of financed project. Common examples include:

13. Security focus cont… Pledge on assets of project company (SPV), Pledge on entity, Pledge on business share in project company Specific security and obligations of owner, investor and suppliers (including advance payments warranty, performance bonds, retained cash etc) The security structure is created individually with respect to a particular project and so to respect its commercial and economic nature.

14. The setup of project financing In the whole process we underline the importance of preparatory phase upon primary project identification, the client receives an indicative term sheet with basic financing parameters outlining basic frame of the Loan terms. In case of acceptance of the indicative term sheet conditions by the client, the process of obligatory credit application follows. After compliance of all conditions set up in the credit application, the credit disbursement may begin. Many project financing organizations focus mainly on energy utilization from primary sources, renewable sources, infrastructure of land constructions and communications, public private partnership, projects (PPP), environmental projects, projects of productive and processing operations etc.

15. Classical versus contemporary understanding of project financing The classical project financing models focuses on equity and debt. In this case security is of paramount importance. This implies that the basis of funding project is dependent on share holders ability to invest own funds or borrow on the basis of security alone. However, since the 1990s, a trend has emerged where other forms of project financing has gone beyond this traditional forms. These emerging trends constitute what is referred to as contemporary. Amongst the emerging common forms includes, project financing that utilized this structure of the project company (SPV), venture capital and a cocktail of other forms. This practice has enhanced funds mobilization for project investment. The distinction is made clearer in the following paragraphs.

16. Classical versus contemporary understanding of project financing cont… A classic project financing is structured to provide for the project company to accrue revenue on a daily basis with payment being made in arrears. This revenue structure is however by no means of universal application and it is now not uncommon for a project’s revenues to include receipts under options or forward sales. A classic debt service cover ratio will be corrupted by a forward sale or an option. Whilst selling forwards and options may be a legitimate (and indeed the most advantageous) business strategy such a sales strategy could also allow a project company to disguise underlying problems with the project which the debt service cover

17. Classical versus contemporary understanding of project financing cont… ratio is intended to reveal. This is because the benefit of forward sales and options, when included in a cash cover ratio, may allow a project company to borrow output and therefore revenue from the future which could be a means of covering up current underlying problems with the project. Under a classic project finance agreement, they would also allow a sponsor to extract received but un-earned cash from the project ( by distributing received but un-earned cash through the repayment of sponsor subordinated loans) at a time when it would be unclear whether such received cash would be required by the

18. Classical versus contemporary understanding of project financing cont… project in the period to which it relates. Given that one of the purposes of the debt service cover ratio is as an early- warning signal, this clearly raises a number of questions to be considered by the lenders. This topic should where relevant be addressed by all participants at an early stage as the solution typically involves complicated amendments to the ratio definitions and the introduction of control accounts or retentions to maintain received but un-earned cash as the project company.

19. Classical versus contemporary understanding of project financing cont… In contemporary project management practice the problem of planning and ensuring of project financing is especially important (fig. 1.1). This is due to the fact that often project budget exceeds many times the company’s own assets, therefore, the only way to ensure adequate financing is the attraction of capital. It should be borne in mind that this work treats profit-oriented investment projects. In case a project is fully financed by a company, it will receive all profits and spend them as it likes. The situation is different when an external investor (hereinafter investor) participates in project financing. Both investor and company are interested to obtain profit from project execution. Then a question arises: how to distribute profit between those parties?

20. Classical versus contemporary understanding of project financing cont… Figure: 1.1 Contemporary investment project financing problems The simplest and most often applied approach to the problem solution is an agreement With investor to apportion him either a fixed amount of money or the profit is distributed Proportionately to invested capital.

21. The development of the project Finance thought Project financing is intricately attached to the history of project management. There was always a need to source for funds. However, the development of project financing thought in its eclectic form as we know it today can be traced to the late 1980s and early 1990s when oil/gas finance on limited recourse basis for formal project finance was considered in the United States of America. Although in the 1930s there was considerable boost by the oil price increases and the development of the North Sea Oil Fields in the 1970s.

22. The development of the project Finance thought cont…… In 1978 the USA witnessed the financing of independent power projects primarily for generating power. This experience was also witnessed in the UK in the ‘90s and thereafter around the world after the deregulation of economies.  In China, the significant project finance related developments started in 1997 which was based on Build-Operate-Transfer (BOT) programme or Build-Operate-Own (BOOT) methods. The development of the BOT enhanced the power of the state planning commission (SPC) over infrastructure investment at a time which the central planning authority’s role in approving

23. The development of the project Finance thought cont…… conventional investment projects is being re-examined. The BOT program can meet the essential requirements of the international lending community without the erosion of natural sovereignty that PRC officials feared. In the 1990s finance for public infrastructure (roads, transport, public buildings etc) was developed through UK’s private finance imitative. In 1993 the 1 st formal project finance was identified and reaching 1994 Project Finance Division was started. In 1998 comprehensive pre-completion coverage of project finance division was done in USA. In 1999 The Division

24. The development of the project Finance thought cont…… was renamed as Structured Finance Division (SFD), the scope expanded to long-term corporate/structured deals. The late 1990s has witnesses the growth of project finance following the explosive worldwide growth in mobile telephone networks. Today in Kenya we are witnessing the growth of project financing through such experiences as in TEAMS (The East African Marine Systems) which has been achieved through project financial engineering. We are likely to see many of such financial arrangement in the infrastructure expansion in the country.

25. Features of Project Finance The project finance has the following characteristics: Eliminate or reduce the lender’s resource to the sponsors. Permit an off-balance sheet - treatment of the debt financing Maximize the leverage of a project Circumvent any restrictions or covenants binding the sponsors under their respective financial obligations. Avoid any negative impact of a project on the credit standing of the sponsors.

26. Features of Project Finance cont…. Obtain better financial conditions when the credit risk of the project is better than the credit standing of the sponsors. Allow the lenders to appraise the project on a segregated and stand alone basis. Obtain a better tax treatment for the benefit of the project, the sponsor or both. Reduce political risks affecting a project. Provision for a “ ringed fence” , project through a special purpose vehicle

27. Project Finance versus Other Forms of Public Funding Project Financing discipline includes understanding the rationale for project financing, how to prepare the financial plan, assess the risks, design the financing mix, and raise the funds. In this sense project Financing is not the same as public financing which is based on tax revenue and other forms of funding provided by governments. In addition, one must understand the cogent analyses of why some project financing plans have succeeded while others have failed. A knowledge-base is required regarding the design of contractual arrangements to support project financing; issues for the host government legislative provisions, public/private

28. Project Finance versus Other Forms of Public Funding cont….. infrastructure partnerships, public/private financing structures; credit requirements of lenders, and how to determine the project's borrowing capacity; how to prepare cash flow projections and use them to measure expected rates of return; tax and accounting considerations; and analytical techniques to validate the project's feasibility Project finance is project specific. It funds a particular project, such as a mine, toll road, railway, pipeline, power station, ship, hospital or prison, which is repaid from the cash-flow of that project. Project finance is different from traditional forms of finance because the financier

29. Project Finance versus Other Forms of Public Funding cont….. principally looks to the assets and revenue of the project in order to secure and service the loan. In contrast to an ordinary borrowing situation, in a project financing the financier usually has little or no recourse to the non-project assets of the borrower or the sponsors of the project. In this situation, the credit risk associated with the borrower is not as important as in an ordinary loan transaction; what is most important is the identification, analysis, allocation and management of every risk associated with the project.

30. Project Finance versus Other Forms of Public Funding cont….. In a no recourse or limited recourse project financing, the risks for a financier are great. Since the loan can only be repaid when the project is operational, if a major part of the project fails, the financiers are likely to lose a substantial amount of money. The assets that remain are usually highly specialized and possibly in a remote location. If saleable, they may have little value outside the project. Therefore, it is not surprising that financiers, and their advisers, go to substantial efforts to ensure that the risks associated with the project are reduced or eliminated as far as possible. It is also not surprising that because of the risks involved, the cost of such finance is generally higher and it is more time consuming for such finance to be provided.

31. THE END THANK YOU