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Abbreviated Contents

Foreword by William L. Megginson xiii

Preface xvii
Acknowledgments xix
About the Author xxi
Chater ! "ntroduction to the #heory and Practice of Pro$ect Finance !
Chater % #he Market for Pro$ect Finance& Alications and 'ectors !(
Chater ) Pro$ect Characteristics* +isk Analysis* and +isk Management )!
Chater , #he +ole of Advisors in a Pro$ect Finance -eal .)
Chater / 0aluing the Pro$ect and Pro$ect Cash Flow Analysis !1!
Chater . Financing the -eal !,2
Chater 2 Legal Asects of Pro$ect Finance %))
Chater 3 Credit +isk in Pro$ect Finance #ransactions and
the 4ew 5asel Caital Accord %3(
vi A 5 5 + 6 0 " A# 6 - C 7 4 # 6 4 # '
Case 'tudies
Case 'tudy ! Cogeneration )%)
Case 'tudy % "taly Water 'ystem ))!
Aendix to Case 'tudy %& 'tructure and Functioning of the
'imulation Model ),!
Case 'tudy ) 8ong 9ong -isneyland Pro$ect Loan )/(
:lossary and Abbreviations )2(
+eferences )(/
"ndex ,1!
Foreword by William L. Megginson xiii
Preface xvii
Acknowledgments xix
About the Author xxi
Chater ! "ntroduction to the #heory and Practice of Pro$ect Finance !
"ntroduction !
!.! What "s Pro$ect Finance; %
!.% Why -o 'onsors <se Pro$ect Finance; %
!.) Who Are the 'onsors of a Pro$ect Finance -eal; ,
!.).! "ndustrial 'onsors in Pro$ect Finance "nitiatives
Linked to a Core 5usiness ,
!.).% Public 'onsors with 'ocial Welfare :oals /
!.).) Contractor='onsors Who -evelo* 5uild* or +un the Plant .
!.)., #he >>Purely?? Financial "nvestor 2
!., 7verview of the Features of Pro$ect Finance 2
!.,.! #he Contractor and the #urnkey Construction
Contract @#9CCA 3
!.,.% 7erations and Maintenance Contractor and the
7BM Agreement (
!.,.) Purchasers and 'ales Agreements (
!.,., 'uliers and +aw Material 'uly Agreements @+M'AsA (
!.,./ Pro$ect Finance as a +isk Management #echniCue !1
viii C 7 4 # 6 4 # '
"ntroduction !(
%.! 8istorical 6volution of Pro$ect Finance and Market 'egments !(
%.% #he :lobal Pro$ect Finance Market %%
%.%.! A Closer Look at the 6uroean Market %.
%.%.% PPP -eveloment %2
Chater ) Pro$ect Characteristics* +isk Analysis* and +isk Management )!
"ntroduction )!
).! "dentifying Pro$ect +isks )%
).!.! Precomletion Phase +isks ))
).!.% Postcomletion Phase +isks )/
).!.) +isks Found in 5oth the PreD and Postcomletion Phases )/
).% +isk Allocation with Contracts 'tiulated by the 'P0 ,/
).%.! Allocation of Construction +isk& #he #urnkey @or 6ngineering*
Procurement* and ConstructionE6PCA Agreement ,/
).%.% Allocation of 'uly +isk& PutDorDPay Agreements ,3
).%.) Allocation of 7erational +isk& 7erations and
Maintenance @7BMA Agreements ,(
).%., Allocation of Market +isk ,(
).) 'ummary of the +isk Management Process .!
Chater , #he +ole of Advisors in a Pro$ect Finance -eal .)
"ntroduction .)
,.! #he +ole of Legal Advisors in Pro$ect Finance -eals
,.!.! Legal Advisor* Legal Advisors* and Law Firms&
#he "nternational Part and Local Legal Counsel
"macts on the +ole of Legal Advisors ..
,.% #he +ole of the "ndeendent 6ngineer in Pro$ect Finance -eals 2/
,.%.! "nitial -ue -iligence +eorting
,.%.% Monitoring +ealiFation of the Pro$ect
@6ngineering and ConstructionA
!./ #he #heory of Pro$ect Finance !1
!./.! 'earate "ncororation and Avoidance of
Contamination +isk !!
!./.% ConGicts of "nterest 5etween 'onsors and Lenders
and Wealth 6xroriation !/
Chater % #he Market for Pro$ect Finance& Alications and 'ectors !(
,.!.% Pro$ect Financing -eveloment 'tages and
ix C 7 4 # 6 4 # '
,.%.) Assistance at the #ime of Plant Accetance 3)
,.%., Monitoring 7erations Management 32
,.) +ole of "nsurance Advisors and "nsurance Comanies in
Pro$ect Finance -eals 33
,.).! +ationale for <sing "nsurance in Pro$ect Finance -eals 3(
,.).% When 'hould "nsurance Products 5e <sed; (1
,.).) Areas Where the "nsurance Advisor "s "nvolved
,.)., #yes of Conventional and Financial "nsurance Products
Available for Pro$ect Finance -eals
,.)./ "ntegrated "nsurance 'olutionsE'tructure and Content (2
,.).. Classification of "nsurance <nderwriters (3
Chater / 0aluing the Pro$ect and Pro$ect Cash Flow Analysis !1!
/.! Analysis of 7erating Cash Flows and #heir 5ehavior in
-ifferent Pro$ect LifeDCycle Phases
/.!.! "nuts for Calculating Cash Flows !1/
/.% -efining the 7timal Caital 'tructure for the -eal !!.
/.%.! 6Cuity !!3
/.%.% 'enior -ebt !!(
/.%.) 0A# Facility !%!
/.%., 'tandDby Facility
/.%./ "dentifying 'ustainable -ebt=6Cuity Mixes for
'onsors and Lenders
/.) Cover +atios !)%
/.).! What Cover +atios Can #ell <s and What #hey Can?t
/.).% Cover +atios as an Alication of the
Certainty 6Cuivalents Method
/., 'ensitivity Analysis and 'cenario Analysis !,1
/.,.! Which 0ariables 'hould 5e #ested in 'ensitivity Analysis; !,!
Chater . Financing the -eal !,2
"ntroduction !,2
..! Advisory and Arranging Activities for Pro$ect Finance Funding !,2
..!.! Advisory 'ervices !,(
..!.% Arranging 'ervices !/%
..!.) "ntegration of Advisory and Arranging 'ervices !/)
..% 7ther +oles in 'yndicated Loans !/2
..) Fee 'tructure !/2
..).! Fees for Advisory 'ervices !/3
x C 7 4 # 6 4 # '
..).% Fees for Arranging 'ervices !/(
..).) Fees to Particiants and the Agent 5ank !/(
..)., 6xamle of Fee Calculation !.1
.., "nternational Financial "nstitutions and Multilateral 5anks !.%
..,.! Multilateral 7rganiFations !.,
..,.% +egional -eveloment 5anks !2!
../ 5ilateral Agencies& -evelomental Agencies and
6xort Credit Agencies @6CAsA !23
../.! -evelomental Agencies !23
../.% 6xort Credit Agencies @6CAsA !2(
... 7ther Financial "ntermediaries "nvolved in Pro$ect Finance !3)
..2 Funding 7tions& 6Cuity !3.
..2.! #iming of the 6Cuity Contribution and 'tandDby 6Cuity
and 6Cuity Acceleration !3.
..2.% Can 'hares in an 'P0 5e Listed on a 'tock 6xchange; !33
..3 Funding 7tions& MeFFanine Financing and 'ubordinated -ebt !33
..( Funding 7tions& 'enior -ebt !(,
..(.! #he 5ase Facility !(/
..(.% Working Caital Facility !(/
..(.) 'tandDby Facility !(.
..(., 0A# Facility !(.
..(./ Loan +emuneration !(.
..(.. Loan Currency !(2
..(.2 +eayment 7tions !(2
..(.3 +efinancing Loans Already :ranted to the 'P0 %1!
..!1 Pro$ect Leasing %13
..!1.! 0aluing the Convenience of a Pro$ect Leasing %13
..!1.% #he #ax 6ffect %!1
..!! Pro$ect 5onds %!!
..!!.! "nvestors in Pro$ect 5onds %!,
..!!.% 0arious Categories of Pro$ect 5onds %!/
..!!.) Municial 5onds %!(
..!!., When 'hould Pro$ect 5onds 5e <sed; %%1
..!!./ Procedure for "ssuing Pro$ect 5onds %%,
Chater 2 Legal Asects of Pro$ect Finance %))
"ntroduction %))
2.! #he Pro$ect Comany %),
2.!.! +easons for "ncororating the Pro$ect in a Pro$ect Comany %)/
2.!.% #he Pro$ect Comany as a Hoint 0enture&
Another +eason to -evelo a Pro$ect in an 'P0 %).
xi C 7 4 # 6 4 # '
2.!.) #he Pro$ect Comany and :rous of Comanies %)2
2.!., Cororate -ocumentation& Articles of "ncororation %)2
2.!./ 7utsourcing the Cororate Functions of the Pro$ect Comany&
8ow the Comany=Pro$ect "s Actually +un %)3
2.% #he Contract 'tructure %)(
2.%.! 5efore the Financing& #he -ue -iligence +eort and the
#erm 'heet %)(
2.%.% ClassiWcation of Pro$ect -ocuments %,%
2.%.) #he Credit Agreement %,)
2.%., 'ecurity -ocuments& 'ecurity "nterests and What #hey -o %./
2.%./ 7ther Finance -ocuments %2,
2.%.. Pro$ect Agreements %23
2.) +efinancing Pro$ect Finance -eals %3/
Chater 3 Credit +isk in Pro$ect Finance #ransactions and the
4ew 5asel Caital Accord %3(
"ntroduction %3(
3.! #he 5asel Committee?s Position on 'tructured Finance #ransactions
@'ecialiFed Lending* 'LA %(1
3.!.! Classes of #ransactions "ncluded in 'ecialiFed Lending
+ating Criteria for 'ecialiFed Lending and #heir Alication to
Pro$ect Finance
3.%.! Financial 'trength %()
3.%.% Political and Legal 6nvironment %()
3.%.) #ransaction Characteristics %(,
3.%., 'trength of 'onsors %(,
3.%./ Mitigants and 'ecurity Package %(,
3.%.. 'ummary of :rading Criteria %(,
3.) +ating :rade 'lotting Criteria of the 5asel Committee and
+ating Agency Practices %(.
3., #he 5asel Accord& 7en "ssues
3.,.! 60ects of the 5asel Proosal on the 'yndicated
Pro$ect Finance Loan Market
3./ "ntroduction to the Concets of 6xected Loss* <nexected Loss*
and 0alue at +isk )1,
3.. -efining -efault for Pro$ect Finance -eals )1.
3.2 Modeling the Pro$ect Cash Flows )13
3.2.! -eWning a +isk Assessment Model )13
3.2.% "dentifying Pro$ect 0ariables and 9ey -rivers )1(
3.2.) "nut 0ariables& 6stimation and -ata Collection )!,
3.2., 6stimating Pro$ect Cash Flow and 0aluing +esults )!2
xii C 7 4 # 6 4 # '
3.3 6stimating 0alue at +isk through 'imulations )!2
3.( -efining Pro$ect 0alue in the 6vent of -efault )!(
3.(.! -eterministic vs. 'tochastic L:- 6stimates )%1
3.(.% L:- -rivers& #he 0alue of <nderlying Assets vs.
-efaulted Pro$ect Cash Flows )%!
3.(.) +estructuring vs. -efault )%!
Case 'tudies )%)
Case 'tudy ! Cogeneration )%)
C!.! 'ituation )%)
C!.% Production Process )%,
C!.) 'onsors of the -eal )%,
C!., Agreements <nderinning the -eal )%/
C!./ Financial 'tructure )%3
C!.. Conclusion& "n Arrigoni?s 7ffice )%(
Case 'tudy % "taly Water 'ystem ))!
"ntroduction ))!
C%.! 5usiness Plan of the Pro$ect ))!
C%.% Assumtions ))%
C%.) Caital 6xenditure )),
C%., Financial +eCuirement and 'ources of Financing )),
C%./ 7erational Period ))2
C%.. 6conomic and Financial +atios ))(
Aendix to Case 'tudy %& 'tructure and Functioning of the
'imulation Model ),!
"ntroduction ),!
A.! 5reakdown of the Financial Model ),%
Case 'tudy ) 8ong 9ong -isneyland Pro$ect Loan )/(
C).! 5ackground on 'yndicated 5ank Lending ).1
C).% #he 8ong 9ong -isneyland Pro$ect Loan ).)
C).) -esigning a 'yndication 'trategy )21
C)., 6xecuting the 'yndication 'trategy )2/
C)./ Conclusion )22
:lossary and Abbreviations )2(
+eferences )(/
"ndex ,1!
William L. Megginson
#his is a timely book examining an extremely timely toic. -uring the ast three
decades* ro$ect finance has emerged as an imortant method of financing largeD
scale* highDrisk domestic and international business ventures. #his is usually defined
as limited or nonrecourse financing of a new ro$ect to be develoed through the
establishment of a vehicle comany @searate incororationA. #hus the distinguishing
features of ro$ect finance @PFA are* first* that creditors share much of the venture?s
business risk and* second* that funding is obtained strictly for the ro$ect itself
without an exectation that the cororate or government sonsor will coinsure the
ro$ect?s debtEat least not fully. PF is most commonly used for caitalDintensive
ro$ects* with relatively transarent cash flows* in riskierDthanDaverage countries*
using relatively longDterm financing* and emloying far more detailed loan covenants
than will conventionally financed ro$ects. @'tefano :atti and his collaborators have
written an excellent and comrehensive survey of ro$ect finance techniCues* roD
cesses* and ractices* which ractitioners and researchers should both value as a key
Pro$ect finance has grown very raidly in the recent ast. 6sty and 'esia @%112A
reort that a record I)%3 billion in PF funding was arranged in %11.* u from I!./
billion in %11) and substantially above the revious record I%!2 billion in %11!. A key
reason why ro$ect finance has emerged so sectacularly recently is that the world
economy is now growing at very nearly its fastest ace ever. 'ince %11)* global :-P
has grown at a comound annual growth rate of almost /J* with growth in develD
oing countries aroaching 2J on average. +aid growth demands even greaterD
thanDaverage investment in infrastructure* such as orts* bridges* roads* telecommuD
nications networks* electric ower generation and distribution facilities* airorts*
intraD and intercity rail networks* and water and sewerage facilities. #he 76C-
redicts that the world will need to send almost ,J of national and global :-P
on infrastructure each year to suort accelerating growthEaround I!.. trillion
annuallyEyet governments are illDlaced to fund more than a fraction of these
investments. #he remainder must come from rivate sources* either as standDalone
xiv F 7 + 6 W7 + -
ro$ects or as ublicDrivate cooerative ventures. Pro$ect finance is certain to figure
rominently in meeting the world?s infrastructure investment needs* esecially in
emerging markets.
PF has also been gaining global financing market share* esecially as a vehicle for
channeling develoment caital to emerging markets. :atti* 9leimeier* Megginson*
and 'teffanoni @%112A reort that over .1J of the value @and .3J of the numberA of
ro$ect finance loans extended between !((! and %11/ were arranged for borrowers
located outside of 4orth America and western 6uroe* with over ,1J of the total
being arranged for Asian ro$ects.
Pro$ect finance is very good at funding secific investments in certain industries.
#yically* PF is used for caitalDintensive infrastructure investments that emloy
estabD lished technology and generate stable returns* referably returns that are
denominated in or can be easily converted to hard currencies. PF is not good at
funding highDrisk investments with uncertain returns* so it is rarely used to fund
research and develoment sending* new roduct introductions* advertising
camaigns* or other otentially highD return intangible investments. PF is used only
for tangible* large ro$ects with known construction risks and wellDestablished
oerating technology. 5realey* Cooer* and
8abib @!((.A also stress that one of the key comarative advantages of ro$ect
is that it allows the allocation of secific ro$ect risks @i.e.* comletion and oerating
risk* revenue and rice risk* and the risk of olitical interference or exroriationA to
those arties best able to manage them. PF is esecially good at constraining
governments from exroriating ro$ect cash flows after the ro$ect is oerating* when
the temtation to do so is esecially great. At this stage* all the investments have
been made and the ro$ect cash flows are committed to aying off the heavy debt
#he key layers in ro$ect finance are the ro$ect sonsors who invest in the
secialDurose vehicle @'P0AK the host government and often stateDowned enterD
risesK the construction and engineering firms resonsible for actually constructing
the ro$ectK legal secialists who design the contracts essential to allocating ro$ect
risks and resonsibilitiesK accounting* financial* and risk assessment rofessionals
who advise the rincial actors and assess ro$ect risksK lead arranging banks that
organiFe and lead the banking syndicate that funds the ro$ect loanK and articiD
ating banks that are art of the loan syndicate. :overnments tyically lay a
much larger and more direct role in ro$ect finance than in any other form of
rivate funding. 'tateDowned enterrises are esecially imortant as counterarties
to ro$ect vehicle comanies* since these state comanies often have rivileged or
monooly ositions as roviders of telecom* electricity* water* and sewerage serD
vices in the host countries.
Pro$ect finance is not really true cororate financeK in fact* PF can be defined in
contrast to standard cororate finance* as clearly discussed in the first chater of this
book. A touchstone of cororate caital investment is the searation of investment
and financing decisions* with cororate managers assessing all investment ro$ects
using a
firmDwide weighted average cost of caital reCuired rate of return* acceting all
4P0 ro$ects* and then funding the caital budget with internal cash flow
@retained earningsA and external securities issues @mostly debtA. Pro$ect finance is the
exact antithD esis of this investment method. "n PF* each ma$or investment ro$ect is
organiFed and funded searately from all others* and the discretion of the 'P0 over
ro$ect cash flows is exlicitly minimiFed. Whereas the essence of cororate finance is
to rovide funding for limitedDliability cororations with eretual life and comlete
discretion over internal caital investment* ro$ect finance involves the creation of
xiv F 7 + 6 W7 + -
an entirely new vehicle
comany* with a strictly limited life* for each new investment ro$ect. A
F 7 + 6 W7 + - xv
ob$ective of PF contracting is to minimiFe the ability of ro$ect sonsors and*
esecially* host governments to exroriate ro$ect cash flows after the caitalD
intensive investment has been made and begins generating high free cash flows.
#hough creation of a vehicle comany is the seminal ste in all ro$ect financD
ings* the work of the syndicated loan lead arranging bank is arguably the most
crucial. #he bank selected by the ro$ect sonsors must erform three vital and
difficult tasks. First* this bank must erform the classic task of erforming due
diligence on the vehicle comany and the ro$ect itself to ensure that all otential
adverse inside information is revealed before loan syndication. #his is esecially
difficult because the sonsor need not be concerned about reutational effectsEit
will arrange but a single financing before exiringEand thus has great incentive to
hide adverse information about the ro$ect and the sonsor?s own motives. 'econd*
the lead arranger must attract a sufficient number and diversity of articiating
banks to fund the PF loan@sA at a rice that is both low enough to ensure ro$ect
solvency and high enough to comensate the banks adeCuately for the @known and
unknownA risks they are taking by extending longDterm* illiCuid financing.
#he lead arranger must also design an otimal loan syndicate that will deter
strategic defaults @Chowdry* !((!K 6sty and Megginson* %11)A but allow for efficient
renegotiation in the event of liCuidity defaults. Finally* the lead arranger must searD
head monitoring of the borrower after the loan closes and discourage the sonsor @or
the ro$ect?s host governmentA from strategically defaulting or otherwise exroriating
ro$ect cash flows. #his is esecially difficult in ro$ect finance* since many such
ro$ects have extremely high uDfront costs but then generate large free cash low
streams after the ro$ect is comleted @5olton and 'charfstein* !((.K 6sty and
Megginson* %11)A. Furthermore* the lenders* reresented by the lead arranger*
tyically have little or no ower to seiFe assets or shut down ro$ect oerations in
ro$ect host countries* so deterrence must be exressed through some other
mechanism. 'urrisD ingly* 9leimeier and Megginson @%111A show that PF loans
have lower sreads than many other tyes of syndicated loans* desite being riskier
nonrecourse credits with longer maturities* suggesting that the uniCue contractual
features of ro$ect finance in fact reduce risk.
#his book analyFes clearly and in detail all of the issues " have raised. #he reader
will find answers to many Cuestions related to the design* organiFation* and funding
of these comlex and fascinating ro$ect finance deals in the ages of this excellent
William L. Megginson
Professor and +ainbolt Chair in Finance
Price College of 5usiness
#he <niversity of 7klahoma
4orman* 7klahoma
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" started working in the ro$ect finance field in !(()* when " was assistant rofessor at
the "nstitute of Financial Markets and Financial "ntermediation at '-A 5occoni
'chool of Management in Milan. My initial involvement was due to the launch of a
new research ro$ect investigating the develoment of ro$ect finance techniCues in
"taly. At that time* 6uroe had $ust started to see the use of this techniCue in the rivate
sector* articularly for the develoment and subseCuent exloitation of offshore crude
reserves @the Forties Fields* off the coast of 'cotlandA. #he "talian ro$ect finance
market was still in its infancy.
From that oint on* the most absorbing field of interest on my research agenda
and in my rofessional activity has been ro$ect finance. "n the ast few years* "?ve
organiFed several teaching activities* both at a graduate level and in M5A rograms* in
"taly and abroad* in order to disseminate knowledge on this imortant field of finance.
"f we look at the numbers* the growth of the market is imressive& From !((, to
%11,* ro$ect finance loans grew at a %,J annual comounded rate* and today this
techniCue accounts for more than /J of the total market for syndicated loans. Let
desite these numbers* this toic has received little attention from the academic or
ractitioners? ress. 4ot many books and no cororate finance international handD
books deal with ro$ect finance. Academic $ournals that have hosted aers on the
sub$ect are very few.
#his is why " decided to collect a large art of the teaching notes* reorts* and
case studies " have develoed over the ast few years and organiFe them into a book.
My ob$ective is to rovide the reader with a comlete view on how a deal can be
organiFedEfrom industrial* legal* and financial standointsEand the alternatives
for funding it. 5ut what must never be forgotten is that ro$ect finance is a highly
leveraged transaction where two rinciles are key to its success& @!A Cash is kingK @%A
lenders control the destiny of the ro$ect. "n fact* lender satisfaction is $ust as
imortant as the legitimate claim of ro$ect sonsors for a satisfactory return on
#his book reCuires no revious exerience in the field* and most of the concets
are exlained for readers who are aroaching this sub$ect for the first time. Let the
xviii P + 6 F AC 6
comlete coverage of all asects involved in structuring deals makes it suitable for
rofessionals as well as graduate=M5A=6M5A students.
Chater ! oens the book with a descrition of the rationale underinning
ro$ect finance deals and a discussion of the difference between cororate finance
and ro$ect finance.
Chater % is dedicated to the analysis of the market at an international level.
#rends clearly demonstrate that ro$ect finance loans are a raidly growing segment
of the syndicated loan market and that the destination of funds is Cuickly changing.
"n articular* the largest ortion of loans is beginning to flow into PPPs @ublicD
rivate artnershisA and into ro$ects where ublic administrative bodies lay the
role of concession awarder to rivate sonsors. "n 6uroe* PPP ro$ects account for
more than ).J of total ro$ect finance loansK in Asia this ercentage stands at a
remarkable %/J.
Chater ) focuses on risk analysis and risk management. #he chater considers
ro$ect contracts as risk management tools. #ogether with insurance olicies* in fact*
they are the most owerful instruments of this kind for reducing a deal?s cash flow
volatility* to the benefit of both lenders and sonsors.
Chater , resents a rare discussion of the role of external consultants in ro$ect
finance transactions. 8ere we also describe what legal advisors* indeendent techD
nical advisors* and insurers are reCuired to do in the overall rocess of deal design*
imlementation and funding.
"n Chater / we discuss how to araise the bankability of the deal. 'ince cash is
king* two toics are of articular relevance& @!A the analysis of cash flows generated
by the venture and @%A the otimal caital structure. #he analysis of cover ratios
@which reresent the balance between cash generation and cash needs for debt serviceA
and sensitivity and scenario analysis comletes the financial analysis of the transacD
Chater . resents an overview of financing otions. 'ince the book targets an
international readershi* we address the role layed by multilateral and bilateral
institutions in develoing countries. 'yndicated loans* eCuity and meFFanine=suborD
dinated loans* and leasing and ro$ect bonds are all included and analyFed from the
economic and financial oints of view.
Chater 2 is dedicated to the legal asects of ro$ect finance. After examining the
secialDurose vehicle* we rovide a thorough descrition of the finance* security*
and ro$ect documents. Although we take the lawyers? ersective* constant attention
is given to the imlications for the finance rofession.
Finally* Chater 3 exlores some recent develoments in the literature on ro$ect
finance* brought about by the forthcoming adotion of the new 5asel "" rules. #he
chater looks at 5asel "" reCuirements for lenders in terms of credit risk analysis of
secialiFed lending deals @which encomasses ro$ect financeA and discusses the asD
yetDunresolved issue of how to measure the value at risk of a ro$ect finance transD
#he book includes three case studies. #he aim of the first* >>Cogeneration*?? is to
describe the setu of the contractual network of a deal and to identify the weak oints
of a ro$ect and ossible available solutions. #he second* >>"taly Water 'ystem*?? is an
6xcelDbased case study that can be used as a business game. #he aim here is to
develo negotiating skills in the articiants* who must maximiFe the tradeDoff of
conflicting utility functions @of sonsors* lenders* and ublic administrationA. #he
third case is a rerint of a classic article by 5en$amin 6sty* from 8arvard 5usiness
'choolK it discusses the syndication rocess of the 8ong 9ong -isney Park.
#his book has taken me more than a year and a half to finish. " hoe that the reader
will areciate all the effort ut into making an udated and comlete handbook.
#his result wouldn?t have been ossible without the continuous suort rovided
by 9aren Maloney* Hay -onahue* and +oxana 5oboc at 6lsevier. My secial thanks
go to 9aren* who from the very beginning enthusiastically suorted my roosal to
ublish a book on the toic with her ublisher and followed the rogress of the work
ste by ste.
Acknowledgments go to all the eole who have worked with me these ast
years* both scholars and rofessionals* to disseminate knowledge on this sub$ect. For
their suggestions and encouragement " would like to thank Andrea 'ironi* Francesco
'aita* Alvaro +igamonti* Mauro 'enati* :iancarlo Forestieri* 6milia :arciaD
Aendini* Andrea +esti* 5en 6sty* 5ill Megginson @who was so kind to dedicate
his time to write the resentationA* 'tefanie 9leimeier* Marco 'orge* 5laise :adaD
necF* "an Cooer* Michel 8abib* :iusee Caellini* 'ergio Ferraris* "ssam 8allak.
'ecial thanks to my contributors in this volume Alessandro 'teffanoni and
-aniele Corbino @for the release of the excel file suorting the "taly Water CaseA*
Massimo 4ovo @for the legal art of the bookA* Fabio Landriscina and Mark Pollard
@for the insurance sectionA.
Alessandro 'teffanoni is the head of ro$ect finance team in "nterbanca* the
"talian merchant bank of 5anca AntonvenetaD A54 AM+7 :rou* and $ointed
the bank in %11. as deuty head of the team. 8e has been involved in advisory and
structuring roles in PF"* waste to energy and renewable energy Pro$ect financing.
From %111 to %11. he was member of ro$ect finance team in 5anca "ntesa focused
on domestic and international PF" and 6nergy transactions. Alessandro has been
collaborating in L. 5occoni <niversity and in 5occoni 5usiness 'chool since !((3.
-aniele Corbino has been working for the ro$ect finance desk of "ntesa 'anD
aolo since %11,* in different industries like ower and energy* media and telecom*
infrastructures and shiing finance. 8e serves as lecturer in investment banking and
structured finance at <niversitaM 5occoni and '-A 5occoni 'chool of
xx A C 9 4 7 WL 6 - : M6 4 # '
Massimo 4ovo is an "talian Cualified lawyer and a artner at Clifford Chance*
Milan. 8e studied at the <niversity of #urin @H-A* the 'cuola 'ueriore 6nrico
Mattei @M5AA and at Columbia <niversity Law 'chool @LLMA. 8e secialiFes in
Pro$ect Finance* AcCuisition Finance and +eal 6state Finance and is a regular
contributor to the ostDgraduate courses at the 5occoni <niversity 5usiness 'chool.
Fabio Landriscina is 8ead of Pro$ect Financing #eam of Marsh 'A in "taly and
he is in charge of 5anks "nsurance Advisory coDordination and develoment for the
"talian market. 8e has been working in the Pro$ect Financing field for eight years
and has been involved in the great ma$ority of the main PF"=PPP ro$ects in "taly
acting both as "nsurance Advisor and Placing 5roker both for Lenders and=or for
the Pro$ect Comanies. 8e $oined Marsh in %11, from another ma$or international
broker* where he was 'enior Account 6xecutive with articular involvement in
the Pro$ect Financing activity. Fabio holds an 6conomics degree from 5rescia
Mark Pollard is 8ead of "ndustry Practices for Marsh 6uroe* Middle 6ast and
Africa* and the Managing -irector of Marsh "nc. 'ince the late ?(1s* he has been
resonsible for Pro$ect Financing consulting in "taly* and has ro$ect managed a
number of innovative rogrammes. 5efore $oining Marsh* Mark worked as underD
writer on international technological and infrastructure risks for a ma$or 6uroean
insurance comany. Mark holds a Master of Arts degree from 7xford <niversity*
graduating in !(3% in Classics* and is a Fellow of the Chartered "nsurance "nstitute.
#hanks also to Hill Connelly and Peter -e 8unt for their hel in translating the
manuscrit and LorenFo Marinoni for the valuable suort in rearing the instructD
ors? material.
Finally* thanks to all my friends and relatives who " have taken time and
attention away from while sending days @and sometimes nightsA writing the ages
of this book. " want to dedicate it to my mother :raFiella* whose love her son is one
of the most recious $ewels in his life.
'tefano :atti* Milan* Hune %112
About the Author
'tefano :atti is Professor of 5anking and Finance at 5occoni <niversity in Milan*
where he is also the -irector of the 5'c of 6conomics and Finance and -irector of
the "#PD"nternational #eachers? Program at '-A 5occoni 'chool of Management.
8e has ublished a large number of books and aers related to financial intermediD
ation* investment banking* and structured finance. 8e also serves as a consultant for
industrial and financial firms and sits on several boards of directors of "talian and
multinational firms.
C 8 A P # 6 +
"ntroduction to the #heory and Practice
of Pro$ect Finance
#his chater introduces the theory and ractice of ro$ect Wnance. "t rovides a general
overview of everything that will be analyFed in greater detail in subseCuent chaters.
We believe it is useful to start with a chater describing the salient features of a ro$ect
Wnance deal* essential ro$ect Wnance terminology* the basics of the four stes of risk
management @identiWcation* analysis* transfer* and residual managementA* together
with the theory that Wnancial economics has develoed on this toic. #his chater also
hels to understand the reasons for using ro$ect Wnance as comared with more
traditional aroaches emloyed by comanies to Wnance their ro$ects.
'ection !.! rovides an exact deWnition of the term ro$ect Wnance so as to avoid
confusion with other* aarently similar contractual structures. #he imression is* in
fact* that all too often cororate loans issued directly to the arty concerned are
confused with true ro$ect Wnance structures.
'ection !.% analyFes the reasons why ro$ect Wnance is used by sonsoring Wrms
and the advantages it can bring to sonsors and lenders* and it highlights the main
di0erences between cororate Wnancing and ro$ect Wnancing.
'ection !.) reviews the main categories of ro$ect sonsors and clariWes the
di0erent reasons why each category is interested in designing and managing a new
ro$ect Wnance deal.
'ection !., introduces the basic terminology of ro$ect Wnance and illustrates the
key contracts used in the deal to manage and control the risks involved in the ro$ect.
#his section is an introduction to the toic of risk management* which is discussed in
greater detail in Chater ).
Finally* 'ection !./ reviews the theory of ro$ect Wnance and the most
imortant concets associated with the Wnancial economics of ro$ect Wnance&
% C 8 AP # 6 + ! "ntroduction to the #heory and Practice of Pro$ect Finance
contamination risk* the coinsurance e0ect and wealth exroriation of lenders by
sonsoring Wrms.
!.! What "s Pro$ect Finance;
A huge body of literature is available today on the sub$ect of structured Wnance in
general and ro$ect Wnance in articular. #he ma$ority of authors agree on deWning
ro$ect Wnance as Wnancing that as a riority does not deend on the soundness and
creditworthiness of the sonsors* namely* arties roosing the business idea to
launch the ro$ect. Aroval does not even deend on the value of assets sonsors
are willing to make available to Wnancers as collateral. "nstead* it is basically a
function of the ro$ect?s ability to reay the debt contracted and remunerate caital
invested at a rate consistent with the degree of risk inherent in the venture concerned.
Pro$ect Wnance is the structured Wnancing of a seciWc economic entityEthe 'P0*
or secialDurose vehicle* also known as the ro$ect comanyEcreated by sonsors
using eCuity or meFFanine debt and for which the lender considers cash Gows as being
the rimary source of loan reimbursement* whereas assets reresent only collateral.
#he following Wve oints are* in essence* the distinctive features of a ro$ect
Wnance deal.
!. #he debtor is a ro$ect comany set u on an ad hoc basis that is Wnancially
and legally indeendent from the sonsors.
%. Lenders have only limited recourse @or in some cases no recourse at allA to the
sonsors after the ro$ect is comleted. #he sonsors? involvement in the deal
is* in fact* limited in terms of time @generally during the setu to startDu
eriodA* amount @they can be called on for eCuity in$ections if certain ecoD
nomicDWnancial tests rove unsatisfactoryA* and Cuality @managing the system
eLciently and ensuring certain erformance levelsA. #his means that risks
associated with the deal must be assessed in a di0erent way than risks
concerning comanies already in oeration.
). Pro$ect risks are allocated eCuitably between all arties involved in the transD
action* with the ob$ective of assigning risks to the contractual counterarties
best able to control and manage them.
,. Cash Gows generated by the 'P0 must be suLcient to cover ayments for
oerating costs and to service the debt in terms of caital reayment and
interest. 5ecause the riority use of cash Gow is to fund oerating costs
and to service the debt* only residual funds after the latter are covered can be
used to ay dividends to sonsors.
/. Collateral is given by the sonsors to lenders as security for receits and assets
tied u in managing the ro$ect.
!.% Why -o 'onsors <se Pro$ect Finance;
A sonsor can choose to Wnance a new ro$ect using two alternatives&
!. #he new initiative is Wnanced on balance sheet @cororate WnancingA.
%. #he new ro$ect is incororated into a newly created economic entity* the 'P0*
and Wnanced o0 balance sheet @ro$ect WnancingA.
) Why -o 'onsors <se Pro$ect Finance;
Alternative ! means that sonsors use all the assets and cash Gows from the
existing Wrm to guarantee the additional credit rovided by lenders. "f the ro$ect is
not successful* all the remaining assets and cash Gows can serve as a source of
reayment for all the creditors @old and newA of the combined entity @existing Wrm
lus new ro$ectA.
Alternative % means* instead* that the new ro$ect and the existing Wrm live two
searate lives. "f the ro$ect is not successful* ro$ect creditors have no @or very
limitedA claim on the sonsoring Wrms? assets and cash Gows. #he existing Wrm?s
shareholders can then beneWt from the searate incororation of the new ro$ect into
an 'P0.
7ne ma$or drawback of alternative % is that structuring and organiFing such a
deal is actually much more costly than the cororate Wnancing otion. #he small
amount of evidence available on the sub$ect shows an average incidence of transacD
tion costs on the total investment of around /N!1J. #here are several di0erent
reasons for these high costs.
!. #he legal* technical* and insurance advisors of the sonsors and the loan
arranger need a great deal of time to evaluate the ro$ect and negotiate the
contract terms to be included in the documentation.
%. #he cost of monitoring the ro$ect in rocess is very high.
). Lenders are exected to ay signiWcant costs in exchange for taking on greater
7n the other hand* although ro$ect Wnance does not o0er a cost advantage* there
are deWnitely other beneWts as comared to cororate Wnancing.
!. Pro$ect Wnance allows for a high level of risk allocation among articiants in
the transaction. #herefore the deal can suort a debtDtoDeCuity ratio that
could not otherwise be attained. #his has a ma$or imact on the return of
the transaction for sonsors @the eCuity "++A* as we exlain in Chater /.
%. From the accounting standoint* contracts between sonsors and 'P0s are
essentially comarable to commercial guarantees. 4onetheless* with ro$ect
Wnance initiatives they do not always aear >>o0 balance sheet?? or in the notes
of the directors.
). CororateDbased Wnancing can always count on guarantees constituted by
ersonal assets of the sonsor* which are di0erent from those utiliFed for the
investment ro$ect. "n ro$ect Wnance deals* the loan?s only collateral refers to
assets that serve to carry out the initiativeK the result is advantageous for
sonsors since their assets can be used as collateral in case further recourse
for funding is needed.
,. Creating a ro$ect comany makes it ossible to isolate the sonsors almost
comletely from events involving the ro$ect if Wnancing is done on a noD
recourse @or more often a limitedDrecourseA basis. #his is often a decisive
oint* since cororate Wnancing could instead have negative reercussions on
riskiness @therefore cost of caitalA for the investor Wrm if the ro$ect does not
make a roWt or fails comletely.
#he essential ma$or di0erences between ro$ect Wnancing and cororate Wnancing
are summariFed in #able !D!.
, C 8 AP # 6 + ! "ntroduction to the #heory and Practice of Pro$ect Finance
#A5 L6 !D! Main -ifferences 5etween Cororate Financing and Pro$ect Financing
Factor Cororate Financing Pro$ect Financing
:uarantees for financing Assets of the borrower
@alreadyDinDlace firmsA
6ffect on financial elasticity +eduction of financial elasticity
for the borrower
Pro$ect assets
4o or heavily reduced effect for
Accounting treatment 7n balance sheet 7ffDbalance sheet @the only effect
will be either disbursement to
subscribe eCuity in the 'P0 or
for subordinated loansA
Main variables underlying
the granting of financing
Customer relations
'olidity of balance sheet
Future cash flows
-egree of leverage utiliFable -eends on effects on borrower?s
balance sheet
-eends on cash flows generated
by the ro$ect @leverage is usually
much higherA
!.) Who Are the 'onsors of a Pro$ect Finance -eal;
5y articiating in a ro$ect Wnancing venture* each ro$ect sonsor ursues a clear
ob$ective* which di0ers deending on the tye of sonsor. "n brief* four tyes of
sonsors are very often involved in such transactions&
. "ndustrial sonsors* who see the initiative as ustream or downstream integrated
or in some way as linked to their core business
. Public sonsors @central or local government* municialities* or municialiFed
comaniesA* whose aims center on social welfare
. Contractor=sonsors* who develo* build* or run lants and are interested in
articiating in the initiative by roviding eCuity and=or subordinated debt
. Purely Wnancial investors
!.).! "ndustrial 'onsors in Pro$ect Finance "nitiatives
Linked to a Core 5usiness
Let?s use an examle to illustrate the involvement of sonsors who see ro$ect Wnance
as an initiative linked to their core business. For instance* a ma$or ro$ect involving
":CC @integrated gasiWcation combined cycleA cogeneration includes oututs @energy
and steamA generated by fuels derived from reWnery byDroducts. #he residue resultD
ing from reWning crude oil consists of heavy substances such as tarK the disosal of
this toxic waste reresents a cost for the roducer.
#he sonsors of these ro$ect Wnance deals are often oil comanies that own
reWneries. "n fact* an ":CC lant allows them to convert the tar residue into energy
by means of ecoDcomatible technologies. #he byDroduct is transformed into fuel for
the lant @downstream integrationA. #he sonsor* in turn* by sulying feedstock for
the ower lant* converts a cost comonent into revenue* hence a cash inGow.
/ Who Are the 'onsors of a Pro$ect Finance -eal;
Lenders in this kind of ro$ect carefully assess the osition of the sonsor* since the
'P0 should face a low suly risk. #he sonsor=sulier has every interest in selling
the tar romtly to the 'P0. "f this does not haen* the sulier not only will forfeit
related revenue but will be sub$ect to enalties as well.
!.).% Public 'onsors with 'ocial Welfare :oals
8istorically* ro$ect Wnance was Wrst used in the oil extraction and ower roducD
tion sectors @as later detailed in Chater %A. #hese were the more aroriate
sectors for develoing this structured Wnancing techniCue because they were
marked by low technological risks* a reasonably redictable market* and the
ossibility of selling what was roduced to a single buyer or a few large buyers
based on multiyear contracts @like takeDorDay contracts* which are discussed in
detail in Chater 2A.
'o ro$ect Wnance initially was a techniCue that mainly involved arties in the
rivate sector. 7ver the years* however* this contractual form has been used increasD
ingly to Wnance ro$ects in which the ublic sector lays an imortant role @governD
ments or other ublic bodiesA. As we see in the next chater* governments in
develoing countries have begun to encourage the involvement of rivate arties to
realiFe ublic works.
From this standoint* it is therefore imortant to distinguish between ro$ects
launched and develoed exclusively in a rivate context @where success deends
entirely on the ro$ect?s ability to generate suLcient cash Gow to cover oerating
costs* to service the debt* and to remunerate shareholdersA from those concerning
ublic works. "n the latter cases success deends above all on eLcient management of
relations with the ublic administration and* in certain cases* also on the contribution
the ublic sector is able to make to the ro$ect.
PrivateDsector articiation in realiFing ublic works is often referred to as PPP
@ublicNrivate artnershiA. "n these artnershis the role of the ublic administraD
tion is usually based on a concession agreement that rovides for one of two
"n the Wrst case* the rivate arty constructs works that will be used directly by the
ublic administration itself* which therefore ays for the roduct or service made
available. #his* for instance* is the case of ublic works constructing hositals*
schools* risons* etc.
#he second ossibility is that the concession concerns construction of works in
which the roduct=service will be urchased directly by the general ublic. #he
rivate arty concerned will receive the oerating revenues* and on this basis
@ossibly with an in$ection in the form of a ublic grantA it will be able to reay
the investment made. 6xamles of this tye of ro$ect are the construction of toll
roads* the creation of a cell hone network* and the suly of water and sewage
0arious acronyms are used in ractice for the di0erent tyes of concession. 6ven
if the same acronyms often refer to di0erent forms of contract* the following are very
. 57# @build* oerate* and transferA
. 577# @build* own* oerate* and transferA
. 577 @build* oerate* and ownA
. C 8 AP # 6 + ! "ntroduction to the #heory and Practice of Pro$ect Finance
"n a 57# framework* the ublic administration delegates lanning and realiFaD
tion of the ro$ect to the rivate arty together with oerating management of the
facility for a given eriod of time. -uring this eriod the rivate arty is entitled to
retain all receits generated by the oeration but is not the owner of the structure
concerned. #he facility will then be transferred to the ublic administration at the end
of the concession agreement without any ayment being due to the rivate arty
A 577# framework di0ers from the 57# framework in that the rivate arty
owns the works. At the end of the concession term the works are transferred to the
ublic administration* and in this case a ayment for them can be established.
Lastly* the 577 framework has characteristics in common with the other two.
#he rivate arty owns the works @as in the 577# caseA* but ownershi is not
transferred at the end of the concession agreement. #herefore the residual value of
the ro$ect is exloited entirely by the rivate sector.
#he country that Wrst launched a systematic rogram of such ro$ects was the
<9* where these PPPs formed art of what was known as the PF"* or Private Finance
"nitiative. #he PF" @Private Finance "nitiativeA is a strategic economic olicy introD
duced in the <nited 9ingdom in !((% to migrate the ublic administration from
being the owner of assets and infrastructures to becoming a urchaser of services
from rivate arties. 6very year a secial deartment of the #reasury Ministry
establishes general lans for ventures involving rivate caital* subdivided into
three categories& @!A comletely selfDWnanced works @not reCuiring any ublic sector
caitalAK @%A $oint ventures @works for which the ublic sector rovides grants while
oerations remain in the hands of rivate artiesAK @)A contracted sale of services to
the ublic sector @where rivate arties bear the cost of the necessary structures to
rovide the services urchasedA.
!.).) Contractor='onsors Who -evelo* 5uild*
or +un the Plant
Clearly* in this case a contractor is interested in sulying lants* materials* and
services to the 'P0. #his aim of this layer is to articiate in the ro$ect Wnance deal&
!. in the initial hase by handling design and construction of the lantK
%. during the oerational hase* as shareholder of the 'P0.
#his interest is entirely ossible* and is in fact legitimate* in rivate ro$ects.
8owever* PPPs involving the ublic administration are normally sub$ect to more
rigid rocurement rocedures. #hese rules serve to safeguard the ublic?s interest and
ensure that sonsors win contracts for a given ro$ect only after undergoing a more
or less comlex ublic tender.
When the contractor is also a shareholder in the 'P0* there is an additional
advantage& #he contractor will beneWt directly if the ro$ect succeeds. As builder*
this comany will be highly motivated to Wnish the lant on time* within budget* and
in accordance with the erformance seciWcations set down in the contract. "n fact* in
this way oerations can be activated as lanned* the ro$ect will begin to generate
cash Gows* and* as a shareholder in the 'P0* the contractor will start earning
dividends after having collected down ayments for construction.
2 7verview of the Features of Pro$ect Finance
"t is Cuite common to Wnd contractors who also o0er to run the lant once it is
oerational. Plant managers have a clear interest in sonsoring a ro$ect Wnance deal
because they would beneWt both from cash Gows deriving from the oeration and
maintenance @7BMA contract as well as from dividends aid out by the 'P0 during
the oerational hase.
!.)., #he >>Purely?? Financial "nvestor
#he urely Wnancial investor lays the art of sonsor of a ro$ect Wnance initiative
with a single goal in mind& to invest caital in highDroWt deals. #hese layers seek
substantial returns on their investments and have a high roensity for riskK as such
they are similar in many ways to venture caitalists. #heir involvement in a structured
Wnance deal is seen @from the ersective of the banks roviding Wnancial backingA as
a rivate eCuity activity in which urely Wnancial investors lay a assive role.
"n other words* they have no say in the industrial olicies of the 'P0. "n ractice*
cases in which urely Wnancial investors are shareholders in the 'P0 are still few* but
the number is growing.
"n Chater .* we will see that along with traditional loans* almost all multilateral
develoment banks imlement investment lans in the eCuity caital of the ro$ect
comanies. What is more* rivate banks are also develoing rivate eCuity alternaD
tives to granting loans for ro$ect Wnance deals. "n the <9* for instance* with various
ro$ect Wnance ventures in the health Weld* banks have oted to Wnance ro$ects with
eCuity rather than loans* in articular in cases where ro$ect Wnance could not sustain
suLcient debtDtoDeCuity ratios.
!., 7verview of the Features of Pro$ect Finance
A ro$ect Wnance deal can always be viewed as a contractual network that revolves
around the 'P0. "n fact* each counterarty sets u contracts with the 'P0 that refer
to seciWc hases or arts of the ro$ect. #he deal is successful when all the interests
of the arties involved @though not always entirely comatibleA are satisWed at the
same time. 6very contract* in turn* can include subcontracts with third arties and
the rovision of collateral guarantees.
Figure !D! rovides a grahic reresentation of a tyical contract framework used
in ro$ects involving cogeneration of electrical ower.
'ome clariWcations are called for regarding the model illustrated in Figure !D!.
First* a single articiant in a ro$ect Wnance deal can take on a number of roles.
"n cogeneration ro$ects* for examle* the contractor can be sonsor* builder* and
oerator of a lant at the same time* either alone or in a $oint venture with others.
"n wasteDtoDenergy facilities* the city administration or a consortium of communities
or a municialiFed comany might act as sulier of solid waste to burn as fuel as
well as shareholder in the 'P0. 5anks can be sonsors and lenders simultaneously.
"t should also be said that in ro$ect Wnance transactions* the fact that only a few
layers @i.e.* the sonsorsA articiate in a variety of ways is erfectly natural. "n fact*
the rimary interest of sonsors is to aroriate the highest share of cash Gows
generated by the ro$ect. 5y laying many di0erent roles* they will gain from greater
Gows @in terms of both higher revenue and lower costs* for examle* if the sonsor
also buys the 'P0?s outut at articularly advantageous conditionsA.
3 C 8 AP # 6 + ! "ntroduction to the #heory and Practice of Pro$ect Finance
bank facilities
an !ermits
e'%it& s%bscri!tion
(SA *+,
TK$$ *2,
F " : < + 6 !D! #yical Contract 'tructure of a Pro$ect Finance -eal O@!A fuel suly agreementK @%A raw
material suly agreementK @)A oerating and maintenance agreementK @,A turnkey construction contractP
'econd* not all the organiFations shown in Figure !D! are necessarily involved in a
ro$ect Wnance deal. For examle* with domestic ventures* there is no foreign host
government* and a deal with exclusively rivate actors would not count sonsors
belonging to the ublic administration.
#he third oint has to do with the Wnancing structure. Figure !D! assumes that
credit is granted directly in favor of the 'P0. 8owever* Wnancing may also be
structured through leasing lants @see 'ection ..!1A* or with a bond issue on the
stock market @see 'ection ..!!A.
Figure !D! indicates that the success of the deal deends on the network of
contracts that the 'P0 sets u with all the di0erent counterarties. A Cuick overview
of such contracts can hel in introducing the risk management rocess in ro$ect
Wnance* which is analyFed further in Chater ).
!.,.! #he Contractor and the #urnkey Construction
Contract @#9CCA
#he contractor is the comany @or consortium of comaniesA that wins the tender for
the design and construction of a given lant on the basis of a WxedDrice turnkey
contract* often known as 6PCE6ngineering* Procurement* and Construction. ConD
tract obligations are taken on by the main contractor @who commits directly to the
'P0A and are later assed on to consortium members. Among these layers* there
may also be an oerator or oeration and maintenance contractor who stes in after
construction is comlete.
#he main contractor is normally resonsible for damages resulting from delays in
comleting the facilities but may also receive an early comletion bonus if the ro$ect
is Wnished ahead of schedule. "n addition* the contractor is reCuired to ay enalty
fees @liCuidated damagesA if the lant does not ass erformance tests on certain key
variables at guaranteed levels. For examle* with a ower lant* the minimum
erformance standard refers to the roduction of energy and steam* emissions* and
heat rate* as certiWed by an indeendent technical advisor @see 'ection ,.%A. 7n the
other hand* the contractor again can earn a bonus if the certiWed erformance of the
ower lant is better than that established in the contract with the 'P0.
!.,.% 7erations and Maintenance Contractor
and the 7BM Agreement
#he oerator is the counterarty who takes over the lant after the construction
hase is comlete. #his comany handles maintenance for a set number of years*
guaranteeing the 'P0 that the lant is run eLciently in keeing with the reestabD
lished outut arameters. #herefore* the oerator lays a key role during the
ostcomletion hase of the ro$ect Wnance initiative.
#he oerator may be an alreadyDinDlace comany @erhas even one of the
sonD sorsA or a $oint venture created to serve as oerator by the shareholders of
the 'P0. "n these cases* two or more sonsors constitute an ad hoc service comany
and grant eCuity. #he ownershi structure of the service comany may or may not be
the same as in the 'P0.
!.,.) Purchasers and 'ales Agreements
#hese are the counterarties to whom the 'P0 sells its outut. Purchasers of goods or
services roduced by the lant might be generic* which means not deWned ex ante
@i.e.* a retail marketA or a single buyer who commits to buying all the ro$ect
comany?s outut. "n this case* urchasers are called o0takers* who buy outut
wholesale based on longDterm urchase contracts often signed on a takeDorDay
basis @see Chaters ) and 2 for more detailsA.
6xamles of the Wrst case can be found in the suly of drinking water* traLc Gow
on a toll road* and tourist Gow in a hotel or leisure ark. 7ther examles are ublic
services managed on the basis of concession contracts* such as cemeteries* arking
lots* and sorts facilities.
A case of wholesale suly would be ro$ects in the ower sector. With cogeneraD
tion lants* for examle* ower is sold to industrial users or utilities along with steam.
"n this case* it is not uncommon for 'P0s to set u a leasing contract with the steam
buyer for the land facing the buyer?s industrial facility. 'imilar circumstances can be
seen in the oil and gas and mining sectors* where outut of a given oil Weld or deosit
is sold on a longDterm basis to one buyer or a few buyers. "n the PPP sector there are
also cases of wholesale suly. "n the health Weld* for examle* users do not ay for
hosital servicesK instead* relative costs are covered directly by a branch of the ublic
!.,., 'uliers and +aw Material 'uly
Agreements @+M'AsA
#hese comanies suly inut to the 'P0 to run the lant on the basis of longDterm
contracts that include arrangements for transorting and stocking raw materials.
"n ractice* in various cases of ro$ect Wnance ventures there are rarely more than a
few suliers. "n fact* reference is generally given to only one sulier* often
a sonsor* with which longDterm +M'As are closed @see Chaters ) and 2 for
more detailsA. 6xamles of ro$ects with a sole sulier are biogas roduction lants.
"n these circumstances* the solid waste for comosting is sulied by a local body
or a consortium of local organiFations that rovide trash for the landWll @i.e.* the
raw material for biogas roductionA.
!.,./ Pro$ect Finance as a +isk Management #echniCue
#he rocess of risk management is crucial in ro$ect Wnance* for the success of any
venture and is based on four closely related stes&
!. +isk identiWcation
%. +isk analysis
). +isk transfer and allocation of risks to the actors best suited to ensure coverage
against these risks
,. +esidual risk management
+isks must be identiWed in order to ascertain the imact they have on a ro$ect?s
cash GowsK risks must be allocated* instead* to create an eLcient incentiviFing tool for
the arties involved. "f a ro$ect articiant takes on a risk that may a0ect erforD
mance adversely in terms of revenues or Wnancing* this layer will work to revent the
risk from occurring.
From this ersective* ro$ect Wnance can be seen as a system for distributing risk
among the arties involved in a venture. "n other words* e0ectively identifying and
allocating risks leads to minimiFing the volatility of cash inGows and outGows
generated by the ro$ect. #his is advantageous to all articiants in the venture*
who earn returns on their investments from the Gows of the ro$ect comany.
+isk allocation is also essential for another reason. #his rocess* in fact* is a vital
rereCuisite to the success of the initiative. "n fact* the security ackage @contracts
and guarantees* in the strict senseA is set u in order to obtain Wnancing* and it is built
to the exclusive beneWt of original lenders. #herefore* it is imossible to imagine that
additional guarantees could be given to new investors if this were to rove necessary
once the ro$ect was under way.
Figure !D% rovides a model of the risk management rocess* highlighting the
critical stes and the ways risks can be managed. #hese are discussed in greater detail
in Chater ) @allocation through contracts with relevant counterarties of the 'P0A
and Chater , @allocation through insurance oliciesA.
!./ #he #heory of Pro$ect Finance
< to now attention has been focused on introducing the basic comonents of a
ro$ect Wnance transaction as they are known in ractice. #his section comletes the
icture and looks at the same concets from the standoint of Wnancial economics
theory. #he aim is to rovide a theoretical rationale for the use of ro$ect Wnance in
the broader context of cororate Wnance theory.
!! #he #heory of Pro$ect Finance
Allocation to
S"V co%nter!arties
t3ro%-3 o!eratin-
*$3a!ter 1,
Allocation to
*ins%rance !olicies,
*$3a!ter 2,
Resi%al risk
borne b& t3e
(inal loan4bon
Total risk
F " : < + 6 !D% #he +isk Management Process in Pro$ect Finance
!./.! 'earate "ncororation and Avoidance
of Contamination +isk
<nder normal circumstances* an alreadyDinDlace comany that wants to launch a
new investment ro$ect would Wnance it on balance sheet. As a result* the ro$ect will
be incororated in the comany?s business and the relative increase in the value of its
assets will deend on the siFe of the new ro$ect as comared with the rest of the
comany?s assets.
7nce the ro$ect is u and running it will generate cash Gows and will be able to
rovide a return on the caital emloyed* which it is assumed eCuals r.
5ut because this is a new ro$ect* comany management is faced with the roblem
of Wnancing the new venture. "n an alreadyDinDlace comany* coverage would Wrst and
foremost come from cash Gow generated by alreadyDexisting business or by recourse to
new debt or by raising fresh eCuity. 7n the contrary* as seen in 'ection !.%* ro$ect
Wnance involves the searation between an existing comany @or more than one* as is
often the caseA and a new industrial ro$ect.
4aturally each otion has a cost for the comany. "n the case of selfDWnancing and
eCuity this will be cost of eCuity @k
A* whereas in the case of debt the cost of this is @k
#he di0erence between the two Wnancing strategies is shown in Figure !D).
We assume that the cost of eCuity can be estimated using the standard CAPM
@caital asset ricing modelA&
Q r
R @r
A b
"n the eCuation* the excess return for the stock market is measured by the
exression @r
A* in which r
is the return for a general stock exchange index
calculated over a long eriod and r
is the riskDfree rate for government securities. 'o*
for instance* if it is assumed that the e0ective return for /Dyear government securities
is ,./J* the excess return for the stock market is /J* and stock risk @ bA eCuals
1.3* then the net cost of caital will be 3./J* that is* ,./ oints of riskDfree return and
a ,Doint risk remium.
#he cost of debt @k
A can be calculated as the weighted average of the e0ective cost
of the various loan facilities used by the comany on which interest is exlicitly
in !lace
E5istin- firm
Ret%rn on e5istin-
assets .A$$
Ret%rn on e5istin-
in !lace
Ret%rn on ne6
$ost of ne6 ebt
Ret%rn on ne6
! r o 7 e c t
$ost of ne6 ebt
$ost of n e 6 e ' % i t& !ro7ect
$ost of ne6 e'%it&
F " : < + 6 !D) Comarison of Cororate Financing and Pro$ect Financing 'trategies
charged. "f* for instance* the comany utiliFes only an overdraft facility with an
e0ective cost of !1J and a mortgage loan with a cost of 3J and the resective
ercentages of the comany?s total borrowings are 21J and )1J* then k
can be
calculated as follows&
Q bk

R k

c @! tA
Q S!1J 21J R 3J )1JT @! 1&))A Q .&)1J
#he weighted average is multilied by @! N 1.))A* where 1.)) is the cororate
income tax rate given the tax deductibility of interests.
:iven the weight of debt and eCuity in the comany?s liabilities* a new investD
ment ro$ect concerning the comany?s core business will cost it a weighted average
of the cost of debt and cost of eCuity @or WACCEweighted average cost of

R k
@! tA
4C R -
For our Wrm* the WACC using values for k
and k
* resectively* of ..)1J net of
tax and 3./J* and a suosed weight of /1J for both eCuity and debt caital is
Assuming management intends to maximiFe the value of the comany* it will go
ahead with the new ro$ect if the return on the new initiative @rA is greater than the
cost of resources reCuired to Wnance it @WACCA* or r WACC.
"t is reasonable to assume that when a comany Wnances a new ro$ect on balance
sheet @cororate WnancingA* creditors and shareholders will establish the cost of new
debt or cost of new eCuity based on two factors&
!. #he soundness and roWtability of the venture that management intends to
%. #he soundness and roWtability of the comany that will realiFe the new
venture @often the more imortant factorA
#his second assessment is the most critical for creditors. "n fact* if the new venture
were to fail and thus were unable to reay caital and interest* creditors could
demand reimbursement from cash Gows generated by other* alreadyDexisting busiD
ness. #his would still be the case even if creditors were guaranteed by the new
ro$ect?s assets and cash Gow. Certainly such a guarantee would give them a referD
ential right with resect to other comany creditors. 5ut it is also true that if the new
ro$ect?s cash Gow and assets were insuLcient to reay caital and interest* then they
could still demand reayment from the remaining cash Gows roduced by other
comany assets.
#here are* however* cases in which the cororate WnanceNbased lending aroach
is not the best solution for realiFing new ro$ects.
Let?s suose now that the new ro$ect shows features that are distinctive to
ro$ect Wnance deals&
!. "t is very large comared to the comany?s current siFe.
%. "t has a higher degree of risk than the average risk level for the asset ortfolio
in the balance sheet.
). "t is linked to the comany?s own core business.
Factor ! indicates that once the ro$ect comes on stream it will have a considerD
able weight in terms of total assets @the sum of assets existing before embarking on
the ro$ect and those concerning the ro$ect itselfA. "n other words* the larger the
ro$ect* the greater will be the increase in assets on the balance sheet. "f the new
ro$ect were to fail* its sheer siFe would $eoardiFe continuation of the comany?s
other business and value of remaining assets. #his risk @often overlooked in Wnancial
theoryA can be considered the contamination risk.
Factors % and ) can be understood by using a classic rincile of Wnancial theory.
'uose two ro$ects @A and 5A were to be recorded on the same balance sheet* each
with a certain measure of risk. @4ormal Wnancial ractice is to utiliFe the standard
deviation of exected returns for the two ro$ects.A #hen it is ossible to establish the
overall risk for the combination of these two ro$ects. "t is assumed that r* the return
on the ro$ect* is measured by +7" @return on investment* that is* the ratio between
47PA#Enet oerating roWt after taxesEand total assets emloyed by each of the
two ro$ectsA* resectively +7"
and +7"
for Pro$ects A and 5.
#he return for the combination of Pro$ects A and 5 is eCual to the sum of the
average returns for the two ro$ects weighted by the resective value of assets for
each ro$ect in terms of total comany assets. #his would mean that
where r
indicates the return on the comany?s business asset ortfolio* A
* the value of assets invested* resectively* in Pro$ect A and in Pro$ect 5. For
examle* if Pro$ect A has a value of !*111 euros and Pro$ect 5 a value of ,*111 euros
and an +7"
of !1J and an +7"
of %1J* then the return for the comany?s asset
ortfolio will be
!1J !*111
%1J ,*111
!*111 R ,*111
Q !3J
% % % %
A 5
"nstead the risk underlying the A R 5 ortfolio is not the weighted average of risks
for the two investments @which can be measured* for instance* using the standard
deviation for returns r
and r
over an aroriate eriodA. "n e0ect* if A and
5 concern oerations in two very di0erent sectors @as* for instance* in the case of
conglomerates with loosely linked strategies and very weak business synergiesA* the
correlation between the two oerations will be very low indeed. #his means the trend
for results of one ro$ect shed little or no light on the trend for the other.
"n Wnancial theory the risk for a twoDoeration ortfolio can be calculated via the
following eCuation&
s w R s w R %s
A A 5 5 A*5
in which w
and w
are* resectively* the weights of Pro$ects A and 5 in the asset
ortfolio @in the examle it is %1J for Pro$ect A and 31J for Pro$ect 5A* s
and s
are the variances for returns of the two investments* and r
is the correlation
between the risk levels for A and for 5.
For uroses of the examle it is assumed that s
and s
are* resectively* /J
and %1J and that the two businesses are negatively correlated by a factor of 1.
@'tatistically* it is said that the two ro$ects are indeendent of each other.A "n this
case the ortfolio risk is less than the simle weighted average of the two business
1&% R %1 1&3 R % / %1 1&% 1&3 1 Q !.&1)%
8owever* the third assumtion indicates that the diversiWcation e0ect is not
resent. #he new ro$ect is linked to the core business* and therefore the correlation
between existing assets and new assets is very strong and ositive.
At this oint the three factors will be considered simultaneously* with the hel of
#able !D%* which shows that Pro$ect 5 is large* has a higher risk than that of alreadyD
existing assets* but also has a higher return than on assets already available to
#A5L6 !D% +eturns and +isks for Asset Portfolios with 0arying -egrees of Correlation 5etween Pro$ects
6xisting Assets
@Pro$ect AA
4ew Asset
@Pro$ect 5A
Market value !*111 ,*111
J on total value %1.1J 31.1J
6xected +eturn !1J %1J
'tandard deviation @R= A /J %1J
Correlation CoeLcient
! 1 1., 1.3 !
6xected return !3.1J !3.1J !3.1J !3.1J !3.1J
+isk @std deviationA !/.1J !..1)J !..,J !..3J !2.1J
"f we examine this case ex ante @that is* review the case before the new ro$ect is
realiFedA* we see that the comany?s overall return will rise to !3J* an increase of 3
ercentage oints over the initial level of !1J. #he forecast average return is the
weighted average of returns for Pro$ects A and 5 and is not a0ected by any correlD
ation between the two ro$ects.
"nstead as regards ex ante forecast risk* correlation has an imortant imact.
"n the examle* a otential range was assumed from a correlation coeLcient of ! to a
coeLcient of R!. #he negative extreme would reresent ro$ects diversifying from the
core business* whereas the ositive extreme would indicate ro$ects that are erfectly
synchroniFed with the trend for returns of Pro$ect A @the core businessA.
7bserving the results* it is Cuite obvious that Factor ) forces toward extreme
results. :iven a constant average return for the combination of Pro$ects A and 5 of
!3J* management will see comany risk @standard deviation of returnsA rise from /J
for Pro$ect A alone to !/J @correlation !A or !2J @correlation R !A for
combined Pro$ects A R 5.
#he signiWcant result caused by contamination risk should also be noted. 6ven if
it were management?s intention to launch a new venture to diversify from the
comany?s core business @in which case the new ro$ect will have a negative correD
lation coeLcientA* the risk for combination A R 5 will be higher than the original /J
for Pro$ect A alone. #his is easily understood* given that Pro$ect 5 is four times the
siFe of Pro$ect A @contamination riskA.
"n e0ect @still from an ex ante standointA* if management wants to launch a
new Pro$ect 5 and Wnances it on balance sheet* therefore combined with Pro$ect
A* these comany directors will have to bear in mind that Wnancers and shareholders
will see the Pro$ect A R 5 combination as being riskier. #hey will be reared to
Wnance the new venture but not at k
and k
levels existing before embarking on the
new ro$ect. #he values of k
and k
will go u in order to comensate creditors and
shareholders for the greater ex ante risk for the comany incororating the new
"f the increase for the weighted average cost of caital @that is* the weighted
average of k
and k
A is greater than the increase for the comany?s exected return
@3JA* then the strategy to Wnance the new venture on balance sheet will lead to a
reduction and not an increase in the value of the comany.
#his conclusion is why large* risky ro$ects are isolated by the sonsors in an
ad hoc vehicle comany* that is* o0 balance sheet. 'earation avoids the risk that
Pro$ect 5 contaminates Pro$ect A* thereby increasing the weighted average cost of
caital for both. 5ecause ro$ect Wnance is indeed an o0DbalanceDsheet solution* it
achieves this imortant result.
!./.% Conflicts of "nterest 5etween 'onsors
and Lenders and Wealth 6xroriation
6verything resented in the revious section assumed that management was reasoning
ex ante* that is* before the new ro$ect was e0ectively realiFed. A further assumtion
was that there were alreadyDexisting assets @in the examle* Pro$ect A assetsA.
"t was stated that searating the two ro$ects can be the otimum solution to
avoid contamination risk* that is* a situation in which default of the new ro$ect also
leads to default of alreadyDexisting assets.
8owever* searation is not necessarily always the best solution from the standD
oint of creditors. Let?s assume that* for simlicity?s sake* management Wnances
alreadyDexisting assets and those reCuired for the new ro$ect with a single debt
with a value at maturity of !11. Furthermore* it is assumed to be a FeroDcouon
debt and that the di0erence between !11 and the resent value of the debt at the start
of the ro$ect is Wnanced by eCuity caital.
Management can decide to Wnance existing assets @Pro$ect AA and new ro$ect
assets @Pro$ect 5A searately by using a ro$ect Wnance aroach* or they could
Wnance the combined ro$ects using a cororate Wnance aroach.
4ow future cash Gows for existing and new ro$ect assets will be considered
according to six ossible scenarios. #he situation is summariFed in the #able !D).
"n 'olution ! @cororate WnanceA* cash Gows from Pro$ects A and 5 are used
$ointly to reay the debt contracted for existing and new venture assets. As can be
seen* the comany defaults in 'cenarios !* %* and )* whereas it manages to make a
ositive ayo0 to shareholders in the remaining ones.
"n 'olution % @ro$ect WnanceA* cash Gows for Pro$ect 5 are only used to reay
debts for that ro$ect. "f there is a ositive di0erence* then Pro$ect 5 can ay
dividends to Pro$ect A @its arent comanyA.
As can be seen in #able !D)* Pro$ect 5 is in default in 'cenarios !* )* and /K it
manages to ay dividends to its arent comany in the remaining scenarios.
#A5L6 !D) 6xamle of #radeDoff 5etween Contamination +isk and Loss of Coinsurance 6ffect
8yothesis ! % ) , / .
-ebt Pro$ect A @assets in laceA !11 !11 !11 !11 !11 !11
-ebt Pro$ect 5 @new ro$ectA !11 !11 !11 !11 !11 !11
6xected cash Gows Pro$ect A @assets in laceA /1 /1 !)1 !)1 )11 )11
6xected cash Gows Pro$ect 5 @new ro$ectA /1 !)1 /1 !)1 /1 !)1
'olution !& onDbalanceDsheet Wnancing
#otal cash Gows Pro$ect A R 5 !11 !31 !31 %.1 )/1 ,)1
#otal debt Pro$ect A R 5 %11 %11 %11 %11 %11 %11
Payo0 creditors !11 !31 !31 %11 %11 %11
Payo0 shareholders default default default .1 !/1 %)1
'olution %& o0DbalanceDsheet Wnancing
#otal cash flows Pro$ect 5 /1 !)1 /1 !)1 /1 !)1
#otal debt Pro$ect 5 !11 !11 !11 !11 !11 !11
Payo0 creditors Pro$ect 5 /1 !11 /1 !11 /1 !11
Payo0 for shareholders Pro$ect A @dividendsA default )1 default )1 default )1
-ividends from Pro$ect 5 @GA 1 )1 1 )1 1 )1
#otal cash Gows ! @LA /1 /1 !)1 !)1 )11 )11
#otal cash Gow @G R LA /1 31 !)1 !.1 )11 ))1
#otal debt Pro$ect A !11 !11 !11 !11 !11 !11
Payo0 creditors /1 31 !11 !11 !11 !11
Payo0 shareholders sonsors default default )1 .1 %11 %)1
'ource& Adated from 5realey* Cooer* and 8abib @!((.A.
Pro$ect A @the arent comanyA can count on its own cash Gows and dividends
aid by Pro$ect 5 to reay its own debts. #able !D) shows that Pro$ect A is only in
default in the two unfavorable 'cenarios* ! and %.
#he following conclusions can therefore be drawn.
!. "n 'cenario %* ro$ect Wnancing is the otimum solution because it avoids the
damaging e0ect of contamination risk from Pro$ect A. @Pro$ect A defaults but
not the new ro$ect.A
%. "n 'cenario )* ro$ect Wnancing is still the otimum solution* but for the
oosite reason. "n this case damage to existing assets as a result of
contamination risk from Pro$ect 5 is avoided. @Pro$ect 5 is in default but not
Pro$ect A.A
). "n 'cenario /* the ro$ect Wnancing solution is still otimal from the standoint
of Pro$ect A shareholders @the ayo0 is %11 instead of !/1 in the cororate
Wnance solutionA* however* not from the oint of view of creditors* since
Pro$ect A shareholders extract a value of /1 from lenders. "n fact* if the ro$ect
had been Wnanced on balance sheet* the remaining Pro$ect A cash Gows would
have avoided default of the ro$ect and enabled full reayment of creditors. "n
other words* in 'cenario / there is no longer a coinsurance e0ect of the
comany as regards the ro$ect* and vice versa.
#o summariFe* in our examle* searation of the comany and the ro$ect is
always the otimum solution from the shareholders? standoint and can cause wealth
exroriation from creditors. 8owever* management must always assess the tradeDo0
between the beneWts gained by searating the two ro$ects and the disadvantages due
to the loss of the coinsurance e0ect created between comany and ro$ect. While
from a urely theoretical standoint it will always be useful for sonsors to searate
new ro$ects from existing comanies* if a new venture defaults it will have a signD
iWcant imact on the sonsors? reutation and could lead to negative conseCuences
with regard to the cost of new debt contracted @k
A to Wnance additional new ro$ects.
"n certain situations* therefore* the coinsurance e0ect might be referable to beneWts
for shareholders as a result of comanyNro$ect searation.
This page intentionally left blank
C 8 A P # 6 +
#he Market for Pro$ect Finance&
Alications and 'ectors
#he focus of this chater is the ro$ect Wnance market. 8ere we resent&
!. #he historical evolution of the sector and of market segments in an interD
national context* distinguishing between various macro areas at a global level
%. A detailed look at the 6uroean market and ublicNrivate artnershis
#he data resented here are taken from the #homson 7ne 5anker databank* and
they refer to loans granted for ro$ect Wnance transactions. 5ond issues* which are
seciWcally addressed in 'ection ..!!* are not included.
'ection %.! focuses on the historical evolution of ro$ect Wnance worldwideK
'ection %.% resents market data. -etails on the 6uroean context and PPP initiaD
tives are given in 'ections %.%.! and %.%.%* resectively.
%.! 8istorical 6volution of Pro$ect Finance
and Market 'egments
"t?s been said that ro$ect Wnance is a techniCue that was already common during the
+oman 6mire. "t was used to Wnance imorts and exorts of goods moving to and
from +oman colonies. 4onetheless* modern ro$ect Wnance dates back to the develD
oment of railroads in America from !3,1 to !321. "n the !()1s* the techniCue was
used to Wnance oil Weld exloration and later well drilling in #exas and 7klahoma.
%1 C 8 AP # 6 + % #he Market for Pro$ect Finance& Alications and 'ectors
Funding was rovided on the basis of the ability of roducers to reay rincial and
interest through revenues from the sale of crude oil* often with longDterm suly
contracts serving as counterguarantees.
"n the !(21s* ro$ect Wnance sread to 6uroe as well* again in the etroleum
sector. "t became the Wnancing method used for extracting crude o0 the 6nglish coast.
Moreover* in the same decade* ower roduction regulations were assed in the
<nited 'tates @P<+PAEthe Public <tility +egulatory Policy Act of !(23A.
"n doing so* Congress romoted energy roduction from alternative sources and
reCuired utilities to buy all electric outut from CualiWed roducers @"PPs* or indeD
endent ower roducersA. From that oint on* ro$ect Wnance began to see even
wider alication in the construction of ower lants for traditional as well as
alternative or renewable sources.
From a historical ersective* then* ro$ect Wnance came into use in wellDdeWned
sectors having two articular characteristics&
!. A cative market* created by means of longDterm contracts at reset rices
signed by big* Wnancially solid buyers @o0takersA
%. A low level of technological risk in lant construction
"n these sectors* the role of ro$ect sonsor has always been taken on by large
international contractors=develoers and multinationals in the etroleum industry.
"n the !(31s and !((1s* in contrast* the evolution of ro$ect Wnance followed two
di0erent develoment trends. #he Wrst involved exorting the Wnancing techniCue to
develoing countriesK this was romoted by the same develoers. 'ince room in the
market in their home countries was gradually diminishing* these entrereneurs
o0ered ro$ect Wnance to governments in develoing countries as a Cuick way to
reach a decent level of basic infrastructure with a greater contribution of rivate
caital. #he suort o0ered by exort credit agencies @see Chater .A in the home
countries of contractors and multinationals layed a key role in the rocess of
develoing the ro$ect Wnance techniCue.
#he second trend in the ro$ect Wnance market emerged in those industrialiFed
countries that initially tested the techniCue in more traditional sectors. "n fact* these
nations began to use ro$ect Wnance as an o0DbalanceDsheet techniCue for realiFing&
. Pro$ects with less @or less e0ectiveA market risk coverageK examles can be found
in sectors where there is no single large buyer* such as toll roads* leisure
facilities* and city arking lots.
. Pro$ects in which the ublic administration articiates in romoting works for
the ublic good. "n many cases* such works cannot reay investment costs or
cover oerating exenses or debt service at market rices. #his is why such
ro$ects have to be subsidiFed to some degree by ublic grants. "n some
countries @the <9 is frontDrunner in 6uroeA* ro$ect Wnance is very often
alied when carrying out ublic works through a rogram called the Private
Finance "nitiative @PF"A.
Figure %D! summariFes these oints. Cell "" refers to the best examle ro$ect
Wnance initiativesK in fact* this is where the techniCue originated. #he two arrows
ointing toward Cell " and Cell """ indicate market trends that are under way. 4ote
that Cell "0 shows a risk combination that is not suited to ro$ect Wnancing. "n fact*
high uncertainty* an extremely rigid contract structure* and high Wnancial leverage



%! 8istorical 6volution of Pro$ect Finance and Market 'egments
8 In%strial !lants
8 Minin-
8 Oil an -as
8 "o6er -eneration
In developing countries
8 In%strial !lants
8 Minin-
8 Oil an -as
8 "o6er -eneration
8 Toll roas
8 Telecom
8 Rail an infrastr%ct%re
8 Hotel4leis%re
8 .ater an se6era-e
8 "(I4"""
In developed countries
In developed countries
Lo6 Hi-3
E5!os%re to market an4or tec3nolo-ical risk
F " : < + 6 %D! 6volution of the Pro$ect Finance Market by #ye of Market and <nderlying +isks
'ource& Adatation of 6sty @%11%aA.
make it diLcult for management to resond Cuickly or to adat to change. "n these
cases a cororate Wnance loan is a more aroriate solution.
#he matrix in Figure %D! is also signiWcant from another ersective& "t enables us
to inoint the sectors in which ro$ect Wnance is alied* deending on the caacity
of the initiative to cover associated costs and investments with its cash inGows.
'eciWcally* note that in the sectors listed in Cells "" and "* the roduct in Cuestion
can be sold at market rices on the basis of longDterm contracts @take or ay
agreements or o0take agreementsK see Chater )A. For the ro$ects in Cell """* on
the other hand @with the excetion of the hotel and leisure facilities and telecomA*
setting a market rice that can generate adeCuate roWts for sonsors is usually
comlicated. #hese initiatives ertain to goods=services with ma$or externalities
@such as water system management or urban and social develoment of areas where
roads are to be builtA or to those associated with the needs of the general oulation
that have costs that dramatically imact lowerDincome segments @health care* for
examleA. "n these situations* entrusting a ro$ect comletely to the rivate
sector could make it imossible for some eole to exloit the service o0ered through
the realiFation of the initiative in Cuestion. #his gives rise to the need for ublic
funding in the form of contributions on works that can mitigate the investment
costs for rivate sonsors and conseCuently the level of rices or fees aid by end
users as well.
"n this regard* a classiWcation is Cuite widely used among oerators that draws a
distinction between ro$ect Wnance initiatives that are fully selfDWnanced @i.e.* ro$ect
Wnance in the strict senseA and those that are artially selfDWnanced. For the former*
the assessment is based on the soundness of the contractual framework and the
counterarties. "n the latter case* in addition to these factors* bankability deends a
great deal on the level of ublic grants conferred.
%.% #he :lobal Pro$ect Finance Market
#he observations made in the revious section are conWrmed by market data on the
value of initiatives undertaken with ro$ect Wnance.
"n this section* we brieGy review
the ro$ect Wnance situation at a global level and then examine the 6uroean context.
We also rovide a summary of the PPP market worldwide. #he time frame considD
ered here is %11)N%11.. #able %D! illustrates the market breakdown for ro$ect Wnance
by geograhic macro areaK #able %D%* in contrast* shows the sectors in which this
techniCue is alied.
"n Cuantitative terms* the data from the #homson 7ne 5anker databank indicate
steady growth in the ro$ect Wnance market at a global level. #his tye of Wnancing
has exanded from <'I2)./ billion in %11) to nearly !)% billion in %11.* with a
CA:+ at %!J @see #able %D!A. #he increase in the value of ro$ect Wnance initiatives
di0ers in various geograhic macro areas. #he Americas* Central Asia=Asia PaciWc*
and* in articular* 6uroe absorb the ma$ority of loans. 8owever* Africa accounts
for a total of around !3J of total Wnancing in the fourDyear eriod.
#his last Wgure conWrms what Figure %D! reveals regarding the market trends for
ro$ect Wnance @a shift from Cell "" to Cell "A. #he macro regions with a higher
concentration of develoing countries show a stronger growth rate in the alication
of ro$ect Wnance than that found in countries where this instrument is traditionally
used. #he case of Africa* with a /,J CA:+ in the fourDyear eriod* clearly exemD
liWes the trends described in 'ection %.!
"n #able %D% we can measure the intensity of the use of ro$ect Wnance in various
sectors. #he icture Cuite clearly shows a high concentration in certain sectors.
'eciWcally* the energy and ower sector absorbs nearly /1J of all loans granted
from %11) to %11.* followed by industrials @which includes transortation and
infrastructureA* with around %/J of the total* and telecom and media* with $ust
over ../J. 6ven health care* a sector where PPPs are tyically alied* accounts
for a resectable !./J of the market total for the time frame in Cuestion. "n this case*
too* an analysis of the growth rates shows the existence of the market trends
illustrated in Figure %D!.
"f we consider the growth rates for government and health care @sectors linked
to the develoment of ro$ect Wnance in the context of PPPsA* we can see that the
increase here is among the strongest in the fourDyear eriod* with R!3J and R,2J
resectively. #he energy and ower sector shows a ma$or uswing @R%/JA* in line
with exansion in industrials* transortation* and infrastructure. #his seems to
demonstrate that while traditional sectors of alication continue to exand in
terms of volume* other sectors where ro$ect Wnance has been more recently introD
duced show even more ronounced growth rates* in articular in develoed
countries. 'o the shift from Cell "" to Cell """ is also substantiated by statistics.
!. #he data referred to in this entire chater should be considered in light of the limitations of the database.
#o be more seciWc* the transactions surveyed by #homson 7ne 5anker do not reresent the entire universe of
ro$ect Wnance initiatives realiFed in a certain year in a given sector=country* since the databank sources
information rovided on a voluntary basis by the intermediaries involved in these ro$ects. :enerally* the
vast assortment of smaller ro$ects set u at a local level @some of which may not even be syndicated because
they are handled directly by the sonsoring bankA are not catured in this collection of data. Furthermore*
this limitation becomes even more critical the more closely we examine an individual country or a seciWc
geograhical area.
Amount J 4umber
@<'I mil.A
Amount J 4umber
@<'I mil.A
Amount J 4umber
@<'I mil.A
Amount J 4umber
@<'I mil.A
Amount J 4umber
@<'I mil.A
Africa=Middle 6ast 2*2/!.!1 !1./1 !.
Americas !)*!.2.(1 !2.(1 2.
Central Asia=Asia !!*),!.)1 !/.,1 .1
6uroe )3*%(2..1 /%.!1 !/!
Haan %*(2(.21 ,.11 !,
<nknown )..31 1.!1 !
!2*,3/.!1 !/.11 )!
%3*()).(1 %,.21 !!!
)!*,/).31 %..(1 3,
)%*((1.21 %3.%1 %1,
/*(21.31 /.!1 )/
22.(1 1.!1 )
)1*1,1.%1 %!..1 ,3
%.*!%2.21 !3.31 !1,
%)*1.,.21 !...1 33
/.*/),.,1 ,1..1 %,3
)*,13..1 %.,1 %,
/!.21 E !
%3*),/.,1 %!./1 )1
),*2,)..1 %..)1 2!
!)*(/%..1 !1..1 ,)
/!*%1/.)1 )3.31 !).
)*21..)1 %.31 %,
3)*.%!.31 !3.!! !%/ /,.!J
!1%*(2).!1 %%.)1 ).% )3.%J
2(*3!%.,1 !2.%( %2/ 2.%J
!2(*1%3.11 )3.23 2)( !1.%J
!.*1./.,1 ).,3 (2 2./J
!...,1 1.1, /
"ndustry total 2)*/2,./1 !11.11 )!3 !!.*(!%.!1 !11.11 ,.3 !)(*%%2.)1 !11.11 /!) !)!*(/).!1 !11.11 )1, ,.!*..2.11 !11.11J !*.1) %!./J
#A5 L6 %D! 5reakdown of :lobal 0alue of Pro$ect Finance "nitiatives by :eograhical Area
#otal CA:+
%11) %11, %11/ %11. %11)N%11. %11)N%11.
'ource& #homson 7ne 5anker.
@<'I mil.A
@<'I mil.A
@<'I mil.A
@<'I mil.A
@<'I mil.A
Consumer roducts .%).)1 1.31 !,
and services
Consumer stales ,1/.11 1..1 )
6nergy and ower )/*.3..,1 ,3./1 !%3
Financials .*/1..%1 3.31 !)
:overnment and agencies /3(.(1 1.31 3
8ealthcare .)3.%1 1.(1 (
8igh technology ...)1 1.!1 !
"ndustrials !(*)23.11 %..)1 (%
Materials ,*13!.!1 /./1 %)
Media and entertainment !*.3(.)1 %.)1 (
+eal estate 2,/..1 !.11 2
#elecommunications )*!./.!1 ,.)1 !!
!*(3%.31 !.21 %/
./..21 1..1 %
/3*//)./1 /1.!1 !(!
/*1(1.!1 ,.,1 )1
).2.!1 1.)1 ,
!*((,.!1 !.21 %(
!*,11.(1 !.%1 /
%,*/!1.,1 %!.11 !11
!%*31/.21 !!.11 /.
,*,(3.)1 ).31 !!
!22.)1 1.%1 ,
,*32/.!1 ,.%1 !!
,*!11.,1 %.(1 %/
.2,.11 1./1 !
.2*1,,.(1 ,3.%1 %,2
.*).2.21 ,..1 %.
23(.11 1..1 .
%*122.)1 !./1 !2
!//.21 1.!1 %
),*!2..11 %,./1 !12
!1*.%(..1 2..1 ,/
)*2/(.21 %.21 !!
!*3%3.,1 !.)1 !,
2*.%,..1 /./1 !%
!*./..%1 !.)1 !,
%/2.!1 1.%1 %
.2*!!,.!1 /1.(1 !.!
,*1%(.%1 ).!1 (
(.).%1 1.21 /
%*11(./1 !./1 !%
2/1.11 1..1 !
)3*,,/.31 %(.!1 .!
(*/2)..1 2.)1 %/
%*)!).,1 !.31 ,
(33.%1 1.21 ,
!*/,).!1 !.%1 !
%*)1(.(1 !.31 /
3*).%.21 !.3! 23 )3./J
!*((%.31 1.,) 3 !,.!J
%%3*)(3.(1 ,(.,2 2%2 %).,J
%!*(().%1 ,.2. 23 !,.3J
%*21(.%1 1./( %) !2.3J
.*2!(.!1 !.,. .2 ,...J
%*)2%.(1 1./! ( !%,./J
!!.*/!1.%1 %/.%, ).1 %/.2J
)2*1(1.11 3.1) !,( )%.(J
!%*%.1.21 %... )/ !!.1J
)*2)(./1 1.3! %( (.3J
!*/,).!1 1.)) !
!2*(2,.21 ).3( )( !1.1J
"ndustry total 2)*/2,./1 !11.11 )!3 !!.*(!%.!1 !11.11 ,.3 !)(*%%2.)1 !11.11 /!) !)!*(/).!1 !11.11 )1, ,.!*..2.11 !11.11 !*.1) %!./J
#A5 L6 %D% 5reakdown of Pro$ect Finance "nitiatives Worldwide by 'ector
%11) %11, %11/ %11. #otal %11)N%11.
'ource& #homson 7ne 5anker.
%/ #he :lobal Pro$ect Finance Market
#he telecom sector* conversely* shows a downslide in the last year of our time
frame. #here may be several di0erent exlanations for this henomenon. First* we
should kee in mind that the technological acceleration seen in the sector in recent
years is gradually slowing. #he second exlanation may be linked to the transforD
mation that has taken lace in the telehony market in several western 6uroean
countries. "n fact* <M#' technology has come to the fore in the fourDyear eriod
considered here. Many oerators Wnanced tenders to win bids for <M#' licenses
using ro$ect Wnance logic on the basis of future revenues generated from exloiting
these ermits. #hat at resent no more licenses are suosedly being issued and the
rogressive consolidation seen in the sector rovide a convincing exlanation for the
downward trend starting in %11/.
Lastly* #able %D) gives the ercentage breakdown of the use of ro$ect Wnance by
sector in the di0erent geograhic macro areas. #he reference data relate to the entire
fourDyear eriod from %11) to %11.. #he information shown in the table indicates the
ercentage weight of Wnancing granted in a given geograhical area with resect to
the total Wnancing conferred worldwide in the same time frame.
#he breakdown by sector is Cuite heterogeneous within di0erent geograhic
areas. 4ote seciWcally the two Fones that most clearly exemlify this disarity&
Africa and the Middle 6ast. 8ere* in fact* the most substantial ercentages cluster
around the base sectors. @6nergy* industrials* and materials alone make u %1J of
the total of ro$ect Wnancing worldwide for the eriod.A 'ectors where the techniCue
is still new* however* reGect much lower Wgures. Conversely* in 6uroe @which has
a longer history of ro$ect WnanceA the sectors with the highest numbers are those
that have recently evolved* shown in Cell """ of Figure %D!. "n fact* telecom*
government* health care* and* obviously* ower and industrials=infrastructure
account for around %1J of the total of initiatives funded with ro$ect Wnance in
the eriod in Cuestion.
#A5L6 %D) Percentage 5reakdown by 'ector and Macro Area of the :lobal 0alue of Pro$ect
Finance "nitiatives
Africa and
Middle 6ast Americas
Central Asia
and Asia Pacific 6uroe Haan
J of #otal
by 'ector
Consumer roducts and services 1.1,J 1.!!J !..!J 1.!!J !.32J !.(J
Consumer stales 1.!/J 1.13J 1.!.J 1.1,J 1.11J 1.,)J 1.,J
6nergy and ower !)./.J !).2!J 3.(3J !%.31J 1.)3J ,(.,)J ,(.,J
Financials 1.1.J !.),J !.!!J %.!%J 1.!2J ,.3!J ,.3J
:overnment and agencies 1.1!J 1.!!J 1.,)J 1.1,J 1./(J 1..J
8ealth care 1.%!J 1.1)J !.!2J 1.1/J !.,.J !./J
8igh technology 1.1%J 1.)2J 1.13J 1.1/J 1./!J 1./J
"ndustrials !.,1J ).12J ,.2,J !/.2,J 1.!2J %/.!%J %/.!J
Materials ).),J !./3J %./)J 1..1J 1.1%J 3.12J 3.!J
Media and entertainment 1.13J !.11J 1.3!J 1.2/J %...J %.2J
+eal estate 1.1)J 1.!2J 1.1%J 1.,1J 1.!(J 1.3!J 1.3J
+etail 1.))J 1.))J 1.)J
#elecommunications !.%2J 1.,)J 1.!1J !.21J 1.,1J ).(!J ).(J
Percent of total by region !(.3J %1.3J !(.)J )2.3J %.)J
'ource& #homson 7ne 5anker.
%. C 8 AP # 6 + % #he Market for Pro$ect Finance& Alications and 'ectors
%.%.! A Closer Look at the 6uroean Market
#able %D, shows the breakdown of amounts Wnanced in 6uroe* di0erentiated by
Monetary <nion member and nonmember states. "t is immediately aarent that
Wgures for countries that belong to the union are much higher than for nonmembers.
#he former* in fact* account for more than (/J of the total on the 6uroean market
in the entire time frame analyFed. #his is due to both the rogressive exansion of the
#A5 L6 %D, 6uroean Pro$ect Finance Market
%11) %11, %11/ %11.
@<'I milA J
@<'I milA J
@<'I milA J
@<'I milA J
6uroean <nion
Cyrus !),..1 1.).
CFech +eublic )/,.)1 1.(/
Finland %*,!(.,1 ..,3
France ./1.(1 !.2,
:ermany !*1/(./1 %.3,
8ungary %3,..1 1.2.
"relandD+e )2,.11 !.11
"taly (*,.1.%1 %/.))
4etherlands )*(/(.11 !1..1
Poland ,)/.)1 !.!2
Portugal (3!.31 %..)
'lovak +e
'ain 2*.3/./1 %1./3
<nited 9ingdom (*/,%.,1 %/.//
#otal )2*),!./1 !11.11
4onN6uroean <nion
Croatia 22./1 !!.)(
"celand !(.21 %.(1
"sle of Man /).11 2.2(
9aFakhstan .1.11 3.3%
4orway !(2.,1 %(.1%
+omania !3..1 %.2)
'witFerland %/,.!1 )2.)/
#otal .31.)1 !11.11
#otal 6uroean (3.%!J
<nion=#otal 6< R nonD6<
)1.,1 1.!1
/(.31 1.!(
%*,.2.!1 2.(%
.,%./1 %.1.
!1%.31 1.))
!*2,/./1 /..1
(,(.31 ).1/
,*),%.21 !).(,
2)2./1 %.)2
%3!.11 1.(1
%*/1..11 3.1/
/*(23./1 !(.%1
!.2.)1 1./,
!!*!)%.21 )/.2/
)!*!,)..1 !11.11
,/..1 /./%
)2(.!1 ,/.3(
,1!.,1 ,3./(
3%..!1 !11.11
!32.,1 1.).
)1.11 1.1.
).%.)1 1..(
/*,(!.31 !1.,.
%*/,,.%1 ,.3/
!*%,!.!1 %.).
!/1.(1 1.%(
3*(3)./1 !2.!!
,1.!1 1.13
!*)33.31 %../
!.(.31 1.)%
%*1,2..1 ).(1
,().)1 1.(,
!.*3%).)1 )%.1/
!%*/,%.,1 %).3(
/%*,(../1 !11.11
!*))3.,1 31.,%
!2..11 !1./3
!,(.(1 (.1!
!*..,.)1 !11.11
))!.21 1..3
(,%.,1 !.(,
)/).11 1.2)
3!3.21 !..(
!.*!23.%1 )).)3
,*(,).31 !1.%1
/2%.)1 !.!3
%).,1 1.1/
!*,,2.31 %.((
2(3.11 !../
,3)..1 !.11
!*,(../1 ).1(
2*/11..1 !/.,2
!%*/3%.,1 %/.(.
,3*,2%.,1 !11.11
!*./3.)1 23./1
!..21 1.2(
,)2.,1 %1.2!
%*!!%.,1 !11.11
'ource& #homson 7ne 5anker.
%2 #he :lobal Pro$ect Finance Market
number of union members and the greater use of the ro$ect Wnance techniCue in
Cuantitative terms in the Wrst grou of nations.
We can see Cuite obvious >>ockets?? of ro$ect Wnance within the 6<. While in
some countries the instrument is almost comletely nonexistent* as in -enmark*
Lithuania* Malta* and 'lovakia* other nations* such as the <9* "taly* 'ain* and
France* are the markets that account for the largest ortion of the total* followed by
:ermany and Portugal. "n these countries* where ro$ect Wnance is most common*
laws exist that seciWcally regulate its use* in articular in the context of PPPsK
moreover* the techniCue is extensively alied in a large number of sectors. "n this
regard* see #able %D/* which gives an overview of the 6uroean situation with
reference to ro$ect Wnance alied to PPPs set u by the 6uroean "nvestment 5ank.
As we can observe in #able %D/* ro$ect Wnance is most widely used in countries in
which sectors of alication for this techniCue are more numerous* and above all*
where the institutional and legislative contexts are more advanced. #hese nations
already have regulatory frameworks in lace and ro$ect task forces in action. MoreD
over* the ublic administration here lays an active role in romoting the use of PPPs.
#he Wnal oint in our discussion of the 6< is that Wgures on countries from the
former 'oviet bloc do not rove very signiWcantK in these nations it aears that
ro$ect Wnance is used soradically.
As regards the other nonD6< countries in 6uroe* we immediately notice the limited
scale of ro$ect Wnance. 8owever* we should oint out that in 6uroe* among member
and nonmember states* various market develoment trends are under way. "n examinD
ing #able %D,* in fact* we can see a higher volatility in amounts in 6< areas with resect
to nonD6< Fones* where the tendency is toward more decisive growth. #hough we
can?t refer to nonmembers as >>develoing nations?? in the strict sense* this henomenon
is further roof of the shift from Cell "" to Cell " highlighted in Figure %D!.
%.%.% PPP -eveloment
A large fraction of ro$ect Wnance initiative is referred to ro$ects involving the ublic
administration. 'uch initiatives are run by the rivate sector on the basis of concesD
sion contracts. #he goods or services in Cuestion are sold to end users @as in the case
of toll roadsA or to the ublic administration itself @hositals or risons* for examleA.
7ne of the most obvious trends in the ro$ect Wnance market at a global level is the
gradual shift from entirely rivate initiatives @Cell ""A to ro$ects involving the ublic
administration @Cells """ and "0 in Figure %D!A* as indicated in #able %D..
#he Wrst key observation is the di0erent level of dissemination of PPPs in the
world. While in 6uroe and Central Asia=Asia PaciWc* PPPs account for more than
%/J of total loans grantedEin the Americas the ercentage is $ust above !,J. #his
Wgure is much lower in Haan and in Africa. #he second factor to consider is the
varying level of distribution of the techniCue among di0erent sectors. #ransortation
and infrastructure make u nearly 31J of the total from %11) to %11.* but siFeable
ercentages are also found in other sectors as well& water @around 3JA* education
@around /JA* and health care and hositals @over /JA. Again* in examining
distribution by sector* in 6uroe we note widesread use of PPPs in all sectors
analyFed by #homson 7ne 5anker. "n the geograhic areas where PPPs are less
common* sectors of alication are limited almost exclusively to transortation and
water. #herefore* it seems that there is additional room for develoing this techniCue
in the coming years.
Austria 5elgium -enmark Finland France :ermany :reece "reland "taly Luxembourg 4etherlands Portugal 'ain 'weden <9
'ocial housing R R RR RR RR R R R R oeration
Airorts R RR RR R oeration RR R R R oeration
-efense R R R !!! R R oeration
8ealth care and hositals RR RR RR R RR !!! R RR RR R oeration
Ports and harbors RR RR RR R R oeration
Prisons R R RR RR R R R oeration
Light railway R traditional !!! RR !!! !!! RR !!! oeration
8eavy railway RR R RR RR !!! !!! R R
+oads RR RR RR RR traditional !!! !!! !!!! !!!! !!! oeration oeration R oeration
6ducation and schools R R RR RR R !!! !!! RR R R oeration
'orts and entertainment RR !!! RR R oeration
Water and sewerage R RR traditional !!!! RR !!! !!! oeration
#A5 L6 %D/ -eveloment of PPPs in the 6uroean <nion in #erms of 'ector* "nstitutional Level* and Legislation @%11/ dataA
PPPE"nstitutional level
ooo o oo o oo ooo ooo ooo ooo ooo oo ooo
Legend& @RA under discussionK @RRA ro$ects under tender auctionK @!!!A many awarded ro$ects* some of them in Wnancial closeK @!!!!A many closed ro$ectsK @oerationA many closed
ro$ects* most of them in oerating haseK @traditionalA many closed ro$ects* most of them in oerating hase @traditional concession agreementsA.
Legend& @
A ro$ect task force still missingK some actions taken and sometimes ro$ect task forces at regional levelK @
A ro$ect task force under way @or existing but only for consulting
urosesAK @
A existing ro$ect task forces heavily involved in romoting PPPK @UA roosed regulationK @UUA draft regulation already roosed and satisfactoryK regulation for seciWc
sectors already availableK @UUUA satisfactory regulation already available.
@<'I mil.A
@<'I mil.A J 4umber
@<'I mil.A
@<'I mil.A J 4umber
@<'I mil.A
City agency
6ducational services
8ealth care rovides
services @8M7sA
Motion ictures=
4ational agency
4ational government
Public administration ...!1 1.3J !
+egional agency 1.1J
#ransortation /*),2.(1 ./.!J !3
Water and waste %*2((..1 ),.!J 3
#otal PPPs 3*%!)..1 !11.1J
#otal ro$ect Wnance 3)*.%!.31
PPP?s=#otal ro$ect (.3J
Wnance deals
)//..1 %.,J !
2.%1 1.1J !
!)*.,..)1 (%.%J )/
2(2.(1 /.,J 2
!,*312.11 !11.1J
!!...1 1..J %
!)..21 1.2J !
)%1.!1 !..J %
!3!.21 1.(J %
!3*(13.!1 ().)J //
.1..%1 ).1J 2
%1*%.(.,1 !11.1J
3!.21 1.!J %
,*,3!.11 ..(J ,.
)*%!..%1 ,.(J ,/
%*!2!.31 ).)J !/
!!).31 1.%J )
,,/.21 1.2J )
!2/.11 1.)J !
!(/.11 1.)J )
!*12,./1 !..J .
,(*,21.,1 2..1J !!!
)*21/.(1 /.2J %2
./*!)!.11 !11.1J
3!.21 1.!J
,.1.31 %..%J !, /*1/3.,1 ,..J
)*)/%.(1 ).1J
%)2.%1 !)./J % %*2.,..1 %./J
!!).31 1.!J
,,/.21 1.,J
!%%.%1 2.1J ! %(2.%1 1.)J
,1.11 %.)J ! .%3.,1 1..J
!*%/..%1 !.!J
,)/.21 %,.3J ) 32*313.,1 2(.2J
,.!.(1 %..)J 2 3*)2!./1 2..J
!*2/2.31 !11.1J !!1*!23.31 !11.1J
#A5L6 %D. -issemination of PPPs by 'ector and :eograhic Area* %11)N%11.
Africa and Middle 6ast Americas Central Asia=Asia Pacific 6uroe Haan
#otal sector
J of
'ource& #homson 7ne 5anker.
This page intentionally left blank
C 8 A P # 6 +
Pro$ect Characteristics* +isk Analysis*
and +isk Management
A successful ro$ect financing initiative is based on a careful analysis of all the risks
the ro$ect will bear during its economic life. 'uch risks can arise either during the
construction hase* when the ro$ect is not yet able to generate cash* or during the
oerating hase.
+isk is a crucial factor in ro$ect finance since it is resonsible for unexected
changes in the ability of the ro$ect to reay costs* debt service* and dividends
to shareholders. Cash flows can be affected by risk* and if the risk hasn?t been
anticiated and roerly hedged it can generate a cash shortfall. "f cash is not
sufficient to ay creditors* the ro$ect is technically in default.
Most of the time allocated to designing the deal before it is financed is* in fact*
dedicated to analyFing @or maingA all the ossible risks the ro$ect could suffer
from during its life. Above all* focus lies on identifying all the solutions that can be
used to limit the imact of each risk or to eliminate it.
#here are three basic strategies the 'P0 can ut in lace to mitigate the imact of
a risk&
!. +etain the risk.
%. #ransfer the risk by allocating it to one of the key counterarties.
). #ransfer the risk to rofessional agents whose core business is risk manD
agement @insurersA.
#he first strategy is Cuite common in a cororate finance setting. An industrial
firm may retain a given risk because it considers risk allocation to third arties too
exensive or the cost of insurance olicies excessive comared to the effects
)% C 8 AP # 6 + ) Pro$ect Characteristics* +isk Analysis* and +isk Management
determined by that risk. "n this case the firm usually tries to imlement internal
rocedures for the control and revention of the risk. 7n the other hand* the same
risk is likely to have a lower imact comared to a ro$ect finance setting. "f a firm
must close a lant that has caught fire* roduction can continue in other remises
of the firm. #echnically seaking* the risk is not idiosyncratic. #his is not true for
ro$ect financing. "f the lant burns down* the 'P0 doesn?t have other remises
where roduction can continue* and the ro$ect is technically @and economicallyA in
default. #his exlains why 'trategy ! is imlemented in 'P0s* but it is not enough.
Lenders would never accet financing an 'P0 sub$ect to risks that are comletely
'trategy % is the cornerstone of the ro$ect finance design* a strategy that is
imlemented through extensive work erformed by the legal advisors of sonsors
and lenders. #he rincile is intuitive. 'ince the key contracts revolving around the
'P0 @construction* suly* urchase* 7BMA allocate rights and obligations to
the 'P0 and its resective counterarties* such agreements can be used as an effective
risk management tool. 6very counterarty will bear the cost of the risk it is best able
to control and manage. "n this way* each layer has the incentive to resect
the original agreement in order to avoid the negative effects determined by the
emergence of the risk in Cuestion. "f a risk arises and it has been allocated @transD
ferredA to a third arty* this same arty will bear the cost of the risk without affecting
the 'P0 or its lenders.
Finally* 'trategy ) is imlemented as a residual mitigation olicy. 'ome risks are
so remote or so difficult to address that any one of the 'P0 counterarties is oen to
bear them. "nsurers are in the best osition to buy them from the 'P0 against
the ayment of an insurance remium. #hese comanies can do so because they
manage large risk ortfolios where the $oint robability of emergence of all the risks
in the ortfolio at the same time is very low.
Figure )D! summariFes these concets and introduces the contents of the chater.
7n the leftDhand side* a classification of risks is roosed based on the different
hases of the life cycle of the ro$ect. 7n the rightDhand side* the most imortant
methods for risk allocation are shown. "t is articularly imortant to stress that the
risks common to the reD and ostcomletion hase are hedged by an almost
exclusive use of insurance contracts or derivative contracts.
#his chater is dedicated to risk analysis and risk allocation through 'trategy %.
+isk coverage through insurance is dealt within Chater ,. More recisely* 'ection ).!
is dedicated to the rocess of risk analysis and rooses a classification of ro$ect
risks based on the ro$ect life cycle. 'ection ).% covers the risk allocation hase and
exlains how risks can be allocated to the 'P0 counterarties by means of key
contracts. 'ecial attention is dedicated to market risk @the risk arising from a dro
in salesA given the aramount imortance of this risk in determining the future cash
flow generation of a ro$ect. Mechanisms such as offtake agreements are analyFed* and
information is also rovided for the use of such contracts in PPPs.
).! "dentifying Pro$ect +isks
+isks inherent to a ro$ect finance venture are secific to the initiative in CuestionK
therefore there can be no exhaustive* generaliFed descrition of such risks. #his is
why it is referable to work with broader risk categories* which are common to
various initiatives.
)) "dentifying Pro$ect +isks
Risk ientification4ma!!in- Risk allocation
"ro7ect life c&cle9
+: "recom!letion !3ase risks
8 Acti;it& !lannin-
8 Tec3nolo-ical
8 $onstr%ction
/: "ostcom!letion !3ase risks
8 S%!!l& risk
8 O!erational risk
8 Market risk
1: Risks common to !recom!letion
an !ostcom!letion !3ases
8 Interest rate risk
8 E5c3an-e risk
8 Inflation risk
8 En;ironmental risk
8 Re-%lator& risk
8 Le-al risk
8 $reit4co%nter!art& risk
Allocation t3ro%-3 contracts
T%rnke& *E"$, contract
"%t or !a& a-reements
O0M a-reements
Offtake a-reements *63en !ossible,
)se of eri;ati;e contracts
)se of ins%rance !olicies
F " : < + 6 )D! Classification of +isks and the 'trategies for #heir Allocation @8edgingA
#he criterion used to identify risk is chronological* an intuitive choice* seeing as
this arameter is generic enough to be usable across different sectors of alication.
A ro$ect goes through at least two hases in its economic life&
!. #he construction* or recomletion* hase
%. #he oerational* or ostcomletion* hase
#hese hases have very distinct risk rofiles and imact the future outcome of the
initiative in Cuestion in different ways. "n keeing with our chosen criterion* the risks
to allocate and to cover are&
. Precomletion hase risks
. Postcomletion hase risks
. +isks common to both hases
).!.! Precomletion Phase +isks
#he hase leading u to the start of oerations involves building the ro$ect
facilities. #his stage is characteriFed by a concentration of industrial risks* for the most
art. #hese risks should be very carefully assessed because they emerge at the outset of
the ro$ect* before the initiative actually begins to generate ositive cash flows.
).!.!.! Activity Planning +isk
Pro$ect finance initiatives are carried out on the basis of a ro$ect management logic.
#his involves delineating the timing and resources for various activities that are
!. 'ee Pro$ect Management "nstitute 'tandard Committee @!((.A.
linked in a rocess that leads to a certain result within a reset time frame. #he logical
links among various activities are vital in order to arrive at the construction deadline
with a lant that is actually caable of functioning. :rid analysis techniCues @the
critical ath methodECPMEand the ro$ect evaluation and review techniCueE
P6+#A* suorted by software* make it ossible to ma out the timing of the ro$ect
activities @:antt chartA. -elays in comleting one activity can have ma$or
reercussions on subseCuent activities. #he risk is* in fact* that the structure on which
the 'P0 deends to generate cash flows during the oerations hase may not be
available. #his is known as lanning risk.
For examle* in a recent ro$ect in the cogeneration sector* a roblem came u in
coordinating the construction of a deashalting lant @reCuired to treat tar so that it
can be used as fuel in the cogeneration lantA with the activation of the ower station.
#he timing of the two activities @building the lant and initiating ower roductionA
was critical for the economic sustainability of the ro$ect. "n fact* the deashalting
lant had to be comleted on time in order for the ower lant to be tested with fuel
that was to be sulied by one of the sonsors. "f the lant was not finished* the test
would be run on an alternative feedstock* which the 'P0?s sonsor would have to
suly for the entire duration of the ro$ect* with a siFeable increase in costs.
Additional effects of bad lanning are ossible reercussions on the 'P0?s other
key contracts. For examle* a delay in the comletion of a facility could result in
enalties to be aid to the roduct urchaser. As a worstDcase scenario* the contract
might even be canceled.
).!.!.% #echnological +isk
"n some sectors where ro$ect finance is alied* construction works can reCuire the
use of technologies that are innovative or not fully understood. <nder normal
circumstances* it is the contractor who decides on the most suitable technology*
with the consent of the other sonsorsK in this case the contractor will almost certainly
ot for tried and tested technology. 8owever* it is not uncommon for a contractor to
find the technological choice made ustream by other sonsors. "n this situation* the
contractor and technology sulier do not coincide* and the risk arises that a secific
license* valid in theory* roves inalicable in a working lant. #his is known as
technological risk.
6xamles of technological risk arise in ro$ects involving innovative technologies
that have not been adeCuately consolidated in the ast. Almost all works in the sector
of alternative ower sources share the risk that the lant ro$ect may not ass
erformance tests* and only then it would become aarent that the ro$ect has
failed from a technical standoint.
:iven the negative otential of technological risk* it is very hard to imagine that a
ro$ect finance venture would be structured on the basis of comletely unknown*
untested technology. "n fact* technological risk reCuires flexibility* while the aim of
ro$ect finance is to foresee every ossible future event ex ante in order to limit the
behavior of management @i.e.* the 'P0A and block the use of ro$ect funds for
different uroses.
).!.!.) Construction +isk or Comletion +isk
#his tye of risk can take various forms* but the key asect here is that the ro$ect
may not be comleted or that construction might be delayed. 'ome examles of
construction risk ertain to&
. 4oncomletion or delayed comletion due to force ma$eure
. Comletion with cost overruns
. -elayed comletion
. Comletion with erformance deficiency
"n a ro$ect finance transaction* construction risk is rarely allotted to the 'P0 or
its lenders. As a result* it is the contractor or even the sonsors themselves who must
assume this risk. Whether or not the banks are willing to accet construction risk also
deends on the nature of the technology @innovative or consolidatedA and the
reutation of the contractor.
).!.% Postcomletion Phase +isks
#he ma$or risks in the ostcomletion hase involve the suly of inut* the erD
formance of the lant as comared to ro$ect standards* and the sale of the roduct
or service. #hese risks are as imortant as those faced by the ro$ect during its
recomletion hase since their occurrence can cause a reduction of cash flows
generated by the ro$ect during its economic life. "f cash flows are lower than
exected* lenders and sonsors can find it difficult to get reaid or to reach satisfying
levels of internal rate of return.
'uly risk arises when the 'P0 is not able to obtain the needed roduction inut
for oerations or when inut is sulied in subotimal Cuantity or Cuality as
that needed for the efficient utiliFation of the structure. 7r the 'P0 might find
inut* but at a higher rice than exected. #his situation is even more serious if
negotiated rices exceed the retail rice of the roduct or service or of the contracted
rice to the urchaser with longDterm agreements with the 'P0. #he effects of suly
risk are that the lant functions below caacity* margins shrink and sulemental
costs accrue due to the need to ta additional sources for inut.
#he oerating risk @or erformance riskA arises when the lant functions but
technically undererforms in ostcomletion testing. "n the ower sector* for
examle* the inut=outut ratio of a lant might gradually deteriorate* or emission
standards might not be met* or inut consumtion could be over budget. #he effect
of erformance risk is lower efficiency and* in the end* unwelcome cost overruns.
-emand risk @or market riskA is the risk that revenue generated by the 'P0 is less
than anticiated. #his negative differential may be a result of overly otimistic
ro$ections in terms of Cuantity of outut sold* sales rice* or a combination of the
two. #his difference can also be due to unanticiated strategies ut in lace by
cometitors* articularly if the roduct can be easily substituted. #he case of the
strong cometition following the construction of the 6urotunnel by air carriers and
ferry oerators is a good examle of market risk due to cross elasticity between
alternative sources of the same transortation service.
).!.) +isks Found in 5oth the PreD and
Postcomletion Phases
+isks found in both the construction and oerational hases are those that might
systematically arise during the life of the ro$ect* though with differing intensity
deending on the hase in the life cycle of the initiative.
Many risks common to both hases ertain to key macroeconomic and financial
variables @inflation* exchange rate* interest rateAK conseCuently* any division between
the categories of industrial and financial risk is actually somewhat arbitrary. For
examle* the exchange rate risk inherent in a construction contract in dollars with an
'P0 domiciled in a 6M< country can be considered both an industrial risk @since it is
linked to a nonfinancial contractA and a financial risk @because it would be covered by
recourse to financial derivatives* if need beA.
).!.).! "nterest +ate +isk
"n ro$ect finance ventures* there is always the risk of fluctuations in interest rates.
We will see in Chater . that in this context credit is always granted with a variable
rate* due to the long life of such ro$ects. "n addition* unlike exchange rate risk*
interest rate risk indiscriminately strikes both domestic and international ro$ects as
well as ventures with multiDcurrency cash flows. 'onsors and their advisors have to
decide whether or not to cover against this risk* a decision that is not exactly identical
throughout the life of the ro$ect.
-uring the construction hase* the ro$ect does not generate revenues. 8owever*
drawdowns begin to roduce interest ayable* the amount of which deends on the level
of interest rates during the years in which the ro$ect is under construction. 7ut of the
total value of direct and indirect investments* clearly the interest on drawdowns cannot
be recisely defined with certainty ex ante. 7nly a ercentage of total investments
consists of definite costsK this ercentage certainly includes construction costs* which
are defined on the basis of a turnkey contract. "n addition* a reasonable estimate can be
made of the cost of landK the same may be said for some develoment costs and for
owner?s costs. "nterest ayable* in contrast* deends on trends in the benchmark rate.
#his cost item reresents a significant ercentage of total costsK in fact* the more
intense the recourse to borrowed caital* the greater the weight of the interest
comonent. #he risk the 'P0 runs is that unexected eaks in the benchmark rate
to which the cost of financing is indexed can cause an increase in the value of the
investments such as to drain ro$ect funds entirely. For this reason* a rather widely
used strategy is comrehensive coverage of the variableDrate loan throughout the
entire ro$ect construction hase.
#he most difficult roblem for the 'P0?s sonsors is to select the best strategy for
covering floatingDinterestDrate loans during the ostcomletion hase of the venture.
7ften advisors decide on the aroach to adot on a caseDbyDcase basis* deending
on the secific features of the ro$ect in Cuestion. 4onetheless* the key concet
advisors focus on is selfDrotection of cash flows* i.e.* valuing whether cash flows
from oerations are sustainable in the face of negative variations in the value of the
debt service. A rise in interest rates imacts debt service value by increasing ayouts
to lenders. Clearly this effect will abate over time @given the same rate variationA due
to the rogressive reduction in the outstanding debt. "n any case* the main oint is to
ascertain the caacity of oerating cash flows* i.e.* to verify how these flows
move over time. 4aturally* selfDrotection of cash flows deends on the underlying
connection among variables that move industrial cash flows and interest ayable.
When this correlation is high and ositive* any increase in interest rates is counterD
balanced by variables that determine oerating cash flows. #he ro$ect* at least in art*
will be >>selfDimmuniFed?? from rate risk. "f there is no such correlation* an unexected
increase in the cost of financing would best be avoided because the ro$ect would not
easily withstand such a contingency.
For examle* consider a PPP ro$ect in the hosital sector* discussed further in
'ection ).%.,.). #he eriodic ayments by the ublic administration to the 'P0=
concession holder are linked secifically to the Consumer Price "ndex as a benchmark
for the rate of inflation. #his is a considerable advantage* because nominal rates
move in relation to the inflation rate. As we know* nominal rates are made u of a
real comonent and a remium reCuested by investors to rotect their urchasing
ower. "deally* therefore* the 'P0 would find itself in a situation where a variation in
debt service would be comensated by an increase in revenues. #he conditional must
be used* however* since inflation can be determined with different arameters in
terms of revenues and interest rates.
#he only risk remaining for the 'P0 to face would be that the trends in actual
interest rates may not be in line with the ro$ections given in the financial model. #he
ideal strategy* then* would be to draw u a swa contract on the true interest rate or
to use contracts that cover inflation risk @'ection ).!.).,A.
"n ractice* interest rate risk tends to be comletely covered during the ostcomD
letion hase& Percentages usually run from 21J to (1J of the outstanding debtK this
gradually decreases as the outstanding debt diminishes. 8owever* we must kee in
mind that this coverage eliminates variability and in so doing revents the 'P0 from
taking advantage of ossible dros in interest rates. Coverage strategies* in fact* are
sub$ect to a very considerable oortunity cost.
).!.).% 6xchange +ate +isk
6ssentially this risk emerges when some financial flows from the ro$ect are stated in
a different currency than that of the 'P0. #his often occurs in international ro$ects
where costs and revenues are comuted in different currencies. 8owever* a similar
situation may arise in domestic ro$ects when a counterarty wants to bill the 'P0 in
foreign currency. 0arious industrial multinational grous* for examle* customarily
invoice in a hard currency* even if it is not that of the host country.
When ossible* the best risk coverage strategy is currency matching. "n other
words* advisors of an 'P0 try to state as many flows as ossible in the home
currency* avoiding any use of foreign currency. "f this is not ossible @usually because
counterarties have strong bargaining owerA* the following coverage instruments
rovided by financial intermediaries must be used&
. Forward agreements for buying or selling
. Futures on exchange rates
. 7tions on exchange rates
. Currency swas
).!.).) -erivatives Contracts for Managing "nterest +ate +isk and 6xchange +isk
Covering financial risk in a ro$ect finance venture does not differ greatly from olicies
on cororate treasury management. 8owever* one ma$or difference is clearly that the
ro$ect life of such ventures is always longer than the time horiFon for which these
instruments are traded. "n articular* this is the case regarding coverage instruments
listed on stock exchanges and for some overDtheDcounter derivatives @such as futures on
exchange ratesA. For this reason* structured finance transactions most often involve
secific negotiated forms of coverage earmarked secifically for the ro$ect or use
rollover strategies on standard contracts as they reach maturity.
Forward Contracts& A forward contract involves an exchange with a delayed
settlement. #raders set down contract conditions @secifically the date of settlement
and the riceA uon signature of the contract* and the exchange is actually settled at a
future* reagreed date. A forward contract might ertain to a currency exchange rate
@on maturity* the traders sell each other one form of currency for another on the basis
of an exchange rate set when the contract is drawn uA* a financial asset* or an
interest rate.
"f the rice is fixed when the contract is made and remains unchanged until
settlement* any otential fluctuations in the Cuotation on exchange rates* interest
rates* or the financial asset in Cuestion do not affect the two arties* so both are
covered. 7f course* when listed rices rise above the negotiated rice level of the
forward contract* the buyer is at an advantageK the reverse will occur if the listing falls
below the agreedDon rice level. @4aturally* for the seller the oosite is true.A
"n ro$ect finance ventures* forward contracts are used for the most art as
coverage against exchange rate risks. #his is true desite the greatest comlication*
which lies in the fact that the forward exchange market is very liCuid only for
maturities u to !% months but is ractically nonexistent for time horiFons sanning
more than !3 months.
Forward Contracts on "nterest +atesE#he Forward +ate Agreement& #raders can
also agree to exchange a future interest rate. #he forward rate agreement @or F+AA is
one of the most widely used futures written on interest rates. With an F+A* the buyer
ledges to ay the seller interest accrued on a rincial at a reagreed rate* starting at
a future date* and for certain eriod of time. #he seller* on the other hand* commits to
aying a fixed interest rate on the rincial based on the interest rate at the future
date. 'o* for examle* a .N( F+A means that for ) months @the difference between (
and .A the buyer and the seller will calculate an interest differential . months after the
contract term takes effect. Clearly* the contract exires in month ( @. R )A. #he F+A
buyer sets the future rate and is covered from interest rate risk. "f in fact the future
rate is higher than what was agreed on in the contract* the seller of the forward rate
agreement ays the difference between the two rates to the buyer. Conversely* the
buyer ays if the future rate roves to be lower than the reset rate.
"n ro$ect finance deals* the 'P0 would buy forward rate agreements in order to
fix the cost of financing. 8owever* the F+A market also shows higher liCuidity on
maturities that are much shorter than the entire tenor of the loan.
'was& 'was are contracts between two counterarties that stiulate
recirocal disbursement of ayment streams at reestablished future dates for a
set eriod of time. We can think of a swa as a combination of several forward
transactions. "n any case* the ayment streams relate to interest calculated on given
rincial. When interest rates are stated in two different currencies* we refer to
currency swas* and the two streams can be either fixed rate or variable rate.
When interest rates ertain to the same currency* obviously one of the flows is
calculated at a fixed rate and the other at a variable rate. Contracts known as
interest rate swas* in their simlest form* are a eriodic exchange of fixedDrate
streams against variableDrate streams @usually indexed to L"57+ or 6uriborA for a
given time horiFon.
'was are used to modify the conditions of a reexisting loan. A swa buyer* who
agrees to ay a fixed interest rate @short ositionA and eriodically receive a variable
rate @long ositionA* aims to cover against ossible future increases in interest rates on
the base loan. "f a rate increase does in fact occur* then the heavier debt burden is
counterbalanced by ositive differentials between variable and fixed rates that the
swa counterarty will have to ay.
'was are overDtheDcounter contracts handled by intermediaries on the basis of
the secific needs of a trader. "n this sense* they are contractual structures that are
well suited to covering exchange and interest rate risk in ro$ect finance deals.
Futures& A future is a forward agreement in which all contractual rovisions are
standardiFed @the underlying asset* date of maturity and date of delivery of the
instrument in Cuestion* minimum contract lotA. #his is done to facilitate and
exedite the trade of these instruments on official exchanges. "n futures markets* a
clearing house serves to guarantee obligations resulting from futures exchanges. #his
organiFation reCuires traders to ay an initial margin as collateral and daily variation
margins until the osition closes @the marking to market and variation margins
mechanismsA. -ue to this fact* futures differ from forward contracts in light of
their lower risk for counterarties and greater market liCuidity.
"n ro$ect finance ventures* interest rate futures can be used to curb the negative
reercussions of a rise in interest rates on a loan raised by the ro$ect comany.
8owever* more difficulties are involved in using this instrument. For examle*
coverage is comrehensive only if there is a future contract on the market that
corresonds to the interest rate aid on the base loan. "f this is not the case* the
oerator is exosed to basis riskK i.e.* the risk that trends in the two interest rates @on
the loan and on the futureA diverge considerably. "nstead* exchange rate risk coverage
entails fewer roblems& Futures markets* in fact* offer contracts written on the most
widely exchanged currencies on an international level. Another drawback regarding
the use of futures lies in the difficulty of finding contracts that last as long as the life
san of the base transaction* as mentioned earlier. 7f course* it may be ossible
continually to renew the contracts in Cuestion as they mature.
7tions and "nterest +ate 7tions @Cas* Floors* and CollarsA& 7tions* which are
either listed on the stock markets or negotiated over the counter* are contracts that
allow @but do not obligeA the buyer to urchase @call otionA or sell @ ut otionA a
commodity or a financial asset at a fixed rice @strike riceA at a future date in
exchange for ayment of a remium. <nlike all the contracts described reviously*
otions let the buyer choose whether or not to settle the contract. #he cost of this
choice is the remium the buyer ays to the seller.
8aving this alternative is very imortant for the buyer* who can minimiFe the
negative effects of keeing a osition while maximiFing ositive effects. 'o* for
examle* the buyer of a call will not exercise an otion if the listing on the underlying
security at the exiry date is lower than the strike riceK in doing so he or she will only
lose the remium. "nstead* the higher the rice of the asset on exiry as comared to
the strike rice* the greater the rofits for the buyer will be. #he oosite occurs when
one buys a ut otion.
"n ro$ect finance deals* otions are used both for covering exchange rate risk and
rotecting an 'P0?s cash flows from interest rate risk. With regard to the latter case*
in ractice interest rate cas* floors* and collars are widely used.
With an interest rate ca* a buyer ays a remium in exchange for the right to
receive the difference @if ositiveA between two interest rates& a variable rate @usually the
rate stiulated for the base loan raised by the ca buyerA and a reset rate agreed on
with the seller @strike rate or ca rateA. #he buyer and seller also establish relative
maturities and time horiFons in advance. "f the difference between the variable interest
rate and the ca rate is negative* the buyer simly ays the remium and receives
nothing in return. #he underlying asset that is the basis for flow calculations is fixed
from the outset. "f a ca buyer has already taken out a longDterm loan* the reference
rincial coincides with the residual debt in each eriod in the amortiFation schedule.
An interest rate ca is an attractive instrument for comanies who have variableD
rate financing and fear an excessive increase in their debt burden. 'P0s fall into this
category. Coverage by means of a ca allows them to fix a Cuota on increases* though
this instrument also intensifies the debt burden when rates fall.
With an interest rate floor* in contrast* a buyer ays a remium in exchange for
the right to receive the difference @if negativeA between two interest rates& a
variable rate and a reset rate arranged with the seller @strike rate or floor rateA.
"f the difference between the variable interest rate and the floor rate is ositive* the
floor buyer in this case simly ays the remium and receives nothing in return.
"nterest rate floor buyers are usually investors dealing in variableDrate assets who
anticiate a downturn in rices. With a floor* they set a lower limit to this downward
trend* though forfeiting art of the yield* given the remium ayment* if rates rise or
remain stable.
Lastly* an interest rate collar is a combination of buying @sellingA a ca and selling
@buyingA a floor. More secifically* a collar buyer is in the same osition as a ca
buyer and a floor seller. "f the variable rate exceeds the ca rate* the collar buyer will
be aid the difference by the counterartyK if instead the variable rate falls below the
floor rate* the buyer will ay the difference to the counterarty. @4ote that we are in
the osition of a floor seller.A "f the variable rate lies between the ca rate and the
floor rate* no exchange takes lace.
Figure )D% illustrates how a collar works.
#he two horiFontal lines indicate the floor rate @lower boundA and the ca rate
@uer boundA. Consider for examle time t
. "n this case the current level of interest
rates is lower than the floor rate* so the 'P0* having sold the floor to the hedging
bank* will ay the difference. 7n the contrary* at time t
we find the oosite
situation. #he current level of interest rates is higher than the ca rate* so the 'P0
is entitled to receive the difference from the hedging counterarty. "n this way* the
risk of interest rate fluctuations is limited to the corridor reresented by the difference
between ca and floor rates.
5uying a collar is a common strategy among 'P0s in ro$ect finance deals. -oing
so allows the comany to establish a >>band?? for rate fluctuation without having to
bear the higher cost of buying a ure interest rate ca.
$as3 in
$a! rate
(loor rate
$as3 o%t
F " : < + 6 )D% Model of 8ow a Collar Works
).!.)., "nflation +isk
"nflation risk arises when the cost dynamic is sub$ect to a sudden acceleration that
cannot be transferred to a corresonding increase in revenues. "nflation risk derives
from the fact that most contracts between 'P0s and their commercial counterarties
are based on revision mechanisms for rates or installments based on the behavior of a
given rice index.
5oth industrial and financial costs and revenues are imacted by inflation risk.
Consider* for instance* the effects of inflation on floatingDrate loans. "t is only natural
that in ro$ect finance this oint is crucial* considering the long tenor of the relative
loans and the multilicative effect of the caitaliFation factor alied to real cash
flows. When costs grow more raidly than revenues* cash flows from oerations used
for debt service slow to a trickle.
"nflation risk is even more difficult to deal with in the framework of ventures in
which the buyer is a ublic entity or a service is offered for ublic use* such as with
ublic transortation. "n this context* in fact* fee read$ustments that take the inflation
dynamic into account must be aroved by means of administrative measures.
-elays in this rocess can create the conditions for diseconomies in oerations for
eriods of time that are not always redictable.
#o cover against this risk* a swa contract is drawn u between a hedging bank
and the 'P0. #his Consumer Price "ndex swa @CP" swaA serves to mitigate the effect
that a dro in inflation would have on the caacity of nominal cash flows to service
the debt* in any given eriod.
When a hedging contract is signed* the benchmark inflation rate is Cuoted by the
hedging bank for the entire tenor of the loan @henceforth Fixed 'waed "ndex* or
F'"A. From that time forward the debt service* in terms of caital and interest* is
>>immuniFed?? from any ossible future change in the rate of inflation. Figure )D)
shows how a CP" works. #he 'P0 receives indexed ayments from the users @marketA
or from the offtaker* and ayments are linked to a given Consumer Price "ndex
A. #he CP" swa stiulates that the 'P0 ays the CP" to the hedging bank*
which in turn ays the F'" to the ro$ect comany. For any future level of CP"
* the
'P0 bears no inflation risk.
"n ractice* the exchange of cash flows between the two counterarties coincides
with each loan reayment after the scheduled revision of rates or eriodic ayments
collected by the 'P0. At this time* after agreeing to a base inflation rate to use for
comuting the coefficient for revising the ayments* one of the two arties gives the
other a certain sum of money deending on the differential between the real
inflation rate @CP"A and the fixed rate @F'"A negotiated when the hedging contract
was signed.
At every loan reayment date* the 'P0 can face three alternative scenarios&
!. CP"
V F'"& When this occurs* the inflation rate at t is less than the rate fixed
when the hedging contract was signed. #he dro in the nominal value of cash
flows and the resulting emergence of inflation risk is counterbalanced by a
corresonding amount aid by the hedging bank to the 'P0.
%. CP"
W F'"& 8ere the inflation rate at t is higher than the rate fixed when the
hedging contract was signed. #he increase in the nominal value of cash flows is
%. "nflation risk coverage takes effect when the oerational hase begins* because it is normally during this
hase that financing is reaid.
Lenin- Banks
Debt ser;ice
*!rinci!al < interest,
$ons%mer "rice
Ine5 *$"I,
(i5e S6a!!e
Ine5 *(SI,
He-in- Bank
F " : < + 6 )D) Counterarties and Cash Flows in a CP" 'wa
counterbalanced by a corresonding amount aid by the 'P0 to the hedging
). CP"
Q F'"& "n this circumstance* the real and fixed rates of inflation are
exactly the same.
7ne can easily intuit that the use of a CP" swa is indisensable in certain
situations. #his is true* for examle* when the sensitivity analysis carried out on the
financial model reveals a strong correlation between variation in the estimated
interest rate for defining the base case and the financial sustainability of the
).!.)./ 6nvironmental +isk
#his risk has to do with any otential negative imact the building ro$ect could have
on the surrounding environment. 'uch risk can be caused by a variety of factors*
some of which are also linked to olitical risk. 8ere are some examles.
. 5uilding or oerating the lant can damage the surrounding environment.
. Change in law can result in building variants and an increase in investment
. Public oosition to ro$ects with ma$or environmental imact could lead the
host government to reconsider government suort agreements @see 'ection
).!.)..A with the 'P0 and may create difficult oerating conditions for the
6nvironmental issues are vital for many kinds of ro$ects. Consider the transorD
tation sector or road construction in an area with significant tourist flow or the energy
sector and the roblem of air ollution. Moreover* in recent years more restrictive
legislation has been ut in lace to safeguard the environment. "n AngloD'axon
countries* for examle* lenders are disinclined to ask for guarantees in the form of
the lant itself* since the resonsibility for ossible environmental damage derives
from the ownershi @or actual controlA of the ro$ect.
).!.).. +egulatory +isk
#here are various facets to regulatory riskK the most common are the following.
. #he ermits needed to start the ro$ect are delayed or canceled.
. #he basic concessions for the ro$ect are unexectedly renegotiated.
. #he core concession for the ro$ect is revoked.
-elays are usually caused by inefficiency in the ublic administration or the
comlexity of bureaucratic rocedures. "f instead delays are the result of secific
olitical intent to block the initiative* this situation would be more similar to olitical
).!.).2 Political +isk and Country +isk
Political risk takes various forms* for instance* a lack of government stability* which
for some ro$ects may be critical. "n energy roduction initiatives* for examle* the
'P0 could be negatively imacted by a change of government if the new administraD
tion does not share the same views as the revious one. "n addition* citiFens themD
selves could comletely reshae their national context through a referendum. An
antinuclear referendum is an excellent examle that gives an idea of the otential
scoe of olitical risk.
#he following is a generally acceted classification of different tyes of olitical
. "nvestment risks& #hese relate to limitations on the convertibility or transfer of
currency abroad. 'uch restrictions are imlemented for macroeconomic
reasons* such as maintaining eCuilibrium in the balance of ayments or defendD
ing the exchange rate. 7ther examles of investment risk are the host governD
ment?s exroriating a lant without aying an indemnity* or nationaliFing a
lant* or the breakout of war* revolt* or civil war @olitical force ma$eure riskA.
. ChangeDinDlaw risks& #hese include any modification in legislation that can
hinder ro$ect oerations.
. XuasiDolitical risks& #his category encomasses a wide range of different cirD
cumstances. 4ormally* it includes all disutes and interretations regarding
contracts already in lace @breach of contractsA that emerge from a olitical*
regulatory* or commercial background. "n some cases* these risks do deend not
on the central government* but on the local administration emowered to imleD
ment its own laws and fiscal olicies. "f these ublic bodies are counterarties of
the 'P0 and they default* the central government is under no obligation to
rovide any suortK this results in >>substate?? or >>subsovereign?? risk. Lastly*
CuasiDolitical risks include soDcalled creeing exroriation* which refers to a
combination of behaviors that a ublic body can adot to >>sCueeFe?? ro$ect
oerations. 'uch actions do not constitute a formal act of breach of contract.
Political risks are esecially imortant for lenders in ro$ect finance ventures
located in develoing countries. #hese nations* in fact* have legal structures that
are not well defined* most have olitically unstable governments* and there is little
exerience of rivate caital investments in strategic sectors.
#here are two ways to cover against these risks. #he first is to draw u an
agreement with the government of the host country stating that the government
will create a favorable @or at least nondiscriminatoryA environment for the sonsors
and the 'P0. #his kind of contract* called a government suort agreement* can
include rovisions with the following intent&
!. #o rovide guarantees on key contracts @for examle* the government rovides
guarantees that a key counterarty will fulfill its obligations as offtaker or
inut sulierA
%. #o create conditions that would serve to revent ossible currency crises from
adversely affecting the convertibility of the debt service and the reatriation of
dividends @for examle* the host country could set u ad hoc currency reserves
through its central bankA
). #o facilitate the oerational caacity of the 'P0 from a fiscal standoint
through tax relief or exemtions
,. #o create favorable institutional conditions @for examle* imortation roceD
dures exemt from customs duties* streamlined bureaucratic rocesses* service
rovision for the 'P0* concessions for the use of ublic lands* or rovisions for
acceting international arbitration outside the host country to resolve legal
#he second way to cover against olitical risks is through the insurance market.
"nsurance olicies are available offering total or artial coverage against olitical
risks. #hese olicies are offered by multilateral develoment banks and exort credit
agencies @as we see in 'ection ../.%A as well as by rivate insurance comanies @see
'ection ,.)A.
).!.).3 Legal +isk
Legal risk centers rimarily on the ro$ect?s lenders* whose lawyers analyFe and
manage this risk @see 'ection ,.!A. #heir $ob is to ascertain whether the commercial
law of the host country offers contract enforceability should roblems emerge during
the construction or ostcomletion hases.
"t should be noted that contract enforceability does not deend exclusively on the
degree of economic develoment in a country. "t also involves a series of other
factors* such as a country?s $udicial tradition and the institutional conditions and
context characteristics. As for the first variable* in countries where the rule of law is
grounded in civil law* lenders find less rotection than in nations where common law
is in force. #his is even true in countries with a solid level of economic develoment
and conseCuently low olitical risk. "nstitutional conditions comlicate matters*
because they are linked to factors such as corrution and the tendency toward illicit
behavior* which can often turn a decision against lenders. #he magnitude this
roblem has reached has led various research organiFations to comile indices
that actually measure the degree of corrution and reliability of olitical and adminD
istrative institutions of a given country.
For examle* the "nternational Country +isk :uide @www.rsgrou.comA bases
its analyses on corrution risk* exroriation risk for rivate roerty* and risk of
contract reudiation. For each country* this guide comiles statistics on the level of
exosure to said risks. "t is easy to see that in these cases* contracts are likely to be
evaded if the institutional system does not adeCuately safeguard the rights of lenders.
Legal risk can be managed and covered by meticulous drafting of contracts. Calling
in lawyers right from the initial setu hase of a venture clearly roves vital. #he
suort of the host government also takes on ma$or significance.
,/ +isk Allocation with Contracts 'tiulated by the 'P0
).!.).( Credit +isk or Counterarty +isk
#his risk relates to the arties who enter into contracts with the 'P0 for various
intents and uroses. #he creditworthiness of the contractor* the roduct buyer* the
inut sulier* and the lant oerator is carefully assessed by lenders through an
exhaustive due diligence rocess.
#he financial soundness of the counterarties @or resective guarantors if the
counterarties are actually 'P0sA is essential for financers.
#he significance of credit risk in ro$ect finance deals lies in the nature of the
venture itself& offDbalanceDsheet financing with limited recourse to shareholders=sonD
sors and a very high level of financial leverage. #hese features form the basis of a
different aroach for determining minimum caital reCuirements that banks must
resect with regard to ro$ect finance initiatives. #his aroach was established by
the 5asel Committee* the international body that counts reresentatives of banking
suervisory authorities from several countries among its members @see Chater 3A.
).% +isk Allocation with Contracts 'tiulated by the 'P0
"n the rocess of risk management* risk is identified and at the same time allocated to
the arties involved in the transaction whenever ossible. #o ascertain that all risks
are aroriately allocated to various layers* lenders take a comrehensive look at
the network of contracts with the 'P0. 4ormally* when lenders are solicited for
funds* the 'P0 has already configured risk allocation by means of a series of
reliminary contracts and has covered the residual ortion of risk with insurance
olicies. -eending on the method used for covering risk* lenders might ask to
reconsider certain terms or renegotiate some contracts. "n this case* renegotiations
can also take the form of direct agreements between lenders @see Chater 2A and some
of the arties involved in the deal.
"n any case* the most comlex situation arises when the ro$ect analyses run by
the banks reveal risks that were not initially addressed in the contracts. "f these risks
are critical to the success of the initiative* the following actions may be taken.
!. Closing on the financing is ostoned until the roblems in Cuestion are
%. Problem solving is ostoned until financial closing* as long as the credit
agreement includes rovisions that oblige the arties to imlement an accetD
able solution by a secified date. #his reCuirement falls in the category of
covenants* which are discussed in Chaters . and 2.
).%.! Allocation of Construction +isk&
#he #urnkey @or 6ngineering* Procurement*
and ConstructionE6PCA Agreement
A turnkey agreementEalso known as 6PC @engineering* rocurement* and construcD
tionAEis a construction contract by which the 'P0 transfers construction risk of the
structure to the contractor. "n exchange for a set fee* the contractor guarantees the
'P0 the following&
,. C 8 AP # 6 + ) Pro$ect Characteristics* +isk Analysis* and +isk Management
. #he comletion date
. #he cost of the works
. Plant erformance
"n addition to these guarantees* there may be coverage against technological risk.
#ransferring this tye of risk to third arties is always Cuite comlex* in articular if
the ro$ect?s base license is extremely innovative. "n concrete terms* the otions
available are the following&
. #o ask indeendent technical advisors @see 'ection ,.%A their oinion on the
effectiveness of the technology
. #o oblige the technology sulier to ay enalties either in one lum sum or
roortional to the atent value of the technology
. #o oblige the contractor to rovide erformance guarantees on the technology
that are incororated in the construction contract @wraing or wraaround
7f course* the $udgments of technical consultants do not constitute legally binding
guarantees. 4onetheless* if a anel of exerts unanimously suorts the validity of
the technology with initial due diligence of technological features* the ro$ect stands a
greater chance of success than if the resonse is general sketicism.
Penalties aid by suliers* whether lum sum or roortional* have a greater
imact on the 'P0?s cash flows. 8owever* it should be said that the amount of these
enalties is always less than the overall value of the ro$ect. #herefore* lenders should
not rely too heavily on these figures to recover their investments in case of setbacks.
Wraing @or wraaround resonsibilityA is what rovides lenders with a real
guarantee. With this tye of contract* the contractor is reCuired to ensure that the
lant corresonds exactly to design and technical secifications listed in the license
agreement for use of knowDhow with the 'P0. 7f course* when contractors give this
guarantee* resumably they are familiar with the technology to be develoed* and as
a result the 'P0 will clearly face higher construction costs.
When the technology in Cuestion is absolutely new* there is no wraing. 4o
contractor* however reliable* would be able to offer an 'P0 such a broad guarantee.
"n these cases* the venture can be financed only if the sonsors guarantee total
recourse to lenders during the construction hase. 'uch recourse is eliminated only
if the lant roves functional once construction is comlete.
As far as guarantees on comletion dates* when the reestablished construction
time is u* one of two ossible situations can occur&
!. #he lant meets minimum erformance standards.
%. #he lant does not meet minimum erformance standards.
Let?s examine the two cases searately via Figure )D,* which shows the crucial
checkoints the lant must ass before starting oerations. #he first test is erformed
by the indeendent technical engineer at the commercial oerating date @C7-A* the
date originally indicated in the construction contract as the deadline for the delivery
of the facilities. #he contractor is considered in comliance with contract obligations
@and therefore does not face additional costs for delays in delivering the structureA if
the lant meets minimum erformance standards @MP'A in the initial test and is given
a Provisional Accetance Certificate @PACA. "n ower lants* for examle* MP's are
"lant testin-9 ;erification
of minim%m !erformance
stanars *M"S,
(inal !lant testin-9
(inal acce!tance
,2 +isk Allocation with Contracts 'tiulated by the 'P0
ealine for com!letion
of t3e str%ct%re
$ommercial o!eratin- ate
If M"S are met9
+: Li'%iate
/: Make -oo
If M"S are not met9
$ontractor in breac3
F " : < + 6 )D, Contractor :uarantees on Pro$ect Comletion -ate and Performance& 8ow #hey Work
set at (/J of the theoretical erformance of the lant. #hese standards relate to
electrical outut* steam roduction* heat rate* and emissions.
"f the lant meets the MP' but does not function at a !11J erformance level as
defined in the contract* the contractor is usually given two otions&
. #o liCuidate
. #o make good
"n oting to liCuidate* the contractor takes no stes to bring the lant u to the
!11J erformance level* but instead ays the 'P0 an amount referred to as buydown
damage* which corresonds to the difference in actual revenue as comared to !11J
yield. #he buydown damage serves to ensure that the ro$ect satisfies debt service
obligations* even in the event of a reduction in revenues caused by the lant?s lower
erformance level. With the makeDgood otion* the contractor ays the cost of
bringing the lant u to !11J outut within a set eriod of time.
#esting continues for a certain eriod of time* after which the lant is issued a
Final Accetance Certificate @FACA @see 'ection ,.%.)A and is turned over to the 'P0.
#he contractor guarantees that the facility is free of any ledges* claims* or mortD
gages. "n addition* the terms of the construction contract include a commitment by
the contractor to reair or substitute defective materials at no cost to the 'P0 for a
reestablished warranty eriod starting from the date of the FAC.
4ow let us return to Figure )D,. "f the lant does not ass the MP' test* the
contractor is considered in breach of contract and in theory is obliged to reimburse
'P0 for all down ayments received during the construction hase. "n actual
ractice* such a radical course of action is never taken. "n fact* technically the ro$ect
would be in default. 8owever* with the consensus of lending banks* the 'P0 always
attemts to negotiate the comletion of the lant with the contractor or another
counterarty* who ays the 'P0 damages in roortion to the revenue lost due to the
#he contractor is not in breach of contract if lant comletion is delayed due to
force ma$eure events. What exactly constitutes such an event is the sub$ect of very
intense negotiations between contractors* sonsors* and lenders. "n addition* conD
tractors always attemt to negotiate the following in the construction contract&
. 5onuses in their favor if the lant is comleted ahead of schedule or if it
functions more efficiently than secified in the contract @for examle* with a
lower level of inut consumtionA
. Clauses that limit their resonsibility for aying damages* u to a maximum
ercentage of the turnkey rice @guaranteed by a erformance bond that conD
tractors ost in deosit until construction is comleteA
).%.% Allocation of 'uly +isk& PutDorDPay Agreements
#he coverage method for limiting or eliminating suly risk consists in drafting
contracts for unconditional suly @ utDorDay agreements or throughut agreementsA.
"n these accords* the sulier sells the 'P0 reset volumes of inut at reagreed
rices @again* ad$usted according to redicted trends of a given rice indexA.
"f suly is lacking* normally the sulier is reCuired to comensate for the higher
cost incurred by finding another source of inut. Figure )D/ illustrates how this
contract works.
A utDorDay contract has the same criticality as a takeDorDay agreement
@see 'ection ).%.,A. "n the ower sector* for examle* one of the rimary aims of a
longDterm fuel suly contract is to ensure that revision mechanisms for the inut
rice are balanced with those relating to rice ad$ustments for the sale of electricity.
F " : < + 6 )D/ 8ow a PutDorDPay Contract Works
"n this way* sales revenues and suly costs are synchroniFed. "n cases where the
inut is not hysically near the lant or the structure in Cuestion* the sonsors also
negotiate contracts for transorting inut from its roduction site to where it will
actually be utiliFed.
).%.) Allocation of 7erational +isk& 7erations
and Maintenance @7BMA Agreements
7erating risk can be mitigated by the exerience and the reutation of the ro$ect
oerator. As far as 7BM contracts are concerned* two solutions are ossible&
. FixedDrice contract& 8ere the oerator assumes risks relating to the fluctuations
in oerating costs and makes a rofit only if the costs actually incurred are
lower than the contract rice for services rendered. 'ee Figure )D..
. PassDthrough contract& "n this case* the oerator receives a fixed ayment and
erformance bonuses while the 'P0 covers oerating costs. With this contract
structure* the level of erformance bonuses is crucial* as is determining
enalties the oerator would face if satisfactory outut levels are not attained.
'ee Figure )D2.
As a sulemental guarantee* lenders also reCuest a steDin right* which is the
otion to remove the original oerator and substitute that comany with another of
the lender?s choosing. #his is one of the many direct agreements made between banks
and the different counterarties of the 'P0 discussed in Chater 2.
).%., Allocation of Market +isk
Market risk coverage is crucial in ro$ect finance. #his is because a reduction or
cancellation of market risk allows the 'P0 to lock in the first line of cash flows or to
reduce its volatility @and conseCuently the risk of a cash shortageA.
F " : < + 6 )D. 'tructure of a FixedDPrice Maintenance Contract
F " : < + 6 )D2 'tructure of a PassD#hrough Maintenance Contract
8owever* this coverage is not always ossible. "t is simler if there is a single
buyer of the good or service @the offtakerA* but it becomes imossible when dealing
with a retail market. For examle* it is much easier to draw u longDterm sales
contracts with an industrial buyer or a utility* as occurs in the ower sector. 8owever*
the situation becomes more comlicated in the transortation sector @roads* tunnels*
arking lots* etc.A or when dealing with building hotels or leisure facilities. "n these
fields* the variability of tourist or traffic flows can never be comletely eliminated.
7nly minor remedies can be ut in lace by sonsors.
. #hey can conduct sensitivity analyses to estimate users? reactions to a @otenD
tially substantialA fee reduction @always within a defined range of robabilityA.
. #hey can attemt to limit demand fluctuations by drawing u contracts that
ensure minimum use of the structure. An examle might be contracts assigning
some arking saces to a secific counterartyK another examle is the hotel and
leisure sector* where tour oerators can contract for guaranteed room availD
ability in certain eriods of the year for the business segment.
. #hey can force the ublic administration to guarantee a minimum level of
revenues where there is a variable market. "n this case* although it is imroer
to talk about offtaking agreements* the ublic administration can act as a
wholesale buyer* reducing the level of market risk otherwise borne by ro$ect
sonsors. #wo examles related to the transortation sector and the hosital=
health care services sector are discussed in 'ection ).%.,.).
).%.,.! 7fftake Agreements
When the 'P0 sells goods or services to a single large counterarty* offtake agreeD
ments reresent a very useful tool for structuring a ro$ect finance transaction.
"n fact* by mitigating market risk* such agreements decrease the volatility of future
cash flows from oerations* which are the basis of lenders? assessments as to the
sustainability of the deal.
7fftake agreements are longDterm contracts in which one counterarty @usually an
'P0A commits to delivering certain volumes=Cuantities of a good or service. #he
other* called the offtaker* agrees to ay redefined sums of money or a set fee for a
certain eriod of time in exchange for a good=service from the 'P0. #he rice the
offtaker ays is indexed to arameters that track trends in the rate of inflation for
roduction rices and consumer rices.
#he most common tyes of offtake agreements are set u on a takeDorDay basis.
Figure )D3 illustrates the functioning of such an agreement. #he offtaker commits to
buying a good or service roduced by the 'P0 and is obligated to ay even if it does
not actually take a good or service. #his latter is true* however* only if the 'P0 is able
to suly the good in Cuestion* i.e.* only if the 'P0?s roduction outut is available
for delivery.
"n contrast* as the lower art of Figure )D3 shows* if outut is unavailable* it is the
'P0 that commits to roviding an alternative source for the roduct or service and
must comensate for the greater costs incurred by the offtaker if and when the case
may be. "n this way* a takeDorDay dulicates a utDorDay contract* discussed earlier
in 'ection ).%.%.
7fftake contracts take various names* deending on the sector in Cuestion and the
business conducted by the 'P0K these agreements have been used the longest in the
ower sector @see 'ection ).%.,.%A. "n the telecom sector* for examle* there are "+<
F " : < + 6 )D3 'tructure of #akeDorDPay Contracts
contracts @indefeasible rights of useA* which refer to the exclusive right to use
a secific ortion of the caacity of a communications cable for a set eriod of
time. "n exchange for this right* the beneficiary comany @generally a service roD
viderA ays fixed eriodic sums to the owner of the network @often the 'P0A. Another
examle is in the shiing industry* where we find time charter contracts @which
usually run from five to fifteen yearsA. #his tool enables shi owners to finance
investment initiatives while emloying a limited amount of their own financial
resources. With a time charter* a third arty @often a service comanyA ays a rental
fee to the 'P0* which is usually the owner of a fleet of shis* for the use of these
vessels. "n this way* the 'P0 curtails its market risk* e.g.* finding no renters and
leaving its fleet anchored in ort.
).%.,.% 7fftake Contracts in the Power 'ector
#he ower sector is certainly the investment area in which such agreements have
evolved the furthest and for the longest time. #oday* in fact* various tyes of contract
frameworks can satisfy the needs of the counterarties involved in an investment
initiative while resecting the rincile of correct risk allocation among ro$ect
articiants. #he contract structures to which we refer are the following&
. PPA @ower urchase agreementA
. tolling @based on a tolling agreementA
Power Purchase Agreement 'tructure& #he contract model for distributing electrical
ower known as the PPA was the first to be used on a wide scale in the <nited 'tates





and various 6uroean countries to develo construction ro$ects for rivate ower
lants. #his contract structure is based on longDterm agreements between rivate
investors and a ublic counterarty or an entity linked to the ublic administration
that essentially oses no credit risk.
With a PPA* the 'P0 undersigns contracts in two directions&
!. A fuel suly agreement @F'AA to ensure fuel suly and mitigate suly risk
%. A ower urchase agreement @PPAA* a suly contract for the longDterm sale of
all ower generated by the lant to one or more wholesalers @offtakersA to
mitigate the risk of selling energy outut
'ecifically* the PPA contract establishes that the ro$ect comany will make
a certain amount of electric ower available dailyK the offtaker* in turn* is obligated
both to make a minimum urchase and to ay a fee* art of which is fixed and art
#he fixed comonent* also known as the caacity charge* serves to cover fixed
costs of the lant* the return on investments of the sonsors* and debt service. #he
variable comonent* which can also be called the energy charge or energy fee* is
indexed to the actual electric ower roducedK it goes to meeting both fuel costs and
variable oeration and maintenance @7BMA costs. 5asically* every increment in fuel
rices should translate into an increase in the electricity rate aid by the buyer @assD
throughA. 4ormally* the method for revising this rate is established at the outset and
is linked to the revision mechanism for fuel costs. #he rate is calculated by using the
following eCuation&
PPA rate Q Cf R 6f
Cf Q Caacity fee Q fixed costs R debt service R sonsor reimbursement
6f Q 6nergy fee Q fuel R variable 7BM costs
Figure )D( illustrates how the PPA rate is determined.
"n the energy sector* the PPA contract is the keystone for ro$ect finance initiaD
tives. "n this context* lenders? main concern should be to verify that the contract
(%el costs
Variable o!eratin- costs
Variable O0M costs
(i5e costs *fi5e O0M costs an ot3er fi5e costs,
Debt ser;ice
Di;iens to s3are3olers
F " : < + 6 )D( -etermination of the PPA +ate
extends to the entire tenor of the loan and on the assessment of the offtaker
creditworthiness. 'ecifically* banks focus on escae clauses that buyers reserve for
themselves. "n addition* banks tend to make buyers accet contract rovisions
allowing for an adeCuate amount of time to devise solutions that would revent
withdrawal from the contract.
#here are two basic PPA contracts* the American model and the 5ritish model.
"n the first* federal and state authorities grant ower roducers the exclusive right to
suly and distribute energy in a given area. As for ower generation* this right is
limited& <tilities can buy the energy generated by indeendent roducers only if this
ower is cheaer than what they roduce themselves.
"n the <9* on the other hand* ower roducers sell their outut on an energy
exchange @the Power PoolA* which then transmits this ower to local distributors who
buy from the same exchange. #he Power Pool is run by the 4ational :rid Comany
@4:CAK roducers offer energy to this comany on the basis of set rices* secifying if
the lant is oerational or in standby. #he 4:C takes resonsibility for eriodically
comiling a classification of ower lants* based rimarily on the bid rice but also
on the lant?s caacity to resond raidly to 4:C demand and on its geograhical
location. 6nergy demand is conveyed to the 4:C through regional electric comD
anies @+6CsA* who base the urchase rices they offer on local needs. "n the 5ritish
model* roducers do not know exactly what rice they will receive for the ower they
suly. #he same is true for the +6Cs* which do not know ahead of time what rice
they will ay for electric ower suly. #herefore* this is a market model in which
rices deend on suly meeting demand.
#his uncertainty is dealt with by means of a mechanism known as a contract on
differences between the indeendent roducer and the +6C. "n this agreement* the
arties set u a hedging fund on the basis of a strike rice. "f the rice aid by the
+6C to the Pool exceeds the strike rice* then the roducer refunds the +6CK if
instead this rice falls below the strike rice* it is the +6C who ays the difference to
the roducer. "n reality* the contract on differences is an exact relica of the PPA
contract in the American model.
#olling 'tructures& PPAs have gradually been relaced by other tyes of contract
models. An examle is tolling* which enables the energy roducer @usually an 'P0 or
an indeendent ower roducerE"PPA to generate sufficient cash flows to reay
initial investments. At the same time* this setu allows for more efficient and
rational risk allocation. #olling contracts were first invented and develoed in the
etrochemical industry* in articular in the crude oil refining sector.
"n the electric ower sector* in contrast* tolling has been used in countries that
first liberaliFed domestic markets for electricity and gas& the <nited 'tates and the
<9 and later 'ain and "taly.
#his tye of contract has basically evolved from the need for fuel suliers to
allocate risk in an innovative way while reserving the ro$ect?s ability to raise caital
on a nonrecourse basis. #he base contract that tyifies a tolling structure is called
). A contract for differences is similar to a hedging contract between the 'P0 and a hedging counterarty.
With hedging* an agreement is drawn u between the two arties for the sale of a commodity at a set rice for a
given eriod of time. At the same time* a lower bound and an uer bound are set to limit rice variations for the
commodity. "f on the settlement date the rice is between the lower and uer bounds* the 'P0 sells the roduct
on the oen market. "f instead the rice goes below the lower bound @above the uer boundA* the 'P0 has the
right to sell the commodity at the lower bound rice to the hedging counterarty @and vice versa* the hedging
counterarty has the right to buy at the uer bound riceA.
F " : < + 6 )D!1 Functioning of the #olling Agreement
a tolling agreement. According to this accord* on one hand a wholesale customer*
called the toller* sulies fuel as a >>free issue good?? to the ro$ect comany?s lant
and gives this comany orders for converting the Cuantity of fuel delivered into
energy. "n exchange for services offered* the 'P0* on the other hand* has the right
to receive a tolling fee. Figure )D!1 shows the functioning of a standard tolling
#he uniCue features of a tolling structure can be summariFed as follows.
. All market risks* esecially those relating to suly and the sales rice of electric
ower* are taken on by the toller* who sets u agreements directly for fuel
suly and transortation and for sale of electric ower.
. #he ro$ect comany* in exchange for the tolling fee aid by the toller* offers its
roduction caacity and rovides the service of converting fuel into electricity.
. 7nly oerating risk is taken on by the 'P0.
. #he ro$ect comany can rely on readily redictable and constant cash flows for
the duration of the tolling agreement* regardless of the fluctuations in the ower
market or in the rice of fuel used to roduce electricity.
#he tolling fee aid by the toller to the ro$ect comany for services rendered is
one way to guarantee this final condition.
#here are generally two aroaches to building a tolling fee& financial and
industrial. "n both cases* erDunit fixed costs and variable costs of oerations are
taken as comonents of the fee* for they are essential to the functioning of the lant.
#he difference between the two calculation methods is the remuneration of factors
taken into consideration& financial resources* loan caital* and eCuity in the financial
aroach* investment caital in the industrial aroach.
According to the financial aroach* the tolling fee can easily be comared to the
caacity charge described earlier in relation to PPA structures. "n fact* this fee is meant
to cover fixed costs of the lant* return on investments for sonsors* and debt service.
Following the industrial aroach* in contrast* the tolling fee is seen as a source for
remunerating the caital invested in the ro$ect. "n addition to covering fixed costs of
oerations* the fee includes amortiFation for goods tied u in the investment initiative
as well as the return on caital invested reCuested by lending institutions.
"n some cases a variableDcost item may be factored into the tolling fee* which is
indexed to contracted thermal efficiency criteria @heat rate ad$ustmentA. 4onetheless*
the key comonent of the variable fee of a PPAEfuel costsEis absent* because fuel is
sulied directly by the toller. #he amount due is calculated by alying the followD
ing eCuations* deending on whether the financial or the industrial aroach is used.
Financial Aroach&
"ndustrial Aroach&
#olling fee Q -s R +s R Foc R 0oc
-s Q -ebt service
+s Q +emuneration of sonsors
Foc Q Fixed oerating costs
0oc Q 0ariable oerating costs
#olling fee Q Am R +ci R Foc R 0oc
Am Q AmortiFation
+ci Q +emuneration of investment caital
Foc Q Fixed oerating costs
0oc Q 0ariable oerating costs
Figures )D!! and )D!% show the structure of the tolling fee in the financial
aroach and the industrial aroach* resectively.
#his tye of contract makes it ossible to maximiFe the financial leverage of the
'P0* since one of the cornerstones of ro$ect finance is fully actualiFed& +isk is
allocated to layers who* in each secific case* are in the best osition to control it.
Lastly* it should be emhasiFed that in tolling structures* risks are taken on rimarily
by the toller. For this reason* the toller must demonstrate to lenders sufficient
technical=rofessional skills to handle both sulying fuel and selling electric ower
while maintaining a high credit standing for the entire tenor of the loan.
#akeDandDPay Contracts @Merchant PlantsA& "n recent years* ro$ect finance
ventures in the ower sector have been structured much more aggressively as far as
the risk assessed and allocated among various articiants in the investment
initiative. #his trend can be attributed to a series of conditions that have emerged
on the financial markets in the ast few years. 6xamles are a high level of available
liCuidity* a growing tendency for commercial banks to assume greater risks in order
to win market share while thwarting cometitors* and high oil rices* which have
allowed energy and oil comanies to boost their rofit margins.




Variable o!eratin- costs
*f%el e5cl%e,
(i5e costs *fi5e O0M costs an ot3er fi5e
costs, *(O$,
Debt ser;ice *DS,
Di;iens to s3are3olers *RS,
F " : < + 6 )D!! 'tructure of the #olling Fee in the Financial Aroach
Variable o!eratin- costs
*f%el e5cl%e,
(i5e costs *fi5e O0M costs an ot3er fi5e
costs, *(O$,
Amorti>ation *AM,
Rem%neration of in;este ca!ital *R$I,
F " : < + 6 )D!% 'tructure of the #olling Fee in the "ndustrial Aroach
Among the financial models adoted in this context* which is characteriFed by
intense seculation on financial markets* we find the merchant structure. Within this
framework* the ro$ect comany does not enter into any longDterm contract guaranD
teeing fuel suly within a set rice bracket or the sale of electricity generated by the
lant. "n fact* the offtaker ays for only what it actually buys @take and ayA.
As a result* the 'P0?s cash flows are exosed to oerating risks* inherent in the
ability to roduce electric ower efficiently and economically* suly risk* and
market risk* i.e.* the level of liCuidity and volatility of the electric ower market
throughout the life of the ro$ect.
With merchant structures* in fact* fuel suliers are forced to accet a considerD
able share of the rice risk of electricity* leaving most of remuneration to the ower
roducers. #his articularly aggressive tye of structure is called merchant sCuare.
"t is distinctive both because there is no fuel suly agreement @F'AA to cover against
suly risk or ower urchase agreement @PPAA to cover against market risk in a
strict sense. "n this way* the 'P0 buys fuel and sells electric outut daily and
is comletely exosed to market risk on both fronts.
4onetheless* in ractice* exosure to fuel suly risk is lower and is normally
mitigated by imlementing an F'A. Moreover* fuel sellers are often forced to accet
rice indexing for fuel that is linked to the actual sales rice of electric ower on
regulated markets.
).%.,.) 7fftake Agreements in PPP initiatives
'onsors of ro$ects falling in the PPP category often ask the ublic administration
to cover at least a art of the market risk related to such initiatives. A PPP* in fact* is
a way to transfer most of the risks of roviding services to a retail ublic of end users
to rivate arties* leaving the ublic sector only the role of director and suervisor of
service rovision to taxayers. For this reason* it seems natural to ask the ublic
administration for some form of subsidy in order to imrove the attractiveness for
the rivate sector and ro$ect rofitability for sonsors.
'uch subsidies are very similar to a takeDorDay agreement. #hey generally involve
the ayment of tariffs when the usage of the facility built by the 'P0 is below a certain
redefined level or tariffs with a minimum floor amount that comensates the rivate
sector for the availability of a given facility* regardless of the number of users.
An examle of the first tye is the shadow toll system used in transortation facilitiesK
the second tye can be found in hosital and health care services.
7fftaking Contracts in the #ransortation 'ectorE#he 'hadow #oll 'ystem& #he
shadow toll system is used in the context of building toll roads and ugrading
reexisting roads. #his contract mechanism facilitates awarding concessions for
segments of roadwaysEeither 57# or its variant* -5F7 @design* build* finance*
and oerateAEto rivate oerators. With this contract* the ublic administration
ays an annual toll to the rivate concession holder based on the volume of traffic on
the road and the service levels. #he word shadow refers to the fact that the end user
does not actually ay a toll to the oeratorK in fact* there are no tollgates for
collecting money. #he final cost of road construction is factored into the national
budget and so is aid for by citiFens through taxes.
#he rivate concession holder ledges to raise caital to carry out the ro$ect and
for a set time eriod has the right to collect shadow tolls @usually for around )1
yearsA. #his revenue allows the concession holder to recover the costs of ugrading or
building the road and to earn a reasonable return on caital invested. When the
concession exires* ayments sto and the road is turned over to the ublic adminD
istration* which ays no additional fee to the concession holder.
-uring the term of the concession* the concession awarder ays the holder on the
basis of the number of vehicles that travel on the road. Payments are based on a
banding system linked to the use of the roadway. "n the <9* a rather common
formula is for otential concession holders to make an offer based on multile
banding* where every band covers a different ro$ect cost rofile @see Figure )D!)A.
5and ! is used to cover fixed 7BM costs and senior debt service. 5and % serves to
cover variable management and 7BM costs and to service the subordinate debt.
Lastly* 5and ) is normally earmarked for aying out dividends. For traffic volumes
above a given level @5and ,A* as decided by the ublic administration and the
concession holder* no shadow tolls are aid. As a result* there is a ca on costs for
the ublic administration and revenue for sonsors.
#here are several advantages to the shadow toll system.
. "ncentives for the concession holder& :iven that ayments to this comany are
based on traffic volumes and service Cuality* it is in the concession holder?s best
interest to comlete the road construction Cuickly and to avoid construction
delays or inefficient management of the infrastructure.
. Limitation of traffic risk& #his facilitates rivate artners in the search for
financing for building new roads or ugrading existing ones. Moreover* a






Ver& 3i-3
Ban 1
Ban /
S%borinate ebt ser;ice < ;ariable o!eratin- costs
Ver& lo6
Senior ebt ser;ice < fi5e O0M costs
Ban +
F " : < + 6 )D!) 5anding 'cheme in #ransortation Pro$ects
wellDstructured banding system can curb the adverse effects of a lower traffic
flow than exected.
. For the ublic administration& #he rivate concession holder assumes the risk of
maintaining and oerating the roadK the ublic sector can set a maximum limit
on its financial commitment by caing shadow toll ayments. "n this way* the
risk of extra revenues to the rivate concession holder is eliminated.
7fftaking Contracts in the 8osital and 8ealth Care 'ervices 'ector& An
interesting examle of contract relicating a takeDorDay agreement is the ayment
of eriodic sums to be made by the ublic administration for the use of services
rovided by an 'P0 that runs a hosital @but this holds true also for the use of
risons or schools* for examleA. #his is the focal oint in setting u a hosital
construction venture structured through ro$ect finance. "n fact* the eriodic
ayment is the sub$ect of lengthy negotiations between the ublic artner and the
'P0 @the rivate concession holderA. 'uch a ayment is made when the new
structure oensK this amount is broken down into a number of fixed and=or
variable comonents. With secific reference to 6ngland* a country with a long
history of imlementing ro$ect finance in the context of PPPs* the ublic body=
rincial @the 48' #rustA makes no down ayment until the hosital actually
oens. At this oint* ayment is based exclusively on services rendered and
usually consists of the following three comonents&
!. An availability ayment linked to accessible floor sace* which is around /2J of
the eriodic ayment
%. A service fee* determined by the level of service Cuality as comared to a
benchmark secified in the contract* usually )/J of the eriodic ayment
). A volume fee* roortional to the number of services erformed @ayment by
usage* volume* or demandA* around 3J of the eriodic ayment
,. More inDdeth information and useful links on the use of -5F7 systems in the roadway sector as well as
data relating to the American and 6nglish situations can be found at www.inn o vativefinan c e.org.
#he largest comonent of the annual installment* therefore* is the availability
ayment. "n fact* the total income generated from service rovision and commercial
activities @for examle* arking* shosA is insufficient to guarantee a satisfactory
level of rofitability to ro$ect sonsors. More secifically* these revenues are
not enough to reimburse rivate investors for their financial commitment to build
and oerate a facility as technologically and oerationally comlex as a hosital*
desite the fact that hositals are setting aside more and more sace for rivate
For all these reasons* the availability ayment becomes the key mechanism for
market risk allocation between rivate investors and the ublic administration.
A further clarification is that the first two comonents of the eriodic ayment
are not fixed during the concession eriod. "nstead* they are sub$ect to an evaluD
ation system that may lead to erformance deductions in the total amount of the
Cuotas due. #hese deductions are calculated by starting with the level of service
offered and then tallying enalty oints if the facility is not available or if services
are inadeCuate. #hrough this mechanism* the rivate oerator takes on art of the
oerational risk associated with maintaining a level of efficiency for the facility in
Cuestion @which is linked to construction and maintenance risksA and service roD
vision @erformance Cuality riskA. #he ublic administration does not share
this risk.
#he third item is also variable* roortional to the volume of services offered.
#his is a way to transfer a share of the ro$ect?s >>market risk?? to the rivate layer. "n
other words* if the hosital?s caacity is not sufficiently filled* a smaller volume of
services will be needed* so the rivate oerator will erform and be aid for fewer
services. "n some cases* the last two items are calculated together in the service feeK in
this case the eriodic ayment is made u of two comonents&
. Availability fee* again linked to the availability of the facility* sub$ect to availD
ability deductions
. 'ervice fee* linked to service rovision* sub$ect to erformance deductions
-uring the first PPP initiatives exerience in the <9* certain drawbacks came to
light when the eriodic ayment was slit into two or more different items. #hese
roblems were basically caused by two factors&
. #he need to redraft an ad hoc contract for every single ro$ect* due to the
fact that the enalty oint system was imossible to relicate for different
. #he risk that once construction was comlete* the rovider would have little
interest in oerating the facility and would instead focus rimarily on recoverD
ing the real estate investment by collecting the entire availability fee
#his exlains why* in the <9* the eriodic ayment is rarely itemiFed. "nstead* it
is combined in a single fee* esecially when several services are rovided by the
concession holder. #his fee includes both the availability of the facility @>>hardware??
servicesA and relative availability deductions as well as service erformance and
relative enalties if contract standards are not met. 'ervice erformance relating to
the two categories is not taken searately* but instead becomes art of an overall
assessment of erformance oints* which are the basis of the evaluation @and
remunerationA of the rivate oerator.
Risks fo%n in bot3 t3e !re? an !ostcom!letion !3ases "recom!letion "3ase
"ostcom!letion "3ase Risks
Rate Risk
Interest Rate
Inflation Risk En;ironmental
"olitical Risk $o%ntr& Risk Tec3nolo-ical@
or Desi-n
S%!!l& Risk Deman Risk
-%arantees to
Limite to
obtainin- b%ilin-
Incl%e in t3e
T%rnke& a-reement
*first test,
"enalties to be
"enalt& !a&ments
an remo;al of
o!erator *later
B%&ers Establis3in- !re?
a-ree inflation
Take or !a&
S%!!liers Establis3in- !re?
a-ree inflation
a-reement or
E5!ort creit
$reit ins%rance
$reit ins%rance
Banks Deri;ati;e
!ro%cts an
creit to back
s%!!lierAs loans
Letter of
creit to back
b%&erAs loans
Ins%rance !olicies Ins%rance !olicies Ins%rance
Ins%rance !olicies
Assessments on
$ertification of later
F " : < + 6 )N!, +isk=Particiant Matrix for a Pro$ect Finance -eal
.! 'ummary of the +isk Management Process
).) 'ummary of the +isk Management Process
8ere we briefly review the toics resented in this chater by building a matrix @also
known as a risk matrixA* shown in Figure )D!,. #he matrix @which reresents only one
ossible examleA is easy to read. 'canning horiFontally* we can evaluate the contriD
bution of each layer in eliminating risks taken on by the 'P0. +eading vertically
instead* we can verify whether each of these risks has been identified and adeCuately
covered. "n other words* the matrix can be used ex ante by lenders @i.e.* before
actually roviding funds and the closing of the credit agreementA to ma risks and
assess whether they have been assigned to at least one of the 'P0?s counterarties.
#he rincile is rather intuitive& #he greater the number of intersections between
actors and risks where the 'P0 does not aear* the lower the ro$ect riskiness to be
faced by the 'P0?s lenders.
This page intentionally left blank
C 8 A P # 6 +
#he +ole of Advisors in a Pro$ect
Finance -eal
A ro$ect finance deal is destined to reCuire the services of a whole host of advisors*
secialists in unrelated discilines whose activity has only one thing in common& All
of their inut is related to the same ro$ect that must then be assembled on aer.
'onsors and lenders are left with the rather comlex task of coordinating all these
various activities and contributions* making strategic decisions while utting together
the ro$ect* even if at times inuts from advisors lead to divergent conclusions.
#he number* secialiFation* and level of exertise of advisors reCuired for a deal
generate Cuite a significant overall cost for the ro$ect comany. #his is not a
marginal factor. Pro$ect finance is a form of financing in which costs are articularly
high in relation to the siFe of the deal in Cuestion. #his is also why each ro$ect
finance deal has a critical minimumDsiFe threshold below which structuring costs
become excessive in relation to its forecasted income and cash flows.
#he team of ro$ect consultants includes various secialists who start working on
the ro$ect at different stages of its develoment. #he involvement of each secific
advisor differs considerably in terms of Cuantity of work erformedK this can also
deend on the tye of ro$ect concerned. #o give $ust one of an endless list of
ossible examles* technical advisors would certainly be much more involved in
a ro$ect based on innovative technology than more >>routine?? ro$ects from a
technological standoint.
#his chater focuses on the roles of legal* technical* and insurance advisors. #he
involvement of these rofessionals in utting together a ro$ect finance deal is
U 'ection ,.! is by Massimo 4ovoK "ntroduction and 'ection ,.% are by 'tefano :attiK 'ection ,.) by Fabio
Landriscina and Mark Pollard.
., C 8 AP # 6 + , #he +ole of Advisors in a Pro$ect Finance -eal
essential for its successK their inut hels to make it bankable for lenders. 7n the
other hand* these advisory services are essential both for sonsors @who need to
submit to arrangers a wellDstructured and credible oerating and financial lan in
every resectA and for banks involved in the venture @first and foremost for arrangers*
but through them also for other banks called on to suort the dealA.
Lawyers* engineers* and insurers lay a critical role in various stages of ro$ect
finance. 8owever* the aroach adoted in the following ages will be to review the
activities of each rofessional category searately. Activities erformed by each of the
sonsors? or banks? advisors will be outlined almost in isolation and* above all*
without taking into account ossible interaction with other rofessional roles.
"n real life* of course* the situation is much more comlex because the advisors
concerned often work in arallel throughout the structuring stage of the deal @and
often during the oerations hase* even though the intensity and imortance of such
activities may differA. #his aroach means that several ideas will recur in all of the
following sections* though ossibly seen from different ersectives.
'ection ,.! illustrates the activities of legal advisors* outlining the various tasks
erformed in chronological order. #he same aroach is used to review the tasks and
ob$ectives of indeendent engineers in 'ection ,.%. Lastly* insurance advisors are
discussed in 'ection ,.).
,.! #he +ole of Legal Advisors in Pro$ect Finance -eals
7ne ro$ect advisor in articularEthe legal advisor or* more correctly* advisors* as is
seen laterElays a very secial role* mainly because of the range of tasks erformed
and conseCuently their imortance as regards the overall structuring of the ro$ect.
For reasons described in the following ages* legal advisors are the ro$ect?s first
>>ure?? advisors @excluding financial advisors* who often act in this role before going
on to become mandated lead arrangers* as we see in Chater .A. #hey are aointed
by sonsors and arrangers* and their task covers the entire rocess of structuring the
deal @and beyond* as mentioned laterA.
"n fact* the imortance of the legal advisors? role in ro$ect finance is such that it
would almost seem $ustified to consider them as being among the key layers within
the overall framework. "n terms of imortance and weight in strategic decisions* this
role is entirely different from that layed by other advisors* inasmuch as it is
intimately linked with the very substance of the ro$ect.
5ut erhas this is excessive& Legal advisors don?t ersonally make* or shouldn?t
make* strategic decisions. 8owever* their erformance and technical=rofessional
decisions @as exressed in the technical=legal advice given to clientsA are of fundaD
mental imortance in structuring the ro$ect. #his role is similar in many ways to that
of an engineer* who establishes the foundations and realiFes an industrial work?s
comlex in detail on a turnkey basis.
#he rofessionalism and restige of a law firm involved in structuring the ro$ect
are essential for the successful outcome of the ro$ect itself. #he comlexity of financD
ing without recourse means there is no room for imrovisation or an >>amateurish??
aroach when rearing the legal documentation for the ro$ect itself. 4o serious
sonsor @or* for that matter* serious lenderA can run the risk of incurring the very high
costs of structuring a deal that then turns out to be organiFed in an aroximate* offD
theDcuff manner. At worst this could lead to a cost for a deal that is then re$ected by the
./ #he +ole of Legal Advisors in Pro$ect Finance -eals
banking system or that gets the >>thumbs down?? when tested by the bank credit market*
thus denying the validity of the very ro$ect finance nature of the deal.
As we see in the next chater* the financial model underlying ro$ect analysis is the
first tool used to check the bankability of the ro$ect for lendersK in fact* from their
oint of view the business lan is the ro$ect. 5ut it is also a fact that in ro$ect finance
the sonsors sell a series of future incomes and cash flows to the banking system that
exist only on aer when banks underwrite the deal.
"t is legal advisors who guarantee
that there is a sound link between current risks and future income=cash flows. #hey do
so by constructing a contractual system that creates a reliable exectation as regards
the effective achievement of the forecast income for the ro$ect and its distribution as
indicated in the financial model. #his is significant from the standoint of sonsors?
and lenders? investment decisions. #o use an exression taken from the theory of
contracts* the aim is to create a bilateral contract @better still* a system of contractsA*
not between arties seated around a negotiating table but between current costs and
forecast rofits. #his is by no means a simle task* but one that sums u the nature of
ro$ect finance or at least the nature of its legal framework.
,.!.! Legal Advisor* Legal Advisors* and Law Firms&
#he "nternational Part and Local Legal Counsel
< to now we have used the term legal advisor in a rather loose manner. "t is
imortant to note* however* that there is never $ust one legal advisor @even if in
certain cases some ingenuous sonsors* terrified by the estimated legal costs for the
deal* think they can manage by aointing only one advisor* who is given a kind of
>>suer artes?? mandate to be the sole legal advisor for the ro$ectA. A ro$ect* in fact*
is develoed in several stages* each of which sees lawyers involved in various asects
and who reresent the different arties concerned. From now on* the term lawyers
will be considered synonymous with legal advisor* even if the role of giving legal
advice can* at least in rincile* by layed by internal legal advisors of comanies
involved in the ro$ect. "n actual fact* however* this does not haen very often.
"t would be unusual for internal lawyers to have the necessary secialiFed knowledge
and even rarer for them to be able to mobiliFe the Cuantity of resources necessary to
follow the structuring of a ro$ect finance deal in an efficient and timely manner.
7ne other oint needs to be clarified& When seaking of lawyers* the lural is used
to emhasiFe that in a ro$ect there are indeed several lawyers involved reresenting
each of the main arties imlicated in the deal @lawyers would say* >>reresenting each
client??A. "n fact a ro$ect reCuires&
. 'ecialiFed exertise in many different fields @ranging from cororate to finanD
cial* real estate to administrative lawA. +ealistically* no single rofessional can
ossess sufficient knowledge in such a wide range of fields* including an
adeCuate knowledge of recedents. @5y recedents* we refer to ractical receD
dents and market ractices as oosed to $urisrudence* namely* court decisions
that can be read in secialist ublications or* for Cuite some time now* downD
loaded from dedicated "nternet sites.A
!. "t is also true* however* that there are cases of ro$ect finance where realiFation of the works concerned is
already under way at the time financing without or with limited recourse is finaliFed.
.. C 8 AP # 6 + , #he +ole of Advisors in a Pro$ect Finance -eal
. A huge Cuantity of work concentrated in a given amount of time& #his clearly
concerns lawyers* but others as well.
When we seak of lawyers* therefore* this really means mediumD to largeDsiFed law
firms that can dedicate a team of several rofessionals to a single ro$ect. 6xerience
over the ast few years has shown that a relatively small number of international or
internationalDlevel law firms has the siFe @and the client base and the intentionA to
develo a ro$ect finance deal. While not necessarily exclusive* and certainly not
>>aristocratic*?? the ro$ect financing >>club?? does tend to have very few members.
As we see in greater detail in Chaters . and 2* bank lending is governed by a
credit agreement or facility agreement* which is the hub around which the ro$ect
finance contractual system rotates. And there are two legal systems that the ro$ect
credit agreement @and numerous other documents related to itA normally refer to the
5ritish and <.'. systems. "n the ma$ority of cases* the latter means the law as
interreted in the 'tate of 4ew LorkK technically it is imroer to refer to the law
of the <nited 'tates of America.
#he choice of one or the other legal system deends on many factors* in the
ma$ority of cases determined by the nationality of sonsors* arranger banks* and
location of works to be realiFed. 'ometimes* for secific ro$ect contracts @tyically
construction contractsA* it can be the management culture or the nationality of the
counterart that dictates the alicable law. Large multinational grous have seD
cific* wellDdefined olicies on such matters* which usually means they refuse to enter
into contracts not governed by their own national legal system or by an internationD
ally recogniFed legal system. "n 6uroe* it is ractice in the large ma$ority of cases to
refer to 5ritish law* although aroaches in some 6uroean countries differ Cuite
substantially. 5y now nations have develoed refined* consolidated ractices within a
mature banking community and Cuite freCuently adot their national law. @"t is
difficult to give examles without running the risk of strenuous ob$ectionsK however*
a tentative list would include :ermany* France* and the 4etherlands.A 7ther counD
tries are still exeriencing a significant divergence between what is accetable to the
international banking community* which continues to refer 5ritish law* and their
national legal systems. 5ut this ga seems to be narrowing.
#his is why it is normal to searate the >>international?? legal inut* which
concerns the finance documents* from the >>local?? inut* strictly linked to the law
of the country in which the ro$ect is located. From a concetual standoint this
distinction would seem clearK however* this is much less the case from the ractical
oerations standoint. <ndoubtedly* there will be a team of lawyers who assist
sonsors and arrangers in structuring a ro$ect finance deal* 5ritish or American
lawyers @more exactly* those entitled to ractice the legal rofession under 5ritish law
or that of the 'tate of 4ew Lork* although the right to ractice almost always
coincides with nationalityA and local lawyers. "n the following ages an attemt is
made to describe the boundary for each of these areas of cometence.
,.!.% Pro$ect Financing -eveloment 'tages
and "macts on the +ole of Legal Advisors
7ur task now is to describe what lawyers do in order to structure a ro$ect. #he first
observation is that the various lawyers involved in structuring a ro$ect erform
.2 #he +ole of Legal Advisors in Pro$ect Finance -eals
different tasks according to the ro$ect?s develoment and* of course* deending on
which client has retained them to work on the ro$ect.
"t is robably advisable to follow a strictly chronological aroach* as was used in
the revious chater when discussing ro$ect life cycle. We describe below the
develoment stages of a ro$ect finance deal* classifying legal activities in each
stage and for each of the arties concerned.
!. Forming the grou of sonsors
%. Prearing the ro$ect documents
). -efining the ro$ect financing
,. Maintaining the ro$ect financing during the building hase and in the followD
ing oerating eriod
#hese distinct stages will now be reviewed one by one* in order to understand what
legal advisors do in each articular stage. +eaders can consult #able ,D! for
an overview of what lawyers do in each stage indicated and which arties are involved.
,.!.%.! Forming the :rou of 'onsors
"t is very infreCuent that a ro$ect finance venture be undertaken by a single
arty* for the reasons exlained in revious chaters. 'een from a strictly corD
#A5 L6 ,D! 'tages in 'tructuring Pro$ect Finance -eals and the +oles of Lawyers
'tage Activity +eCuired Lawyers "nvolved
!. Forming the grou of sonsors 7rganiFing the ro$ect comany 'onsors? lawyers
Articles of incororation for the
ro$ect comany
Agreements between sonsors
@$oint ventures or whateverA
Check on bankability of the
venture on a without or limited
recourse basis
'onsors? lawyers
'onsors? lawyers
'onsors? lawyers
Pro$ect comany lawyers
%. "ndustrial develoment of the ro$ect Pro$ect documents Pro$ect comany lawyers
'onsors? lawyers @when the sonsD
ors are a counterart of the
ro$ect comanyA
Arrangers? lawyers @bankability
-ue diligence reort Arrangers? lawyers
Legal oinions 'onsors? lawyers
Arrangers? lawyers
). Pro$ect financing Mandate letter and financing term sheet Arrangers? lawyers
Pro$ect comany lawyers
Finance documents Arrangers? lawyers
Pro$ect comany lawyers
Assistance during syndication hase Arrangers? lawyers
,. Maintenance of ro$ect
Periodic contacts with agent bank
and sonsors
'onsors? lawyers
Arrangers? lawyers
orate standoint* it can be said that the initial stage of a ro$ect is more or less
similar to a $oint venture. #he distinctive feature of a $oint venture in relation to
ro$ect finance is the need to ensure right from the early stages that the initiative
has the necessary characteristics to be financed without or with limited recourse.
#he worst outcome for a venture of this nature is to discover* erhas after many
months? work* that the system doesn?t consider it to be bankable* in which case
sonsors are either forced to abandon the ro$ect or to finance it using their own
"n this reliminary hase and based on initial indications as to the nature and
eculiarities of the deal @which lawyers receive directly from either sonsors or their
advisorsA* the sonsors? legal advisors organiFe the ro$ect comany* rearing the
articles of incororation and negotiating the necessary agreements between sonsors
@normally incororated in the shareholders? agreement* but they can also involve
more detailed* comlex contractual structuresA. #hese agreements will regulate relaD
tions between sonsors and distribution of ro$ect risks. "t will be remembered*
furthermore* that art of the ro$ect funding must be ut u by sonsors* who* for
this urose* can be called on to sign agreements as regards their eCuity contribution
in financing the ro$ect.
5ecause a number of sonsors are robably involved* normally each of them is
assisted by a different legal advisor* given that at this stage each sonsor has two
ob$ectives @so necessary comromises between sonsors may not be easy to reachA&
@!A to create the best ossible legal basis for develoing the ro$ect so that future
contractual artners @lenders but also the ro$ect comany?s suliers and urD
chasers of goods or servicesA see it as a solid and cohesive venture* but also @%A to
obtain the best result for itself in financial and contractual terms when structuring
the ro$ect as a $oint venture. #his ob$ective is not easily attained* for sometimes an
advantage for one sonsor will be a disadvantage for another or erhas all other
otential artners. 4onetheless* this critical asect cannot be overlooked @although
it often is neglected by inexert legal advisors or those inexerienced in ro$ect
#his means that once the reorganiFation hase between sonsors of the ro$ect
comany is comlete* one legal advisor @normally* but not always* the main sonsor?s
lawyerA or sometimes a different legal firm is assigned the role of legal reresentative
for the ro$ect comany itself.
'ometimes in the initial stage a ro$ect is develoed by a single sonsor who later
@either by choice or out of necessityA invites other arties to articiate as cosonsors.
#his can be achieved either by negotiation with a single arty selected beforehand as
a result of direct contacts or by means of a cometitive bid. "n the latter case the main
concern of the sonsor organiFing the bid @or embarking on negotiationsA is the
confidentiality of information that inevitably must be made available to the counterD
arty for negotiation uroses. "nstead the counterarty instructs its lawyers to
review the venture and its legal and contractual imlications. #his reCuires a due
diligence investigation similar* from many standoints* to that conducted for comD
any acCuisition uroses* but with two secific differences.
!. <nlike a cororate acCuisition* it is an exercise conducted entirely on aer&
#he ro$ect* by definition* doesn?t yet exist* and so the only asects that can be
verified are whether its develoment and resulting revenue are reasonable and
likely to be achieved.
%. #he overriding factor to check is the venture?s bankability with or without
limited recourse. #he advisors asked to make an initial assessment of this
essential condition are the lawyers.
,.!.%.% "ndustrial -eveloment of the Pro$ectE#he Pro$ect -ocuments
#he choice of ro$ect counsel @who* technically seaking* is the legal advisor of the
ro$ect comany* which aoints a law firm by granting a formal ower of
attorneyA is a $oint decision taken by the sonsors. As already mentioned* someD
times this is the law firm referred by the main sonsor* who may be the one
making the largest investment in the ro$ect @and therefore in the ro$ect comanyA
or the one who more than any other characteriFes and=or conditions the ro$ect
itself. @For instance* it could be the sonsor that has the underlying technology for
the ro$ect.A
'o ro$ect counsel is the lawyer for the ro$ect. "n the event of conflict of
interest among sonsors* the aim of ro$ect counsel is to remain neutral @clearly
an embarrassing situationA and to act in the best interests of the ro$ect* that is
@sub$ectivelyA* of the ro$ect comany. #his is by no means $ust a theoretical
situation* esecially when other fundamental layers in structuring the financD
ingEthe arrangersEenter the scene. 'uose* for examle* that the arrangers are
not entirely convinced that the contractor for turnkey construction work is reliable
and that the comany in Cuestion is one of the sonsors or belongs to the same
grou. #he arrangers will ask for greater coverage @a mitigation* another of the key
words used in relation to ro$ect financeA for this risk. Who ays the bill* the
sonsor concerned or all sonsors; #he answer* if there is one* lies in the agreeD
ments between sonsors mentioned in the revious sectionK otherwise this oens a
legal and negotiation arenthesis in the ro$ect develoment that is art of the
revious stage in terms of structure* though not in terms of time. #his* in turn* leads
to a further consideration& 5ecause of unforeseen issues arising during definition of
the relevant ro$ect finance agreements* the agreements between sonsors can and=
or must change. "n extreme cases* this may even lead to a change in the original
grou of sonsors. "n ractice* this has haened in the ast on a number of
When seaking of industrial develoment of the ro$ect* this in fact refers to
making the necessary rearations to begin construction work but not construction
itself. #his is because the necessary financing is not yet availableK in fact* work will
begin when structuring the deal* as described in these ages* is comlete.
#yically this develoment stage concerns the ro$ect documents& "n this stage
the ro$ect comany sets u contracts and obtains ermits and other legal
aers reCuired to realiFe the necessary works and to oerate in accordance with
the aims of the ro$ect. At this stage* the ro$ect comany lawyers usually erform
the task of drawing u a comlete list of these documents and finaliFing and=or
obtaining them.
Following is a list of ossible ro$ect documents* drawn u without reference to
any secific deal.
Concessions from the Public Administration& #his is a necessary element when
ublic works or works of ublic interest sub$ect to a government concession are
realiFed using a ro$ect finance aroach. As seen in Chater ! when seaking of
the involvement of rivate caital in ublic works* this factor comes u
freCuently but not always in ro$ect finance. 8owever* it is found in the <9*
articularly in the case of PF"s realiFed as art of that government?s PPP
Permits to +ealiFe Pro$ect Works& Again these are not documents roduced by the
ro$ect comany* although they are reCuired to be able to realiFe the ro$ect. #heir
existence and validity is a necessary condition for launching the ro$ect* and so they
are the sub$ect of secific clauses in the credit agreement* which will normally contain
an attachment listing the ermits reCuired to realiFe the ro$ect works. #own
lanning and building ermits are articularly imortant* as are those relative to
the environmental imact of the ro$ect itself.
Contracts for <se of #hirdDParty Assets or +ights& #hese are documents by means of
which the ro$ect is assured tangible rights @for instance* the ownershi of or right of
access to the area where the ro$ect will be realiFedA or intangible rights @like those
allowing the use of a given technologyA necessary for its realiFation. 'ometimes these
rights are granted by the ublic administration* and so the relevant document
assumes an imortance @alsoA from the standoint of administrative law.
+ights +elevant to the Area Where the Pro$ect Works Will 5e -eveloed& #he
ro$ect comany must ensure it has the necessary rights @normally rights of
ownershi or a building leaseA as regards the site where the ro$ect will be realiFed.
A legal comlication concerning these rights comes u in 57#Dbased contracts*
in which the works will be transferred to the ublic administration after a certain
eriod. 'uch rights reresent a considerable technical and legal comlication in
ro$ects in which the nature of legal roerty rights as regards the ro$ect are more
difficult to define* for examle* ro$ects such as the exloitation of oil fields under the
4orth 'ea @whether in territorial waters or otherwiseA and the Channel #unnel.
Contract for +ealiFation of the Pro$ect Works and +elevant 'ubcontracts& #his is the
document that contains clauses regulating the area of the ro$ect sub$ect to most risk
and is robably the most imortant document ro$ect comany lawyers have to
reare. "t should be noted that one ossible scenario that could significantly affect
negotiation of this contract is whether the erforming comany is or is not linked to
one of the sonsors.
7eration and Maintenance @7BMA Management Contracts and #echnical Consultancy
Contracts& 7ften this is covered by the 7BM contract described in Chaters ! and )
and is the other essential ro$ect contract concerning the oerating stage. 'ecific
ro$ects may have secial characteristics that mean ro$ect comany oeration
management is covered by several contracts. Again in this case* it is not infreCuent
that one of the sonsors is also the sulier of ro$ect management services. Also this
contract is initially >>managed?? by the ro$ect comany lawyers.
5onds and :uarantees for Pro$ect Contracts& #hese are guarantees @bondsA from
banks or financially sound third arties @normally the arent comany or holding
comany of one of the arties to the ro$ect contractA* the urose of which is to
render the resonsibility of a given arty bankable* usually as regards damages or
%. -ata for the 6< market reared by the 6uroean "nvestment 5ank show that PF" ro$ects received
suort from the bank between !((1 and the end of %11) amounting to around !/ billion euros* of which %/J
went to the <9. #hese transactions were mainly in the form of a design* build* finance* and oerate @-5F7A
scheme that didn?t roduce a negative imact on national deficits or debt. 'ee 6"5* 6valuation of PPP Pro$ects
Financed by the 6"5* March %11/.
reayment of advances received. "n essence these are seen as accessories to the ro$ect
documents* and the reCuired forms for these guarantees are given in attachment.
"n reality these are rather wellDknown* standard forms in the financial market.
"nsurance& #echnically seaking* these are ro$ect contracts* even if normally
advisors secialiFed in the insurance sector are assigned to reare them* as is seen in
'ection ,.). #he ro$ect comany must have adeCuate insurance coverage for risk
exosure and is an asect regulated in an extremely detailed manner in the credit
agreement. #he insurance element is vital when structuring a ro$ect finance dealK
however* ractices in the insurance field are extremely secialiFed and are therefore
considered the domain of a searate rofession. "nsurance is handled by
consultants and brokers with a considerable degree of searation from the rest of
the legal and contractual activity in terms of structuring the ro$ect finance deal.
Procurement Contracts for +aw Materials +eCuired for Pro$ect 7erations& Fuel
suly agreements @contracts for the urchase of fuel for ro$ects in the ower
generation fieldA are articularly imortant in this category.
'ales Contracts& #hese contracts generate the ro$ect comany?s income. A detailed
analysis of the nature and necessary features of these contracts can be found in
Chaters , and 2.
,.!.%.) Pro$ect FinancingE#he Finance -ocuments
#he stage when the finance documents are defined @first and foremost* the credit
agreementA is clearly central to a ro$ect finance deal.
While ro$ect contracts are normally reared by ro$ect comany lawyers and
reviewed @and modified* if necessaryA by the arrangers? lawyers* rearation of the
finance documents is usually the resonsibility of the arrangers? lawyers* who then
negotiate them with the ro$ect comany lawyers. 'o in this case the arrangers?
lawyers lead the rocess by rearing and managing the documents concerned*
whereas the ro$ect comany lawyers come into the icture afterwards when they
receive and review the documents.
At this stage the ro$ect is almost entirely in the hands of lawyers. More than any
other document* the credit agreement is a contract that reCuires highly secialD
iFed lawyering. -ecisions of a business nature reCuired from the rincial actors
@arrangers and ro$ect comany?s sonsorsA are the guidelines around which the
credit agreement is fashioned. #his then becomes the control document for the entire
ro$ect. "n the early stages* a secific ro$ect finance deal is above all an industrial
idea regulated by a financing contract* which will then rovide most of the financial
resources to realiFe the ro$ect itself. 5earing this in mind* it indeed makes sense to
say that >>on the starting grid?? ro$ect financing is a legal roduct waiting to become
an industrial and financial reality. "f not* this concet would be difficult to accet.
#he finance documents usually include the following.
. -ocuments by which the sonsors aoint one or more banks @the arrangersA to
organiFe and grant the financing& #hese are normally referred to as mandate
documents or commitment documents. #hese usually include a letter of aointD
ment @a mandateA* in which the arrangers @as we see in Chater .* they are
referred to as mandated arrangersEMAsEor even mandated lead arrangersE
MLAsK a bit of emhasis at this stage doesn?t do any harm and costs nothingA
are aointed to organiFe the financing* or a letter of commitment* in which the
arrangers commit themselves to sign @initially* i.e.* before but with a view to
syndicationA a table summariFing the main financial and legal terms of the deal.
. #he credit agreement
. #he security documents* which constitute the ackage of collateral granted in
relation to the financing
. #he intercreditor agreement* which regulates some or all of the relations
between lenders
. 'ome other ancillary documents relating to the credit agreement* for instance*
fee letters that establish the commissions due to the arrangers
. Contracts concerning caital made available to the ro$ect comany by sonD
sors* often known as the eCuity contribution agreements.
. 7ther documents concerning financing in the event the credit agreement and
eCuity caital ut u by sonsors are not the only sources of ro$ect financing
. 8edging agreements to cover the risk of swings in both interest and currency
exchange rates
. -irect agreements* which ertain to an area lying between security documents
and ro$ect contracts
An analysis of the credit agreements and other finance documents refers more to
the legal nature of ro$ect finance as oosed to describing the role layed by legal
advisorsK this analysis is found in Chater 2.
,.!.%., #he -ue -iligence Legal +eort
#his document is a reort reared by the arrangers? lawyers for their clients giving a
summary of the ro$ect and its formal and substantial bankability. "ts content
describes everything concerning the ro$ect assembled by the sonsors and ro$ect
. 4ature and characteristics of the ro$ect comany
. Pro$ect contracts
. Administrative concessions and ermits
. #he general regulatory setting for the ro$ect& -eending on the case* arrangers
may want a descrition of other legal asects concerning the ro$ect* for instance*
the guarantee system and the administrative and concessionary system
#his document normally constitutes one of the many conditions governing the
ro$ect comany?s ability to utiliFe the financing granted under the credit agreement.
#his is a consolidated ractice* to the oint that no ro$ect comany or sonsor
raises any ob$ection to the fact that from a formal standoint this reort is controlled
entirely by the arrangers @who must unilaterally state that they are satisfiedA and the
arrangers? lawyers. "n theory the due diligence legal reort ought to be reared months
before the credit agreement is finaliFed. "n ractice* however* things are very
different& #he due diligence legal reort is one of the many documents finaliFed by the
lawyers and aroved by the arrangers during the last few days before the financial
close of the ro$ect.
,.!.%./ Legal 7inions
#he legal oinions are contained in yet another summary document used in the final
stages of structuring the financing and again constitute a condition for releasing the
financing itself.
#he legal oinion document is very formal and extremely technical from a
$uridical standointK therefore* a detailed analysis of how it is structured is beyond
the scoe of this book. 'uffice to say that the following oints are ones that arrangers
and lenders would exect to see covered by legal oinions concerning a ro$ect
finance deal.
. #hat the ro$ect comany has been formed and comlies with laws in force.
. 0alidity of the finance documents and ro$ect contracts signed by the ro$ect
comany and other arties @normally the soDcalled >>oinion documents*?? which
collectively refer to documents that are sub$ect to a legal oinionA.
. 0alidity and conformity with laws in force of the oinion documentsK under
5ritish law such documents are considered to be legal* valid* and binding.
. 0alidity of collateral that guarantees credit facilities lenders grant to the ro$ect
. 7wnershi of ro$ect assets by the ro$ect comany.
. 0alidity @and sometimes the aroriate scoeA of licenses* concessions* and
other administrative ermits.
. #he existence of and any restrictions referring to convertibility of foreign
exchange* tax withholdings on interest ayments* other taxes due for concesD
sions once the oinion documents are signed.
. 0alidity of secific clauses concerning damages* grossDu and calculation and
ayment of lateDayment interest. Certain legal systems can create various
obstacles as to the validity of such clausesK for this reason the international
banking community is Cuite concerned about such issues.
. Legal status of the ro$ect comany?s bonds and existence under local law of
regulations ensuring referential treatment to given creditors @ossibly the state
for income taxes* social security agencies* emloyees* and* in certain cases* the
national banking systemA.
. Whether according to local law a arty can be sentenced to ay sums of money
in other than the country?s own local currency.
. 0alidity of rovisions in the oinion documents as regards choice of other than
local law in favor of foreign $urisdiction @or arbitration clausesA.
. #he existence of immunity from legal or executive action in favor of any arties
involved in the ro$ect. #hese issues are clearly very imortant for ro$ects to
realiFe assets under a concessionary or similar regime.
#he foregoing list is only given by way of examle. "t is difficult to imagine that
the receding oints would not be covered in legal oinions foreseen in a ro$ect
credit agreementK however* deending on the circumstances* there could well be
several more issues that the arrangers would like to see covered by legal oinion.
When rearing and issuing legal oinions* the lawyers involved in the ro$ect are
once again formally distinct from one another. Arrangers @and lendersA will certainly
want to see a legal oinion from their own >>local?? legal advisors @namely* those legal
advisors in the country where the ro$ect is to be develoedA and one of its
own advisors as regards @let?s sayA 5ritish law ertaining to those documents @norD
mally the credit agreement and certain other finance documentsA that are governed by
other than local law* as mentioned in 'ection ,.!.!.
4ormally ro$ect comany lawyers also issue a legal oinion concerning local law
8owever* the content of this is sometimes @but not alwaysA rather >>lightweight?? by
comarison to the one reared by the arrangers? lawyers. 'ometimes certain secific
asects concerning the ro$ect comany or other arties* such as the existence of
litigation or other agreements that could affect the ro$ect contracts* are covered by
the internal legal staff of the sonsors or other arties. Less freCuently @although it
does haenA* the ro$ect comany?s international lawyers are asked to give their
legal oinion on the finance documents.
,.!.%.. 'yndicating the Financing
7nce structuring of the ro$ect finance deal is comlete* the arrangers and coarrangD
ers face the delicate task of syndicating the transaction in the banking market. #his is
the moment when the deal is at the mercy of the oen sea* so to seak* when a
significant number of secialists from various banks @each with its own rofessional
and comany culture and oinions* and not only thisA will examine the deal with a
magnifying glass to decide whether or not to buy in.
As for the sonsors* for them* at least formally* this is a Cuiet moment @>>their??
ob$ective has been achieved because the financing has been assuredA. #hey have every
interest* and normally a formal obligation* to cooerate with the arrangers to ensure
syndication goes well.
7nce again the arrangers? lawyers lay a fundamental role. #o simlify matters
@but not excessivelyA* three things are resented to banks invited to articiate in the
!. #he ro$ect in terms of its industrial and technical nature. #his is* of course* a
necessary asect* although it is not exected to cause any surrises. "t is
difficult to imagine that sonsors with reliable industrial exerience in the
sector fail to convince otential lenders of the technical=industrial merits of
what they are roosing to do and their ability to achieve it. 5ut because of its
very nature it is extremely unusual that an industrial ro$ect roosed for
funding using a ro$ect financing aroach is not actually reliable from a
technical=industrial standoint.
%. #he ro$ect in numbers. #he figures for the ro$ect can be esecially ositive or
otherwise* however* again this asect will not normally cause any surrises&
#he numbers have obviously been good enough to $ustify financing it @otherD
wise the arrangers themselves would have abandoned the deal long beforeA.
<sually secialiFed advisors are called in to audit the financial model used.
). +egulatory and contractual asects of the ro$ect. #his is a task for the lawyers&
At this oint they reare the summary reort showing the transformation of
an exected income into binding and reliable contractual relations. #he lawD
yers must be able to demonstrate that they have turned the technical=industrial
exectations @oint !A and figures from the financial model @oint %A into an
effective value by means of a network of legal* comany* and contractual
relationshis created so that lenders invited to articiate can be convinced
>>to buy the ro$ect.??
,.!.%.2 #he 7erating Period& Maintenance of the Pro$ect Financing
With the financial close @that is* when all conditions established have been met*
thereby enabling initial disbursement of financing to build the lant or worksA* the
ro$ect comany is authoriFed to use the ro$ect financing facility. "n theory this
would coincide with the start of constructionK however* in reality Cuite freCuently
construction of ro$ect works has already gotten under way by utiliFing&
2/ #he +ole of the "ndeendent 6ngineer in Pro$ect Finance -eals
. 6Cuity that in any event the sonsors are committed to assign @see 'ection ..2A
. 'ubordinated loans made temorarily by sonsors to the ro$ect comany and
that are reimbursed to them simultaneous with the first utiliFation of the ro$ect
financing facility @see 'ection ..3A
. A temorary loan @bridge financingA that the ro$ect financing lenders @less
often* other lenders* for obvious reasonsA have granted to the ro$ect comany*
backed by collateral rovided by the sonsors @see 'ection ..(A
Whatever the scenario in which the ro$ect will be carried forward* the time when
lawyers lay an essential role has now come to an end. Also* the arrangers? task is
technically and formally comlete and the role of directing the deal asses to the
agent. #he agent and sonsors will consult with their lawyers from time to time in the
event of roblems concerning the ro$ect or financing if things aren?t roceeding
according to lan. 8owever* this doesn?t haen very often @unless the ro$ect hits
rough water from a technical* industrial* and* therefore* financial standointA* so
relations normaliFe between the main arties involved in the deal and their advisors
@legal or otherwiseA. #he lawyers? moment of glory @for which they ay a high rice in
terms of stress and work hours* even though they are usually well aid for their
effortsA comes to an end. #he ro$ect now becomes a new chater in their cursus
honorum and* erhas* in the leaflet describing the law firm and its track record in
terms of the most imortant deals in which it has articiated.
,.% #he +ole of the "ndeendent 6ngineer in Pro$ect
Finance -eals
7ne of the most critical areas when structuring a ro$ect finance deal is the technical
asects involved. While the ro$ect?s construction and engineering features may be
clear to the sonsors* often this is not the case for lenders* who therefore need a
secialiFed rofessional to hel them evaluate the deal and decide whether to suort
it or not. 7n the other hand* as was seen in the revious section* technical asects are
also very imortant for the sonsors? and arrangers? lawyers when they are rearing
the ro$ect documents and finance documents.
'o the technical consultant?s roleEoften known also as indeendent engineer or
indeendent technical advisorEis extremely imortant in deals for ro$ect financed
transactions. #he indeendent engineer lays a suer artes role and is asked to
exress an oinion as to the ro$ect?s feasibility* make a survey to evaluate it* and
act as the controller in order to safeguard the ro$ect and* above all* those who ut u
the money to finance it.
#he indeendent engineer?s role is useful not only for lender banks but also for
the other arties involved. Activities concerning the ro$ect can be erformed for the
benefit of sonsor comanies or the 'P0 itself* for instance* in a case where a reliable
technical oinion is reCuired as regards the ossibility to use a given roduction
technology develoed by one of the sonsors in the deal.
'o* in effect there will usually be not one but a number of >>technical consultants.??
As we will see* the sonsors and the constructor?s site manager also use thirdDarty
technical advice at various stages in the ro$ectEesecially when works are nearing
comletion and the ro$ect will be moving into the test hase. At these times there
will be a $oint resence of the sonsors?* constructors?* and banks? indeendent
2. C 8 AP # 6 + , #he +ole of Advisors in a Pro$ect Finance -eal
engineers* each of whom is reCuired to give an oinion to the arty that has
aointed them.
#he more significant activities erformed by indeendent engineers in a ro$ect
finance deal can be subdivided into four basic hases&
!. -ue diligence reorting
%. Monitoring realiFation of the ro$ect @engineering and constructionA
). Assistance during accetance of the lant
,. Monitoring oerations management
As mentioned* this is only a very rough classification and should therefore not be
taken as either rigid or exclusive. "ndeendent engineers will be involved more or less
intensively* deending on the stage of the ro$ectEcertainly they will have a more
dominant role in innovative or highly comlex technological ro$ects.
5ut even though only a general guide* the categoriFation according to the hases
$ust indicated is effectively that used normally at an international level to outline
activities by ma$or engineering comanies. #he ob$ective is always to minimiFe the
risks lenders run during a ro$ect finance deal.
Furthermore* the hase categoriFation constitutes a good starting oint and
framework for the analysis. 6ach hase will be analyFed in terms of&
. An indeendent engineer?s ob$ectives
. 6xected benefits for banks
. 5asic documentation necessary for the hase concerned
. 'ulementary and accessory activities and services @as aroriateA
. 'coe of activities for each hase and reorts roduced by the indeendent
,.%.! "nitial -ue -iligence +eorting
'een from the osition of an arranger or a bank that may finance a structured
finance deal* even aarently simle ro$ects can create roblems in terms of
evaluating techD nical factors* and in fact no bank has the necessary technical exertise
on its staff. #his is why involvement of an indeendent engineer is $ustified during
the early stages of structuring the deal. #he due diligence reort the indeendent
engineer will roduce consists of a critical analysis of all technical asects of the deal*
with reference to ro$ect* contractual* and financial ictures that are usually already
Cuite well defined.
A review of the technical and technological variables clearly constitutes the focus
of this advisor?s activity. "n addition* banks often ask for an oinion as regards
business and insurance asects of the ro$ectK however* these assessments are only
secondary to the basic activities outlined earlier.
#able ,D% summariFes the main content of due diligence activities* covered in
detail in the following ages.
A technical advisor?s activities in this hase benefit lenders because they obtain an
analysis made by an indeendent arty. As art of the study* the indeendent
engineer checks that the technical variables included in the financial model are
accetableK an oinion is then given as to the reasonableness of costs forecast to
realiFe the ro$ect. "f the indeendent engineer confirms that the fundamental ro$ect
variables roosed by the sonsors are comlete and reasonable* then this is already
an imortant factor as regards the ossible bankability of the deal under review.
22 #he +ole of the "ndeendent 6ngineer in Pro$ect Finance -eals
#A5L6 ,D% 'ummary of the "nitial -ue -iligence Phase
"ndeendent 6ngineer?s
Activities -ocuments +eCuired -ocumentation Produced
"nitial due diligence Critical analysis of the
ro$ect?s technical asects
Analysis of the ro$ect?s
business asects
Analysis of the ro$ect?s
insurance asects
!. Preliminary feasibility study with
draft financial lan
%. 5asic or detailed ro$ect outline
). Market analysis
,. "nformation memorandum with
indications of the main arties
involved in the deal @sonsors*
constructor* buyers and suliers*
banks* insurance comanies* etc.A
and financing term sheet
/. 'uly and rocurement contracts
.. Agreements
2. AuthoriFations* ermits* licenses*
and concessions
3. Any services and construction
(. 'ecurity ackage
"nitial due diligence reort
#he oinion of the indeendent engineer is* furthermore* a great hel to the banks?
lawyers when rearing the due diligence legal reort discussed in 'ection
,.%.!.! -ocuments +eCuired for the -ue -iligence Activity
Prearing an accurate initial due diligence reort reCuires the availability of various
documentsK following are those normally reCuested by an indeendent engineer.
. Preliminary feasibility study and draft financial lan
. Pro$ect outline or details
. Market analysis
. "nformation memorandum with indications of the main arties involved in the
deal @sonsors* constructor* urchasers and suliers* banks* insurance comD
anies* etc.A and the financing term sheet
. 'uly and urchase contracts
. Agreements
. AuthoriFations* ermits* licenses* and concessions
. Any service and construction contracts
. 'ecurity ackage
,.%.!.% Accessory 'ervices
#he indeendent engineer can even be asked to give an oinion when some of the
documents indicated earlier are in a rough first draft or even lacking. 'ome engiD
neering comanies are also able to assist lenders during initial structuring of the deal.
"n this case they hel banks comlete the necessary documents to clearly define all
asects of the ro$ect for uroses of the feasibility study.
An indeendent engineer might rovide an oinion on a wide range of issues* for
. Market analysis for roducts* semifinished goods* and raw materials reCuired to
feed the roduction cycle and relevant simulations based on alternative sceD
. Whether assumtions underlying the sonsors? sales lanEin terms of CuanD
tities and ricesEare realistic
. Maturity of technology
. Aroriateness of lanned technical choices
. Possible imacts as regards the choice of machinery and eCuiment
. Whether assumtions concerning lant system outut are realistic
. 'ensitivity analysis of the financial lan. #he aim here is to evaluate the degree
of robustness of cash flows once the ro$ect is oerative* in the event a change in
one or more variables might affect the venture @identified by means of risk
,.%.!.) -ocuments Produced -uring the -ue -iligence Activity Phase
-uring the due diligence exercise* alreadyDavailable contractual documentation is
reviewed in deth in order to identify critical oints as regards relations between the
arties involved in the deal* which mainly ertain to otential technical and technoD
logical roblems. 7nce the study is comlete* a due diligence reort is reared @first
in a reliminary form as a collection of comments and then as a final reortA in which
the indeendent engineer gives an oinion on the following issues.
. Whether documentation is comlete and the technologies are adeCuate and
reliable based on a check of significant asects of the ro$ect to ensure the
startDu and functionality @otential* erformance* utiliFation factorA of lant
oerations. #he oinion also takes into account the freCuency and duration of
maintenance reCuirements.
. Analysis of the ro$ect?s vulnerability if harmful events were to occur. #his
review is useful for Cuantifying the maximum robable loss @or MPLA as regards
the works in the event of accidental damage. 'ee also 'ection 3.2.).
. Pro$ect data as regards lant safety. #his reCuires a simulation of several
ossible emergency scenarios in order to assess the robability of catastrohic
events and their imact in terms of damage to structures and the surrounding
environment @6nvironmental "mact Assessment* or 6"AA.
. #he soundness of financial assumtions concerning construction and manageD
ment costs for the structures.
. #he reasonableness of assumtions concerning the time schedule for construcD
tion and startDu of business oerations.
. #he organiFational framework for the construction and management of the
works* esecially organiFational and oerational caabilities of comanies
involved in the construction stage.
,.%.% Monitoring +ealiFation of the Pro$ect
@6ngineering and ConstructionA
#his is a articularly delicate hase in a ro$ect finance deal. "n fact* the 'P0 has been
financed based on the conditions laid out in the credit agreement and has started to
draw funds made available by the financing banks.
#he start of the ro$ect works reCuires careful rogress monitoring. ConseD
Cuently* eriodic reorts should be roduced for lenders certifying that the venture
is going ahead as lanned. #hus indeendent engineers both monitor and certify the
"n brief* these are the activities they erform&
. Monitor construction of the works
. "ssue certified rogress reorts
. 0alidate mechanical comletion @certify comletion of worksA
,.%.%.! Monitoring Construction of the Works
#he aim of monitoring construction by means of onDsite insections and assessments
is to check that works are roceeding in accordance with secifications established at
the time of initial lanning. #he check is allDinclusive and covers the construction site*
works associated with it* and also rocurement of materials. #he indeendent engiD
neer checks that everything is roceeding satisfactorily in terms of timing and cost.
A summary of the activities and documentation roduced in this hase is shown in
#able ,D).
Furthermore* this monitoring activity means assumtions concerning timing and
cost to finish can be evaluated and* therefore* so can the effects of ossible delays
on the 'P0?s business lan. #his last oint is essential information for lenders. As a
result of monitoring works eriodically* they receive an udated icture of
rogress and can* if necessary* take timely corrective action as indicated in the credit
#A5L6 ,D) 'ummary of the 6ngineering and Construction PhaseEMonitoring Pro$ect +ealiFation
6ngineer?s Activities -ocuments +eCuired
of the
Check that rogD
ress for works
corresonds to
initial lans
Check rocureD
ment activities
!. Contracts @6PC contract* civil works and relevant
%. -etailed lans @data sheets* technical
secifications* lans and diagrams*
construction standardsA
). Progress reorts issued by the rincial or the
general contractor* together with&
'chedule baseline and definition of ro$ect
-etailed construction schedules
Any recovery lans
Progress curves
'ite organiFation and relevant organiFation
chart* lus subcontractor organiFation with
'Dcurve for resources emloyed
'afety lan and Cuality control
Procurement lan with main item urchasing list
List of lifting and handling eCuiment
List of changes during course of works
Permitting lan
Progress moniD
toring reorts
agreement to kee risk factors under control and limit the imact on the ro$ect?s
oerating cash flow.
-ocuments +eCuired to Monitor Works& #he rocess of monitoring works is based
on a wide range of very technical documents. While a detailed descrition of each of
these falls outside the scoe of this book* a list of them is given here for reference
!. 'uly contracts @6PC contract* civil works and related subcontractsA
%. -etailed lans @data sheets* technical secifications* lans and drawings* conD
struction standardsA
). Progress reort issued by the 'P0 or the general contractor* accomanied by&
. :eneral lans for works @schedule baselineA and definition of ro$ect milestones
. -etailed construction schedules
. +ecovery lans* if alicable
. Progress curves for works
. Construction site organiFation and relevant organiFation chart and* in addiD
tion* the organiFation of subcontractors with the 'Dcurve for resources
. 'afety lan and Cuality control system
. Main item urchasing list
. List of lifting and moving machinery and eCuiment
. List of changes while work is in rogress
. Permitting lan
Accessory 'ervices& "n addition to monitoring works and construction sites* the
indeendent engineer may be asked to rovide suort to reare some of the
documents mentioned reviously&
. Prearation of the overall works lan using ro$ect management techniCues
@CPMEcritical ath method* P6+#Erogram evaluation and review techD
niCue* grid analysis* and W5'Ework breakdown structureA and assistance
for defining organiFations resonsible for safety and Cuality control @reD
aration of roduction* monitoring* and testing lansA
. 'tudy and rearation of recovery lans as a resonse to changes in oerD
ating conditions included in the works baseline* the aim of which is to bring
the ro$ect back on track to achieve initial ob$ectives and at the same time to
limit otential damage
. Assistance in the testing and accetances hases for ma$or eCuiment
. As regards ro$ects that have not yet reached the executive hase* a critical
evaluation of choices made during the develoment hase and check for
consistency with contractual terms
-ocuments Produced -uring the Construction of Works Phase& #he indeendent
engineer effectively acts as the ro$ect manager on behalf of lenders* and so the
). 'Dcurves reresent the cumulative figures for resources emloyed on a ro$ect at a given time. #hey are
obtained by adding u costs incurred to realiFe activities necessary to achieve an ob$ective. <sually these
activities are defined in detail at the start of works using what in ro$ect management are referred to as W5'
@work breakdown structureA techniCues* whereby tasks are listed alongside the resources reCuired for their
comletion. #he 'Dcurve* in other words* indicates cumulative costs for resources over time and based on the
concatenation in time of activities established by alying grid analysis @CPM* critical ath method* and P6+#*
ro$ect evaluation and review techniCueA. For detailed information on this sub$ect* see 8arrison @!(3/A.
tasks erformed in no way differ from those erformed by the ro$ect manager
aointed by the general contractor.
-uring the construction stage* various eriodic monitoring reorts are reared
that summariFe analyses and valuations made&
. Physical rogress made* evaluated using work breakdown structure techniCues
. #ime reCuired to comlete the works
. Actual and otential causes that have led or may lead to artial delays
. Forecast variances from the works baseline lan by evaluating time necessary
for comletion
. Changes while works are in rogress and risks arising from these changes
. 'tatus of authoriFations and ermits reCuired to start or comlete works
. 6fficiency and effectiveness of the organiFational and roductive structures
assigned to carry out the works
. 0alidity of business assumtions based on exected develoments in the market
,.%.%.% "ssuing Progress +eorts
From Chater ) we know that constructors are often aid based on the rogress of
works. 'o when redefined stages in the construction rocess are reached* the 'P0
ays a ercentage of the total value of the works. 5efore such ayments are made*
a condition recedent @to be discussed in Chater 2A is the issue of a secific certificate
by the indeendent engineer. #his is based on a check of effective execution of works
and confirms that costs indicated in the construction contract corresond* also taking
into account any changes during work in rogress. A summary of the activities and
documentation roduced in this hase is shown in #able ,D,.
#he works rogress certificate is essential for lender banks inasmuch as it rereD
sents a guarantee that financing used by the 'P0 for works carried out by the general
contractor to a given date is in line with contractual commitments.
-ocuments +eCuired to "ssue Works Progress Certificates& #he indeendent engineer
must have at least the following documents before issuing the works rogress
. 'uly contracts
. Plans* lus relevant siFe and volume calculations
. :eneral ledger
#A5L6 ,D, 'ummary of the 6ngineering and Construction PhaseE"ssue of Certified Progress +eorts
"ndeendent 6ngineer?s
Activities -ocuments +eCuired
"ssue of
Check that a tranche of
the works has been
Check that costs are in
line with the 6PC conD
tract and with changes
during the course of
!. Contracts
%. Plans together with relevant survey calcuD
lations and measurements
). :eneral ledger
,. Works accounts
/. Progress reort signed by the site manager
.. 'tatement that works have been executed
as lanned* signed by the engineer and the
site manager
Certificate statD
ing that works
have been exeD
cuted in conD
formity with
. Works accounting records
. Progress of works status* countersigned by the site manager
. -eclaration that works have been executed as rescribed* countersigned by the
design engineer and site manager
-ocuments Produced& #he indeendent engineer?s certificate takes the form of a
reort attesting that the rogress of works status signed by the site manager
corresonds to works effectively realiFed.
,.%.%.) 0alidation of Mechanical Comletion @Works Comletion CertificateA
0alidation of mechanical comletion reresents the final review of all rogress of
works statusK it includes a check* erformed on a samle basis* that works have been
executed and realiFed in a satisfactory manner. 'o the works comletion certificate
attests to the correctness of declarations made by the site manager and the sonsors?
technical advisor. A summary of the activities and documentation roduced in this
hase is shown in #able ,D/.
5anks rely heavily on this certificate* which reresents a guarantee given by the
indeendent engineer as to the comleteness and accuracy of certified data and in
articular that the latter corresond to what was established contractually and
included in the financial lan.
-ocuments +eCuired to "ssue the Mechanical Comletion Certificate& #he indeD
endent engineer can issue the mechanical comletion certificate based on the same
documentation indicated in the revious section. "n effect* mechanical comletion is a
summary of all the works rogress reorts&
. 'uly contracts with list of rices
. Construction lans with relevant siFe and volume calculations
. :eneral ledger
. Works accounting records
. All rogress of works status reorts* countersigned by the site manager
. All declarations that works have been executed as rescribed* countersigned by
the design engineer and the site manager
. AuthoriFations* ermits* and concessions @as reCuired for the case in ointA
#A5 L6 ,D/ 'ummary of the 6ngineering and Construction PhaseE0alidation of Mechanical Comletion
"ndeendent 6ngineer?s
Activities -ocuments +eCuired
0alidation of
'amle check that works
have been comleted
Check correctness of site
manager?s certifications
Contracts* with list of rices
Construction lans* with relevant survey calculaD
tions and measurements
:eneral ledger
Works accounts
All rogress reorts signed by the site manager
All statements that works have been executed as
lanned* signed by the engineer and the site
AuthoriFations* ermits* and concessions @reCuired
for the uroseA
Certificate attestD
ing to mechanD
ical comletion
-ocuments Produced& #he site manager and sonsors? technical advisor together
with the indeendent engineer check comletion of the works and reare the
unch list @a document listing construction details not yet comletedA to check that
any roblems that might have arisen during construction have been resolved. #his
activity leads to roduction of a certificate stating that everything covered by the
contract as regards realiFation of the works has indeed been comleted.
,.%.) Assistance at the #ime of Plant Accetance
With mechanical comletion* the site manager and the technical advisor certify that
the construction hase has been comleted. #he comletion of this stage overcomes
certain risks tyically found during the material realiFation stage reviewed in
Chater ). 8owever* lenders must now verify whether the lant has been realiFed
in accordance with contractual secifications and* therefore* that outut is in line
with the erforD mance assumtions initially included in the financial lan @and
certified in the initial technical due diligence reort reared by the indeendent
#herefore the indeendent engineer also lays an imortant role during acceD
tance of the lant. "n fact this exert?s assistance will be reCuested&
. #o validate the Provisional Accetance Certificate* or PAC* for the lant
. -uring the test hase @between issue of the PAC and the Final Accetance
Certificate* or FACA
. #o validate the FAC for the lant
,.%.).! 0alidation of the Provisional Accetance Certificate @PACA
After evaluating the testing rocedures as regards the lant* the banks? indeendent
engineer then articiates in accetance testing itself. #he first test the lant must
ass is to meet the minimum erformance standard. "f this is not met* the general
contractor is deemed to be in default and is reCuired to ay liCuidated damages.
Furthermore* the indeendent engineer analyFes the results certified by a thirdDarty
organiFation and confirms their accetability in terms of meeting contractual
erformance reCuirements. Particiation in testing lus evaluation of the tests and
the results constitute validation of the PAC for the lant @see #able ,D.A.
5enefits for banks as a result of validation of the PAC are that they obtain
certification as to the comleteness and accuracy of certified data* articularly
as regards their meeting standards established contractually and included in the
financial lan.
-ocuments +eCuired to 0alidate the PAC& "n order to validate the PAC* the
minimum documentation the indeendent engineer reCuires is the following&
. 'uly contracts @6PC* civil works* subcontractsA
. Construction lans
. 7erating manual
. Maintenance manual
. 'afety lans
. AuthoriFations* ermits* and concessions @reCuired for the urose concernedA
. -etailed lans covering commissioning* startDu* accetance testing* and testing
hases @an oinion must be given as regards validity of testing itselfA
#A5 L6 ,D. 'ummary of Assistance -uring the Plant Accetance PhaseE0alidation of the PAC
"ndeendent 6ngineer?s
Activities -ocuments +eCuired
0alidation of
the ProviD
Particiation in acceD
tance tests
Analysis of test standards
+eview of certificates
issued by third arties
Contracts @6PC contract* civil works* subcontractsA
Construction lans
7erating manual
Maintenance manual
'afety lans
AuthoriFations* ermits* and concessions @reCuired
for the uroseA
-etailed schedule for the commissioning* startDu*
accetance test* and final testing hases @this is
reCuired in order to exress an oinion on adD
eCuacy of testingA
List of resources used and relevant Cualifications
@with training lan* if reCuiredA
Accetance rocedure* with details of reliminary
oerations* raw materials reCuirements* aramD
eters to be checked* methods of execution* and
alicable test standards
+eort on the
adeCuacy of
the rovisional
accetance cerD
. List of human resources emloyed and relevant Cualifications @with training
lan* if necessaryA
. Accetance rocedure* with details of reliminary oerations* raw materials
reCuirements* arameters to be checked* methods to be emloyed* and aliD
cable testing standards
-ocuments Produced& As already mentioned* the indeendent engineer must first
exress an oinion on the testing methods as to their alicability* comleteness* and
adeCuacy of the standards indicated* highlighting any shortcomings in the testing
rocedures adoted. Particiation in testing means the indeendent engineer can
evaluate whether the rocedures have been alied correctly and that arameters
checked in fact corresonded to the standards and that certified erformance data
agree with contractual reCuirements. #his also means that any variances can be
identified and analyFed.
As a result of the foregoing* the PAC for the lant certifying that standards have
been reached and the reCuired erformance achieved are validated.
,.%.).% Monitoring the #esting Phase
#he testing hase for the lant is usually never very short* and so Cuite some time can
ass between issue and validation of the PAC and roduction of the Final AcceD
tance Certificate. -uring the time between the PAC and the FAC* the indeendent
engineer must constantly insect the lant and analyFe eriodic maintenance reorts
roduced by the manager of the facility. "t is very imortant that technical and
oerational variables for the lant be checked* together with the methods emloyed
,. "f there is a variance between certified test values and those guaranteed* then it is not art of the
indeendent engineer?s task to rovide a suort service and assistance to the banks in order to evaluate the
technical and financial imact of differences found and define strategies to minimiFe any negative effects of
these. 'uch services are considered accessory to the PAC validation.
#A5 L6 ,D2 'ummary of Assistance -uring the Plant Accetance PhaseEMonitoring the #esting Phase
"ndeendent 6ngineer?s
Activities -ocuments +eCuired -ocumentation Produced
the testing
Periodic insection of the
+eview and check eriodic
maintenance reorts issued
by the manager
Check the correctness and
alication of safety
Contracts @6PC contract* civil works*
AsDbuilt lans
7erating manual
Maintenance manual
'afety lans
'afety statistics
List of oerations ersonnel and relevant
Periodic maintenance reorts reared
by the manager
8istorical records of alerts and breakdowns
8istorical records of main oerating
arameters for lant system erformance
@to be defined based on tye of roductionA
Accounts for consumtion of raw
materials* fuels* chemicals* consumables*
service fluids @water* natural gas* etc.A
Accounts for roduction
Accounts for disosal of byDroducts
Periodic monitoring reortK
statement as to the correctD
ness of maintenance
for carrying out maintenance activitiesK the indeendent engineer?s task includes
checking the facility?s safety rocedures and verifying that they are alied correctly
by management. @'ee #able ,D2 for a summary of activities and documentation
roduced by the indeendent engineer.A
Careful monitoring of the testing hase is very helful for lenders. #hanks to the
articiation of the indeendent engineer* they obtain certification from an indeD
endent arty attesting that the oerational management of the facility is roceeding
in accordance with contractual standards and international good engineering safety
standards and comlies with environmental regulations. Conformity of these variD
ables is a critical recondition to ensure oerations can continue throughout the
entire life of the ro$ect. 7n the other hand* eriodic checks on maintenance reorts
means that the following asects can be identified raidly&
. -amage to machinery and systems due to bad management* defects in conD
struction or assembly* lack of or inadeCuate maintenance
. Financial damage due to systems being down because of oor management or
inadeCuate maintenance
. Catastrohic events and=or environmental catastrohes as a result of oor
management of lant safety
-ocuments +eCuired to Monitor the #esting Phase& #he minimum documents that
the indeendent engineer must have are the following&
. 'uly contracts @6PC* civil works* subcontractsA
. Plans as built
. 7erating manual
. Maintenance manual
. 'afety lans
. 'afety statistics
. List of oerations staff and their Cualifications
. Periodic maintenance reorts reared by management
. 8istorical reort of alarms and breakdowns
. 8istorical reort of main oerating arameters concerning lant erformance
@to be defined according to tye of roductionA
. Accounts for use of raw materials* fuels* chemicals* consumables* service fluids
@water* gas* etc.A
. Production accounting records
. Accounts for disosal of byDroducts
-ocuments Produced& -uring the testing hase the indeendent engineer eriD
odically roduces a monitoring reort that summariFes valuations of the variables
,.%.).) 0alidation of the Final Accetance Certificate @FACA
0alidation of the FAC for the lant is carried out when eriodic checks during the
testing eriod have been comleted. #he bank?s indeendent engineer articiates in
the final insection of lant systems @which is an activity the site manager and
sonsors? technical advisor are resonsible forA* analyFes historical oeration and
maintenance reorts* analyFes results certified by the thirdDarty organiFation* and
confirms that the latter are correct in terms of meeting contractual reCuirements
@#able ,D3A.
#A5 L6 ,D3 'ummary of Assistance -uring the Plant Accetance PhaseE0alidation of the FAC
"ndeendent 6ngineer?s
Activities -ocuments +eCuired -ocumentation Produced
0alidation of the
Final AcceD
tance CertifiD
Particiation in final tests
of the lant
Analysis of reorts during
the testing eriod
Contracts @6PC contract* civil works*
Construction lans
7erating manual
Maintenance manual
'afety lans
AuthoriFations* ermits* and concessions
@reCuired for the uroseA
-etailed schedule for the commissioning*
startDu* accetance test* and final testing
List of oerations ersonnel and relevant
Maintenance reorts
8istorical records of alerts and breakdowns
8istorical records of main oerating
arameters for lant system erformance
Accounts for consumtion of raw materials*
fuels* chemicals* consumables* service fluids
@water* natural gas* etc.A
Accounts for roduction
Accounts for disosal of byDroducts
'tatement that stanD
dards established in
the construction conD
tract have been fully
-uring the final check the following asects are considered&
. 'tate of reair and maintenance of the works
. A checku on the sare arts inventory and warehouse
. Any oerating roblems identified
0alidation of the FAC is very imortant for banks. "n fact* they will receive
certification from their indeendent engineer that lant erformance conforms with
what was established contractually and included in the financial lan.
#he validation of the FAC reCuires the same documents indicated for the test
monitoring hase* and the result of this hase is a document attesting that lant
erformance fully conforms with the contractual terms.
,.%., Monitoring 7erations Management
After the FAC has been issued* the lant is finally considered to be oerative. From
this moment onward the attention of articiants in the deal @and among these*
of course* the banksA is focused on checking that lant management and maintenance
meet the standards defined in the oeration and maintenance agreements. #he task of
the bank?s indeendent engineer* therefore* is to carry out eriodic insections of
lant systems and to analyFe historical oeration and maintenance reorts reared
by management of the facility. #he check made by the indeendent engineer concerns
maintenance rocedures* management of stocks and the sare arts warehouse* and
management of safety systems @#able ,D(A.
For banks* the advantage of the indeendent engineer?s activities during the
oerations hase is that they obtain reorts certifying the adeCuacy of maintenance
#A5L6 ,D( 'ummary of the 7erations Management Monitoring Phase
"ndeendent 6ngineer?s
Activities -ocuments +eCuired
Make eriodic checks
of the lant
Check management of
the materials and sare
arts warehouse
Periodic check of validity
of safety devices and
+eview historical
maintenance reorts issued
by the manager
AsDbuilt lans
7erating manual
Maintenance manual
'afety lans
'afety statistics
List of oerations ersonnel* with relevant
Cualifications and costs
Maintenance reorts
8istorical records of alerts and breakdowns
8istorical records of main oerating
arameters for lant system erformance @to be
defined based on tye of roductionA
Warehouse accounts @materials and sare
arts managementA
Accounts for consumtion of raw materials*
fuels* chemicals* consumables* service fluids
Accounts for roduction
Accounts for disosal of byDroducts
oerations in terms of their being sufficient to ensure that the lant can continue to
roduce the cash flows indicated in the financial lan. Furthermore* the reort means
that any corrective action reCuired can be taken @and the necessary costs CuantifiedA
if there are significant variances from redefined standards as a result of events listed
in 'ection ,.%.).%.
-ocuments +eCuired for Periodic Monitoring& Periodic monitoring of oerations
reCuires availability of the following documentation&
. Plans as built
. 7erating manual
. Maintenance manual
. 'afety lans
. 'afety statistics
. List of oerations staff and their Cualifications and cost
. Maintenance reorts
. 8istorical reort of alarms and breakdowns
. 8istorical reort of main oerating arameters concerning lant erformance*
deending on the tye of facility realiFed
. Warehouse accounting records @materials and sare arts managementA
. Accounts for use of raw materials* fuels* chemicals* consumables* service fluids
. Production accounting records
. Accounts for disosal of byDroducts
-ocuments Produced -uring the 7erations Phase& -uring the oerations hase*
after each insection the indeendent engineer reares a eriodic monitoring reort
that summariFes the valuations of technical variables indicated reviously.
,.) +ole of "nsurance Advisors and "nsurance
Comanies in Pro$ect Finance -eals
"nsurance advisors lay an extremely imortant role in ro$ect finance deals. 'een
from a bank?s or an investor?s standoint* the insurance rogram established to
mitigate risks can often make a difference in terms of a ro$ect?s bankability and in
certain cases may even be indisensable. #he insurance rogram and bonding system
are* in fact* an effective art of the security ackage* and the ability of insurance
advisors involved in analyFing insurable asects of the ro$ect is essential for the
ositive outcome of the ro$ect itself. #he ability to lace insurance coverage in
domestic and international insurance and reinsurance markets is fundamental too.
:iven that ro$ect finance is basically a credit roblem and that credit risks
absorb eCuity caital* banks have become articularly sensitive to risk issues. #his
would suggest that in the future insurance rograms will lay an even more imorD
tant role in the various forms of the structured finance deal. "n fact* they reresentE
together with ro$ect contractsEa way of allocating risks associated with a business
venture in a more aroriate manner based on the tye of ro$ect. 'tructuring
a ro$ect finance deal resuoses that the negotiation of oerational and financial
contracts are coordinated with insurance contracts that* above all* take into account
the effective caacity of the international insurance and reinsurance market to absorb
at a reasonable cost the increased number of risks identified. Another imortant
3( +ole of "nsurance Advisors and "nsurance Comanies in Pro$ect Finance -eals
oint is that structuring a deal includes the very imortant task of subdividing and
allocating risks between all arties involved in the ro$ect. 8owever* this allocation of
risks must be based on an analysis of the effective ossibility individual arties have
to be able to urchase=negotiate aroriate insurance cover.
"n this section* an attemt is made to identify how and to what extent banks use
the insurance solution in deals* why they use it* and which arties banks work with to
analyFe insurance issues. Precise indications are also given as regards the more
common tyes of insurance contracts structure.
,.).! +ationale for <sing "nsurance in Pro$ect Finance -eals
"t must first be said that while insurance is an imortant contractual risk mitigation
tool* Cuite often it is treated as an addDon as oosed to being a fully integrated art
of ro$ect finance. #his tends to reduce its effectiveness and credibility* and in Cuite
a number of cases it can be an obstacle to the bankability of ro$ects.
As mentioned in Chater )* the very essence of ro$ect finance is to understand
and evaluate otential risks* both those directly linked to the venture and side effects
of indirect risks that can have a negative imact on the ro$ect?s erformance. #he
skill of a structured finance advisor is to define all ossible risks that may affect the
successful outcome of a ro$ect by rearing a list of robabilities that the events
concerned will indeed occur and their likely imact. After comleting this initial
exercise* the next ste is to determine the otimum method to mitigate each risk
wherever this is effectively ossible. #he result of this rocess should be to make the
deal >>bankable?? and establish the cost of risks concerning the ro$ect.
"nsurance should be seen as a risk mitigation tool on a ar with other key contracts
in the deal* such as an offtake @takeDorDayA contract. "n effect takeDorDay contracts
are considered very imortant because as they generate and stabiliFe cash flows that
will service the debt. 8owever* the validity of an offtake agreement in mitigating
market risk is clearly a function of lant roduction* and this could be interruted or
blocked either directly or indirectly in many different ways and for various reasons.
'o insurance is a tool that must be roerly coordinated and linked to the
ro$ect?s contractual structure. Coordination also means taking into account the
technical rinciles of insurance and the effective negotiating ower of the individual
arties involved. 7ne of the main roblems is to analyFe the real caability of the
insurance and reinsurance market to rovide aroriate solutions. #his analysis*
which starts with the risk matrix @see Chater )A constructed by the financial advisor
based on oinions given by the various indeendent advisors* must then be assed to
insurance advisors secialiFed in nonrecourse or limitedDrecourse structured finance
deals. "t will then be the insurance advisors? task to check whether suitable insurance
rograms can be sourced in the markets. "n fact any decision to invest or oerate in
a given market imlies assuming a certain degree of risk* which can usually be
evaluated in terms of market risk. 8owever* further risk factors must be considered
when a ro$ect concerns other than the domestic environmentK olitical* legal* and
business uncertainties of the country concerned lay an imortant role. "n many cases
these uncertainties can be a critical factor as regards suort @including financingA for
the venture. "f these additional risks can be minimiFed or controlled* freCuently the
ro$ect becomes not only bankable but also more attractive for lenders. 'o it is
indisensable to use the services of an advisor who can evaluate the insurability of
the tyes of risk identified for each secific ro$ect.
(1 C 8 AP # 6 + , #he +ole of Advisors in a Pro$ect Finance -eal
5ecause there isn?t $ust one tye of risk classification* certain factors or macro
areas can instead be considered when defining insurability. 6xamles with definitions
of those used more freCuently in the insurance market follow.
. Pure risks& #he characteristic feature of these risks is their unredictability*
inasmuch as they are linked to accidental causes* only generate losses* and
normally include the ma$ority of traditional insurable conditions.
. Financial risks& #hese risks can sometimes result in losses but can also roduce
gains. #hey are linked to financial lanning and even though redictable can
generate rofits or losses.
. Legal=contractual risks& #he source of these risks is contractual agreements.
-amage will arise in the case of noncomliance with contractual terms and
conditions* but an additional damage will occur where the contractual asect
generates a liability for the arty involved.
. 7rganiFational risks& #hese risks arise in cases where owers of decision and
relevant resonsibilities have not been roerly allocated between arties
involved in the ro$ect.
. 'trategic risks& #hese risks are intimately linked to comany strategies* as
regards both determining relationshis with other ro$ects and develoment
,.).% When 'hould "nsurance Products 5e <sed;
"nsurance should be used when the 'P0?s cost of risk mitigation using insurance
olicies is less than the remium for risk exressed in interbank interest rates
reCuested by banks if no coverage exists. 7f course* there is a minimum accetable
level of risk allocation for lenders that will finance the deal* which must necessarily
be taken into account when structuring the insurance lan. "n the first instance it is
the sonsors? financial advisor who must make this difficult evaluation. #he advisor
is resonsible for ensuring that the deal is structured in the most favorable manner
for the sonsors. #herefore* insurance coverage will be used only if it is the most
costDeffective way to achieve the risk mitigation reCuested. "n making this assessD
ment the financial advisor must be assisted by the insurance advisor* who should
check the terms and cost of insurability in the insurance markets. #he greatest
difficulty in making this evaluation is that information and documentation to be
submitted to the insurance and=or reinsurance markets is incomlete at this stage.
At the same time* the volatility of these markets in recent years* in terms of both
ricing and risk underwriting caacity* has become a further issue to be carefully
considered. 'o the financial advisor?s osition also has a significant effect as far as
lenders at a later stage are concerned& #he lower the nonfinancial costs incurred by
the ro$ect and the wider the insurance coverage* the more likely it is that the
ro$ect will be a success and so be able to service the debt. "t is therefore vital that
the financial model for the ro$ect be structured taking into account a realistic
estimate for insurance costs both during the imlementation stage of the ro$ect
and after it becomes oerative and for a sufficiently long eriod while at the same
time attemting to make reasonably reliable forecasts as regards the viability of the
insurance cost.
(! +ole of "nsurance Advisors and "nsurance Comanies in Pro$ect Finance -eals
,.).) Areas Where the "nsurance Advisor "s "nvolved
"n the ma$ority of cases* it is the bank acting as advisor and=or arranger of a deal
that reCuests the services of an insurance advisor when structuring the security
ackage. #he reCuest normally follows a standard outline* giving a descrition of
the deal* indicating the reCuirements=revious exerience necessary in order to
formulate the roosal* reCuesting details of the ro$ect team=curricula of rofesD
sionals involved* and summariFing the scoe of work when the deal is being
structured and as the ro$ect rogresses. #he scoe of work to be erformed by
the advisor will of course follow the develoment of the ro$ect based on rogress
in structuring the financing. Following is an examle of the scoe of work for an
insurance advisor as regards the construction and oeration of a lant using
a ro$ect finance aroach.
,.).).! Preliminary "nsurance +eort Phase
#he reliminary insurance reort and general risk lan cover the following oints&
!. Analysis and comments concerning contractual documentation for the ro$ect
as far as insurance coverage is concerned and also with reference to any
environmental guarantees that must be given
%. "nsurance identification* allocation* and ossible rotective mechanisms as
regards ma$or ro$ect risksK identification and comments on noninsurable
). Analysis of insurance regulations and their imlications for the ro$ect
,. Prearation of the contractual term sheet for the roosed insurance rogram
/. :athering and analyFing information with reference to rendering the services*
rearing* when reCuested* memoranda* notes* and documents for discussion
.. Assistance in rearing those sections of the financial documentation that
directly or indirectly refer to the insurance coverage rogram
2. 'ummary of the contractual terms of the main olicies* secifying risk covered*
limits on claims* exclusion* tenor* and other ma$or conditions in order to
adeCuately safeguard the banks? interests* also bearing in mind market stanD
dards for similar ro$ects
,.).).% Final "nsurance +eort PhaseEConstruction Phase
#he final insurance reort is issued at the time of the financial close and in any event
before the first drawdown of funds. #his document will in fact constitute a condition
recedent for disbursement. #he reort reviews the overall adeCuacy of the roosed
insurance strategy* with a check on final documents that will be submitted to the
insurance advisor. 'ecifically* it will ertain to&
. Checking the insurance rogram against the financial documentation for the
. "ndications of ratings for underwriting comanies
. Checking the insurance documentation @letters and oliciesA against financial
documentation for the ro$ect
. Prearing a final insurance reort ascertaining that the insurance rogram
stiulated is in conformity with indications in the reliminary due diligence
(% C 8 AP # 6 + , #he +ole of Advisors in a Pro$ect Finance -eal
,.).).) Final "nsurance +eort PhaseE7erations Phase
#he final insurance reort will be issued before startDu of each lant oeration
hase. Activities concerned will be as follows&
. Checking the insurance rogram for the oerations hase against the financial
documentation for the ro$ect
. "ndications of ratings for underwriting comanies
. Checking the insurance documentation @letters and oliciesA against financial
documentation for the ro$ect
. Prearing a final insurance reort ascertaining that the insurance rogram
stiuD lated is in conformity with indications in the reliminary due diligence
,.).)., #he Most Problematic Areas
"n order to better understand the imortance of the role of Cualified insurance
advisors* following is a brief outline of some of the ma$or insuranceDrelated roblems
encountered in ro$ect finance deals. 7bviously these roblems aear greater seen
from the lenders? standoint* whereas they seem accetable to the ro$ect?s sonsors.
#his difference in oints of view can often cause a bottleneck in ro$ects.
. #he ricing of the insurance ackage from the very beginning of ro$ect
lanning @feasibility studyA* then for the ro$ect imlementation hase and
throughout the entire oerating eriod reCuired to reay the debt
. #he soundness of insurers and=or* in certain cases* reinsurers and the ossibility
of knowing their rating for the entire tenor of the loan
. #he ossibility for insurers to cancel olicies if certain conditions should arise
@e.g.* an unfavorable claims=remium ratioA
. #he ossibility that sonsors may not renew or might reduce the insurance
rogram @reduction of claim limits or maximum sum insurable* elimination of
certain guarantees* increasing exclusionsA
. #he ossibility that reinsurance markets* and therefore insurance markets*
reduce or even comletely cancel underwriting caacity @for instance* this
haened during the two years after %11! as far as guarantees against terrorist
attacks were concernedA
. #he ossibility that insurers claim they were not correctly informed of ro$ect
risks when these were underwritten and that they therefore reduce or cancel the
extent of contractual guarantees. #his contingency means that intermediaries
used must be able to satisfy market reCuests for further information.
. #he ossibility that sonsors do not ay for insurance coverage or fail to utiliFe
any claim reimbursements to reconstruct the works
. #he ossibility that claim reimbursements are aid to arties that are not
entitled to them and the latter do not make an aroriate use of them
. A further asect to consider is that it isn?t always ossible for a single insurer to
cover the entire insurance ackage. #his means there will be different legal
latforms for each insurable risk* and these must be interreted and reconciled.
"t is to be hoed that with the hel of secialiFed rofessional intermediaries* the
current modus oerandi of insurers will* in time* change radically. "n fact* the
situation could reach the oint that a role of lead insurer will be recogniFed with a
status similar to that of lead arrangers in syndicated loans. #his would then create
a single reference oint for full insurance coverage.
() +ole of "nsurance Advisors and "nsurance Comanies in Pro$ect Finance -eals
,.)., #yes of Conventional and Financial "nsurance
Products Available for Pro$ect Finance -eals
Following is a list of conventional insurance roducts and those roviding financial
insurance coverage used in ro$ect finance deals.
. 4onayment risks& #hese are olicies covering damage for the 'P0 due to
olitical or business reasons. 'uch accords can concern both mediumD and
longDterm receivables and also leasing contracts and documentary credits.
. "nvestment risks& #hese are olicies that cover the 'P0 for risks of currency
inconvertibility* exroriation without comensation* war* and other olitical
. Collateral derivation risks& #hese olicies guarantee the 'P0 rotection against
risks of loss of assets and failure of the concession authority to reurchase the
. Contract frustration risks& #hese olicies cover wrongful calling of guarantees
and failure to deliver arts or ieces that are functional for the imlementation
of the ro$ect.
. Credit enhancement& "nsurance can be reCuired to guarantee a credit from a
third arty and to make asset securitiFation transactions easier to set u.
. #ransfer risks& #hese olicies are very freCuently used in international ro$ects
in countries where there is very little stability. #hey cover risks of failure to
retransfer investments back home* to service the debt* or as regards ayments
for leasing contracts.
. Political risks& Coverage for olitical risks is a very secialiFed field of
insurance @see Chater )A. "n fact* by definition in this case the ro$ect is
imlemented in a country marked by olitical uncertainty and instability or
with a fragile legal structure. "t is Cuite obvious that* comared to normal
situations* the Cuestion of insuring an investment or the osition of a lender
becomes a much more significant insurance issue. Political risk insurance is
available to cover various events* such as&
D Confiscation* exroriation* and nationaliFation
D Forced abandonment of the venture
D #ransfer risks
D 8ost government?s refusal to reurchase the structure
D <nilateral re$ection of contracts
D War* civil war* internal revolts* acts of terrorism
#here can* however* be arties interested in coverage for olitical risks even for ro$ects
imlemented in countries that are not unstable. "n effect* the need for olitical risk
coverage is an issue not only when the ro$ect concerns emerging or develoing
countriesK it can also deend on the secific features of a deal set u in industrialiFed
countries in which a change in olitical situation or global economic trend could
damage the venture concerned. #he key oint in this case is if the country has been
given an accetable credit rating by ma$or international agencies in relation to the
contractual terms roosed to lenders* articularly if the deal is not limited to banks or
investors from a single country. +atings for any one country can be revised and
downgraded* sometimes even unexectedly.
(, C 8 AP # 6 + , #he +ole of Advisors in a Pro$ect Finance -eal
"t is very difficult to fix arameters to determine if olitical risk coverage in one of
its various forms is necessary or not. #his is exemlified in the fact that today* for
certain ro$ects in several countries* even wellDdeveloed ones* insurance is reCuired
against acts of terrorism or revolts. A further examle is based on the widesread
conviction that a comany in a given country cannot raise money at a lower interest
rate than the corresonding sovereign debtor. <se of insuranceDtye risk mitigation
that has the effect of achieving credit enhancement by removing art of the risks can
easily lead to a lower cost of funding than would be reCuired for the country risk in
which the ro$ect is domiciled. "n any event* insurance coverage can be very effective
in this sense even in countries with very robust economies.
When seaking of coverage for conventional risks* a distinction must be made
between the ro$ect imlementation hase and the oerations hase. While construcD
tion is under way* the most common forms of coverage used are as described next.
#ransort Policy& #his olicy covers all materials* including lant* eCuiment* and
sare arts* from the moment the material leaves the sulier?s warehouse to be
loaded onto the transort vehicle. Coverage continues during transit and includes
any intermediate stocking* until such time as the material is delivered to the oint
where works are being executed.
'tartD< -elay Caused by #ransort& #his olicy is closely linked to the revious
one and is a solution for rotecting the financial lan by guaranteeing the debt and
ro$ect cash flow from damage or losses resulting from the transort olicy.
"t rovides coverage for loss or damage to ro$ect materials during transort that
cause a delay in the date established for startDu of business oerations.
#hirdDParty Liability and Accidental Pollution& #his olicy rovides insurance
coverage for claims against the insured made by third arties for hysical damage*
death* loss* or damage to thirdDarty roerty* including unexected and accidental
6mloyers? #hirdDParty Liability& #his olicy rotects the insured from legal action
that may be taken by their emloyees or by legal reresentatives or agents aointed
by emloyees and* in general* by all contingent* temorary* or ermanent workers
following death or in$ury for which the insured is liable. 6ach arty involved in the
ro$ect must take out such a olicy for its own emloyees working on the ro$ect.
All Assembly +isks Policy& #he main urose of this coverage is to guarantee ro$ect
materials during stocking* construction* assembly* installation* commissioning* and
testing u to the time ownershi is transferred* enabling the arties involved to recover
the reair or relacement costs for the goods damaged as a conseCuence of the event
guaranteed. Coverage includes damage caused by reexisting works. #he tenor of the
olicy will include the works eriod and all commissioning and testing activities u to
the issuance of the rovisional accetance certificate and must also cover the extended
maintenance eriod u to issue of the Final Accetance Certificate.
-elay in 'tartD< -ue to Assembly& #his covers financial losses caused by a delay in
startDu of lant oerations as a result of an interrution during the construction*
assembly* installation* commissioning* or testing hases due to an event covered by the
all assembly risks olicy that gives rise to a loss of rofits or ayment of fixed costs.
All 'ite 6Cuiment +isks Policy& #his olicy is usually art of the all assembly risks
olicy and covers eCuiment* machinery* and temorary buildings used on the
construction site by the contractor* subcontractors* and suliers during conD
struction of the works.
(/ +ole of "nsurance Advisors and "nsurance Comanies in Pro$ect Finance -eals
Force Ma$eure& #he aim of this olicy is to rotect the owner for interest due to
lenders in the event of a delay in comleting the ro$ect or if it is abandoned. #his
olicy should sulement the olicies covering all assembly risks and indirect damage
caused by assembly in order to comlete coverage by including events that don?t
cause material damage to ro$ect assets. #he main events insured are&
. Fire and accessory guarantees occurring outside the lace where works are
being executed* including damage during transort during the construction
hase of assets that will be sulied and in sulier lants
. 'trikes=shutdowns
. <nion disutes
. Changes in law after the olicy becomes effective leading to additional costs for
the ro$ect than those originally lanned under the reviously existing law
Furthermore* in general it covers all other causes not within the control of the
owner* constructor* or other articiants in the ro$ect.
#hirdDParty Liability of the 5oard of -irectors and 6xecutives& #his olicy rotects
administrators* directors* and statutory auditors of comanies involved in the ro$ect
from monetary conseCuences* exenses as a result of aointing legal reresentatives*
and ayment of damages for which the individuals concerned are ersonally exosed
in the event of errors or omissions committed during the exercise of their functions.
"n contrast* the following insurance olicies concern the ro$ect oerations hase.
All +isksEMaterial and -irect -amage& #he aim of this olicy is to guarantee the
widest ossible >>all risks?? coverage for all arties concerned. #he main scoe here is
to indemnify the owner and lenders for material damage to lant comonents
comrising the ro$ect* including sare arts and fuel* based on new relacement
value. #he oerator must set u this olicy* which should include the owner* lenders*
and constructor as additional insured arties* at its own exense.
"ndirect -amages @5usiness "nterrutionA& "f an event of material damage concerning
the ro$ect guaranteed by the all material and direct damage risk olicy negatively
affects the ro$ect?s ability to generate a financial return* then the resulting financial
loss will be covered by this olicy.
:eneral #hirdDParty Liability& #his olicy insures arties involved in oerations for
accidents and=or damage to assets and=or financial losses affecting third arties
during lant oerations* including thirdDarty roduct liability. #he oerator must
set u this olicy* which should include the owner* lenders* and constructor as
additional insured arties* at its own exense.
6mloyers? #hirdDParty Liability& #his olicy rotects insured arties from legal
action that may be taken against them by their emloyees or by legal reresentatives
or agents aointed by emloyees and* in general* by all contingent* temorary* or
ermanent workers following death or in$ury for which the insured are liable. 6ach
arty involved in the ro$ect must take out such a olicy for its own emloyees who
are working on the ro$ect.
#hirdDParty Pollution Liability& #he olicy rotects arties involved in lant
oerations for cases of thirdDarty liability as regards accidents and=or damage to
roerty and=or financial losses as a result of ollution @sudden or gradualA arising
during oeration of the lant. #he oerator must set u this olicy* which should
(. C 8 AP # 6 + , #he +ole of Advisors in a Pro$ect Finance -eal
include the owner* lenders* and constructor as additional insured arties* at its own
#hirdDParty Liability of the 5oard of -irectors and 6xecutives& #his olicy rotects
administrators* directors* and statutory auditors of comanies involved in the ro$ect
from monetary conseCuences* exenses as a result of aointing legal reresentatives*
and ayment of damages* for which the individuals concerned are ersonally exosed
in the event of errors or omissions committed during the exercise of their functions.
,.).,.! 5onding
7ne of the fundamental factors in ro$ect finance is a comlex structure of guaranD
tees that must be set u in which the 'P0 is the reciient while contractors* suliers*
and oerators are the committed arties* in order to safeguard down ayments made
based on stated erformance and other contractual commitments. #he strong need
for guarantees is to a large extent covered by bank bonding* roducts that u to now
have been those most widely used and areciated by banks lending to the 'P0.
8owever* because sonsors today are finding it increasingly difficult to obtain this
kind of guarantee* cometition in the form of insurance guarantees is becoming more
intense and effective.
#he increasing use of guarantees rovided by the insurance market is mainly due
to the fact that bank guarantees affect the borrower?s level of indebtedness and so
indirectly lower credit caability* which in turn imacts general borrowing ower.
#his negative effect associated with use of bank bonding has led to an everDincreasing
use of insurance bonds. 5ut one of the roblems concerning use of insurance instead
of banking bonds is that the insurance market* as a general rule* is unwilling to issue
guarantees that are not linked to a secific negative event. 8owever* insurance
olicies can be used to define recise conditions that would reasonably $ustify the
enforcement of the guarantee.
Aart from the imossibility of issuing an insurance olicy in the absence of
a secific negative event* an insurance bonding offers some advantages for the
borrower comared to bank bonding.
. "nsurance doesn?t have the negative effect of the borrower?s level of indebtedness.
. An insurance guarantee doesn?t affect bank credit facilities* which can therefore
be reserved for other uses.
. An insurance guarantee can sometimes be less costly than bank bonding.
. 'uch a guarantee can be negotiated with insurers to develo a tailorDmade
guarantee that is more in line with the reasons for which it is rovided to
a third arty and can only be enforced by the beneficiary based on secific
events of default incurred by the arty resenting the guarantee.
Aart from this* the two forms of guarantee @bank and insuranceA are identical*
excet for that insurance bonding tends to define conditions determining the ayment
reCuest in much more detail than in the case of bank bonding. When a beneficiary
files a claim* the only difference from the bank bonding case is that in order to reCuest
ayment the beneficiary must draw u a formal reort referring to the secific event
of default for its own insurer. #his is done at the time the claim is submittedK if the
claim is found to be un$ustified* then the necessary rocedures are activated to
recover sums aid by the insurer. #his means that beneficiaries must be more
cautious at the time they file claims.
(2 +ole of "nsurance Advisors and "nsurance Comanies in Pro$ect Finance -eals
,.)./ "ntegrated "nsurance 'olutionsE'tructure and Content
A recent trend seen in the insurance market for ro$ect finance olicies is the
diffusion of integrated insurance ackages. "nitially studied for the needs of the
construction sector* integrated insurance rograms are now used in many ro$ect
finance alications. "ntegrated ackages mean the 'P0 doesn?t have to assemble an
insurance ackage by shoing around for olicies from a number of insurers* often
based on different legal latforms.
'tiulating an integrated olicy can offer some benefits for those articiating in
the deal* as summariFed next.
. Coverage is based on a single olicy structured around secific comonents
relevant to the various asects of risk and based on a single legal latform.
. Coverage concerns all asects of ro$ect develoment @indeendent of the
reCuested start date for the coverageAK it is in lace right from the start* with
known costs* and is not sub$ect to negative changes in the market for the entire
develoment eriod.
. #he integrated ackage has features not currently available in alternative
. "ntegration simlifies the negotiation rocess for the insurance ackage.
. Many difficulties concerning construction litigation @about 31JA can be
avoidedK this in turn substantially reduces the ossibility of what can often
be very lengthy legal disutes.
. #he sales rocess is simlified considerably* and the need for additional docuD
mentation and negotiations is reduced to the minimum.
. Financing the deal is simler and faster because banks don?t need to worry
about checking that all risks are adeCuately covered or the terms for the
coverage concerned. An integrated scheme* in fact* rovides a uniform* inteD
grated insurance latform* with a single insurance underwriter who works with
lender banks from the very start of the ro$ect.
. #he cost is lower than the sum of costs that would be incurred by adoting
a conventional system of coverage with no coordination of all arties involved*
which also inevitably results in less ervasive coverage. All asects of minimum
remium and dulication of coverage are eliminated at the comonent level.
. Costs associated with coverage are defined and known right from the start.
'tandard integrated insurance ackage often include the following olicies.
. Contractors >>all risks??& #his is the main insurance comonent during the
construction eriod.
. Financial risks& #his comonent refers to bonding as regards erformance* bid=
ayment* maintenance=retention* and other business guarantees.
. Advance loss of rofits& #his is of articular interest for ro$ect finance* since in
its basic form it guarantees debt service during the construction hase of the
. Professional indemnity& #his coverage concerns legal and contractual liabilities
arising from rofessional activities reCuired by the ro$ect.
. Public and roduct liability& #his coverage is for liabilities arising from damage
to thirdDarty goods or roerty or damage to ersons as well as thirdDarty
financial losses.
(3 C 8 AP # 6 + , #he +ole of Advisors in a Pro$ect Finance -eal
. All risks roerty damage& #his comonent rovides comlete coverage for risks
of damage to the structure after comletion certificates are issued* namely*
risks not covered by the contractors >>all risks?? comonent. "t rovides a wide
range of financial rotection for structures that have been comleted but not yet
occuied* occuied by the develoer* or leased to third arties.
. 5usiness interrution resulting from roerty damage& #his area covers risks
arising because of direct material damage that negatively affects the ro$ect?s
ability to generate incomeK the sums insured include debt service* fixed costs*
and* in certain cases* exected rofits.
,.).. Classification of "nsurance <nderwriters
8aving seen the main categories of insurance olicies available on the market* it is
now time to look at the arties who offer such roducts.
#here are four main categories of insurance underwriter in the international insurD
ance market as regards ro$ect finance deals. 7f these* some only act as
financial insurance comanies* whereas others oerate over a more conventional
range of insurD ance coverage. 8owever* in general terms the categories refer to
either multilateral* commercial* grou cative* or monoline underwriters. #he
characteristics of these tyes of underwriter are as follows.
. Multilateral insurance underwriters& As the name suggests* these are financial
insurance comanies controlled by multilateral develoment banks. #he most
famous is the Multilateral "nsurance :uarantee Agency @M":AA @see 'ection
..,.!.!A. #his organiFation is art of the World 5ank :rou and oerates on
a nonrofit basis to rovide insurance for ro$ect finance ventures based on
guidelines established by the World 5ank itself. #he strength of multilateral
agencies is that they can rovide coverage not available on the market* eseD
cially as regards countries with very low income levels. #hey do* however* have
weaknesses& "t usually takes a very long time to obtain aroval for an aliD
cation* and the uDfront fees reCuested tend to be rather high.
. Commercial insurance underwriters& #his is the largest grou and includes the
numerous comanies offering a comlete range of conventional insurance
services and that* in certain cases* also offer financial insurance roducts.
"n the field of structured finance the main underwriters are Lloyds of London
and A":. Lloyds covers the entire sectrum of insurance and is robably the
bestDknown comany in the structured finance segment because of its ability to
take on very secific risks for each venture concerned. "ts rocedures are also
faster and more flexible than other underwriters at the international level. A":*
on the other hand* has a very comlete range of insurance roducts and is best
known for its secialiFation in the olitical risk insurance field. A": can also
rovide eCuity for ro$ects either directly or through its own or thirdDarty
managed closed funds.
. :rou cative insurance underwriters& #hese are insurers that oerate only with
comanies that make subscrition club ayments to obtain their insurance
services. #he amount of coverage available is based on the level of contribution
to the subscrition club that each member is willing to make. 6xorters "nsurD
ance Comany of 5ermuda is robably the bestDknown grou cative underD
(( +ole of "nsurance Advisors and "nsurance Comanies in Pro$ect Finance -eals
writer for trade and ro$ect finance dealsK it rovides a comlete range of
insurance coverage for exort credit and olitical risks.
. Monoline insurance underwriters& Monoline insurers are global financial insurD
ance comanies* and financial insurance is their only line of business @hence the
term monolineA. #hese are secialiFed underwriters with a 'BP* Moody?s* and
Fitch best rating that rovide credit enhancement guarantees offering adeCuate
suort for ro$ect finance deals under certain conditions. "n fact* they can issue
lenders and certain other arties unconditional and irrevocable guarantees
to ay caital and interest for debts at maturity. #he fact that today comliance
with caital coefficients is becoming a critical issue for banks in many countries
has rovided considerable imetus for insurance roducts focusing on increasD
ing credit ratings for deals. A further factor for this growth has been the
imressive develoment of assetDbacked securitiFation transactions* which
have many features in common with ro$ect finance deals.
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C 8 A P # 6 +
0aluing the Pro$ect and Pro$ect Cash
Flow Analysis
"n order to ascertain whether or not a ro$ect finance formula can be alied for
a given initiative* an advisor builds a financial model. #he technical=industrial*
legal* and insurance considerations are comiled* collated* and translated into numD
bers. 'ome are obtained from ob$ective data* and others are comuted within the
framework of a recise set of assumtions. #he advisor?s aim is to come u with
estimates on cash flows* rofit and loss* and the balance sheet* along with a series of
ratios based on the same forecasts. #he ro$ected cash flow calculation is vital for
valuing the ability of the initiative to generate enough cash to cover the debt service
and to ay sonsors dividends that are in line with exected returns.
Any general discussion of financial modeling is always far too theoretical. #his is
why the resent chater is based on data relating to the "taly Water Case* which is
included in this book together with the financial model rovided on a C- +7M.
#he financial model is a crucial comonent of any investment ro$ect that
comanies intend to develo with ro$ect finance. 5y analyFing technical* economic*
financial* and fiscal variables* the sonsors? idea is carefully scrutiniFed to ascertain
whether it is convenient from an economic and financial standoint.
'etting u a financial model is also imerative when a comany wants to bid on a
ublic service concession or a 57# scheme. "n PPP initiatives* the ublic adminisD
tration very often rovides ublic grants during the construction haseK in other
situations* it eriodically ays the concession holder an oerating fee. "n still other
cases* the concession holder?s only comensation comes from roceeds related to
roviding a ublic service or oerating the facility in Cuestion.
Concessions are awarded on the basis of tendersK comanies cometing for
concessions must secify the roosed tariff level for the service in Cuestion as art
!1% C 8 AP # 6 + / 0aluing the Pro$ect and Pro$ect Cash Flow Analysis
of the tender documentation. #his tariff is the key factor considered by the concession
authority in choosing who will win the bid among the cometing firms. For this
reason* a comany vying for a 57# concession for a lant has to build a financial
model in order to determine a tariff scheme ex ante that will adeCuately cover
construction costs and=or lant oerations as well as to guarantee a satisfactory
return on the caital invested by lenders and sonsors.
For examle* in the "taly Water Case* the sonsors have to make exact estimates
of construction costs @construction* additional charges* and develoment costsA and
oerating exenses. #hese figures are used to establish the tariff to charge the ublic
administration for every liter or gallon of treated water and the total ublic grants
reCuired to make the deal financially sustainable. 7f course* this analysis must be as
recise as ossible. "n fact* the comany that wins the concession cannot charge a
higher rate than that secified during the bidding rocess @unless extraordinary
circumstances arise and only on aroval of the ublic administrationA. "f the
comany were to do so* it would be sub$ect to enalties @normally Cuite costlyA*
and the concession would be ut u for ublic tender once again.
#his chater is structured as follows. "n 'ection /.! we introduce the concets of
cash flow and the inut variables needed to estimate it. 7nce oerating cash flow is
defined* 'ection /.% describes the uses for cash flow and clarifies how to find the
otimal caital structure for the realiFation of the investment in Cuestion. #his
structure must be determined in terms of both its financial sustainability as well as
its economic convenience for sonsors and lenders. 6conomic convenience @measured
by the "++ for the ro$ect* sonsors* and lendersA is discussed in 'ection /.%. 'ection
/.) turns to financial viability and the cover ratios used to measure it. 'ection /.,
concludes with a resentation of sensitivity and scenario analyses.
/.! Analysis of 7erating Cash Flows and #heir 5ehavior
in -ifferent Pro$ect LifeDCycle Phases
"dentifying the oerative comonents of cash flow during the feasibility study is vital
for various reasons.
!. Pro$ect finance is viable only in light of the siFe and volatility of flows generated
by the initiative. "n fact* it is with these oerating cash flows that the ro$ect
ays back its loans and ays out dividends to the 'P0?s shareholders.
%. Lenders can?t count on sonsors to recover loans because limitedDrecourse
clauses actually revent any such action.
While these oints reresent two constants in initiatives where ro$ect finance
logic is alied* building the financial model of the initiative can?t be done without
taking the eculiarities of this logic into consideration. #he technological and oeraD
tive asects discussed in rior chaters are often very secificK because of this* the
modeler needs to develo ad hoc models on a caseDbyDcase basis.
#o design the financial model of a ro$ect finance initiative effectively* advisors
must first identify the cash flow comonents of the ro$ect. "n other words* they must
!. Consider two cases& building a section of a toll road and constructing a lant for incinerating waste or
biomass and roducing electric ower. #hese ro$ects have very little in common* beginning with two basic
features& the end roduct and the inut needed to obtain it.
!1) Analysis of 7erating Cash Flows and #heir 5ehavior
Re;en%es from sales
Ra6 materials
an o!eratin-
O0M fees
*B, O!eratin- cas3 flo6C-ross
Increase in
6orkin- ca!ital
B O!eratin- cas3 flo6Cnet
*)nle;era-e free cas3 flo6,
F " : < + 6 /D! Waterfall 'tructure of the 7erating Cash Flow
determine the difference between inflows and outflows before taking financial items
into account @rincial and interest ayments* reserve account contributions* and
dividends to sonsorsA. #his difference is called the oerating cash flow. 'ee Figure /D!*
where the structure of cash flows is deicted as a >>waterfall.??
#he oerating cash flow takes on the configuration shown in Figure /D! in every
year of the ro$ect?s life. #he waterfall structure shown in Figure /D! can be found in
all cororate finance manuals labeled >>unlevered free cash flow.?? 8owever* this
reflects the situation for ongoing concernsK for ro$ect finance things are different.
"n fact* Figure /D! shows that the weight of each category of items differs deending
on the ro$ect?s current hase. -uring construction* for examle* the gross oeratD
ing cash flow and the change in working caital items are Fero* whereas the oerating
cash flow is siFeable @and negativeA. #he exlanation for this is that the Caex
reCuired for realiFing the ro$ect is considerable.
Conversely* when oerations are under way* Caex dros to Fero. @"n a ro$ect
finance initiative* we have only one lant* which reCuires annual 7BM costs only
after construction is comlete.A At the same time* we start to see ositive flows from
current oerations as well as changes in working caital.
#he fairly clearDcut searation between sustaining Caex and roducing ositive
cash flows deriving from these caital exenditures is tyical in ro$ect finance. For
an ongoing concern that manages a ortfolio of assets* the two tyes of cash flows
can be found simultaneously in every year of the comany?s life.
#he dynamic of oerating cash flows can be illustrated as in Figure /D%. #he
diagram shows the time from startDu to the end of the ro$ect life on the horiFontal
axis* and the value of cumulative net oerating cash flows for each year of ro$ect life
on the vertical axis. #he first area @from time 1 to time $ on the horiFontal axisA
O!erations !3ase
j k *!a&back,
En of !ro7ect
F " : < + 6 /D% #he -ynamic of Cumulative 7erating Cash Flows for an "nvestment Pro$ect
reresents the eriod in which the lant is under construction. From an economic
standoint* the ro$ect does not yet generate revenue* costs are incurred and aid
over several years and are caitaliFed in the cost of construction. #he income
statement is >>blank*?? and cost items refer solely to the 'P0?s balance sheet. From
a financial viewoint* during the construction hase the ro$ect can?t generate
revenue or cash inflows.
#he lack of revenues and inflows during the construction hase goes hand in hand
with disbursements for Caex. ConseCuently* oerating cash flows are negative* and
cash reCuirements have to be covered by a ool of banks @brought together by the
arrangerA and by sonsors who begin to confer eCuity and subordinated debt. "n the
construction hase* therefore* lenders allow the ro$ect comany to start drawing
down the loans. At the same time* they count on the ositive cash flows roduced by
the initiative* which will emerge only at some future oint in time* i.e.* at time $ as
shown in Figure /D%.
After oint $* the ro$ect moves into the oerating hase and starts generating
revenues @and therefore inflowsA earmarked for aying oerating costs. After the first
few years in which oerating cash flows are negative* the curve of cumulative flows
reverses its course& 7erating cash flows become ositive* and this hels curtail the
overall financial reCuirement.
7n the grah* the distance between oint $ and oint k @which reresents the
nondiscounted ayback eriod on the investmentA deends on the Cuantity of oerD
ating cash flows after construction is comlete. More substantial flows corresond to
a shorter $Nk eriod* and vice versa.
As the ro$ect gradually moves forward in time toward year n @i.e.* the last year of
the ro$ect?s lifeA* the financing obtained from the sonsors is gradually aid back.
"n the final years of the ro$ect?s life* revenues are earmarked solely for covering
oerating costs and financing increases in working caital* if reCuired.
%. "n certain situations* some lant tests can also result in outut that can be sold on the marketK however*
this does not involve substantial flows. An examle in the ower sector is when lant testing roduces electricity
that can be sold to an offtaker.
As regards flows that emerge at the end of the ro$ect?s life* two clarifications
should be made. First* the amortiFation eriod for the loan granted to the ro$ect is
shorter than the entire duration of the ro$ect life cycle. @"n technical terms* this
difference is called the tailK see also 'ection /.%.%A "n fact* circumstances may be such
that at the end of its lifetime the ro$ect is not caable of generating the cash flows
forecast by the arranger. #his gives rise to the need for loan rescheduling* which
would not be feasible if the duration of the oerational hase and the amortiFation
schedule were the same.
#he second clarification has to do with the siFe and comosition of the flow relating
to the last year of oerations. #he terminal flow or terminal value @#0A deends on the
tye of investment ro$ect at hand. "n cases of 577 concession schemes or investments
in which the facility is legally owned by the 'P0* the terminal value is either the
ayment the ublic administration makes at the end of the concession or the scra
value of the facilities and the current assets that are still on the 'P0?s books. 0ice versa*
with a 57# scheme* the concession authority already owns the lant and therefore
makes no final ayment to the 'P0 when the concession exires. #he terminal flow in
this case is negligible* amounting only to the liCuidation of current assets.
/.!.! "nuts for Calculating Cash Flows
From an oerational standoint* to come u with the estimate of exected future
cash flows shown in Figure /D!* first we have to define an extremely detailed set of
inut variables&
. #he timing of the investment
. "nitial investment costs
. #he 0A# dynamic
. :rants @when alicableA* esecially in PPP initiatives
. Analysis of sales revenues and urchasing costs
. Analysis of oerating costs during the oerating life of the ro$ect
. Fluctuations in working caital
. #axes
. Macroeconomic variables
/.!.!.! #he #iming of the "nvestment
First* a thorough understanding of the time frame for the investment is needed. As an
examle* #able /D! shows the timing on the "taly Water Pro$ect* secifying the start
and end dates* the duration of the concession* and the construction eriod @slit into
two work sectionsA and the oerating eriod @again* divided into two work sectionsA.
#he length of the lant construction eriod imacts financial costs* esecially
interest and commitment fees* which accrue during construction. Legislation in many
countries allows caitaliFation of these costs. "n other words* they are not included in
the rofit and loss account and are added to lant costs and treated likewise during
amortiFation. "f the comletion date set down in the contract is not resected* the
contractor is sub$ect to enalties* which must be factored into the financial model.
When the hysical building of the lant is comlete @i.e.* mechanical comletionA*
turnkey construction contracts usually call for successive testing and a commissionD
ing eriod. "f the lant has not achieved the reset minimum erformance levels* the
contractor is forced to ay the ro$ect comany enalties roortional to the length
#A5 L6 /D! "nut 0ariables <nderinning the #iming on the "taly Water Pro$ect
Pro$ect #iming
'tart date
6nd date
Concession duration
-uration of entire oerating hase
Han !* %11.
-ec )!* %1,1
)/.1 yr
)1.1 yr
Construction Period 7erating Period
#otal duration /.1 yr 'tart of oerations Han !* %11(
'ection !
'tart date Han !* %11.
!st 'uly Level
'tart date Han !* %11(
6nd date
-uration of 'ection !
-ec )!* %113
).1 yr
6nd date
-ec )!* %1!1
%.11 yr
'ection %
'tart date Han !* %11.
%nd 'uly Level
'tart date Han !* %1!!
6nd date
#otal duration
-ec )!* %1!1
/.1 yr
6nd date
-ec )!* %1,1
)1.11 yr
of the delay in reaching these levels. #he delay liCuidated damages are also secified
in the construction contract and must be included in the model. "n fact* it is actually
by analyFing the model that the sum of these damages is calculatedK this figure is then
incororated into the construction contract. #he model Cuantifies these enalties*
which are normally exressed as a ercentage of the contract value er week of delay
with a maximum value* or ca* on these damages. #his is comuted on the basis of
costs incurred every week that lant comletion is ostoned* naturally including
financial charges.
7nce minimal erformance levels have been verified* the lant is tested to ascerD
tain guaranteed levels @which* of course* are higher than minimum levelsA corresondD
ing to lant design. "n some cases* the two tyes of testing are run simultaneously.
#able /D% shows the levels of water sulied by the "taly Water lant and the
amount of ower generated by the hydroelectric lants.
#A5 L6 /D% #echnical "nuts for the "taly Water Pro$ect
4onotable water sulied rior %1( Mln mc=yr 6nergy roduced at
full caacity
!1..!!! :Wh=yr
Potable water sulied rior !%) Mln mc=yr Caacity in startDu hase 31J
!st 'uly Level
4onotable water& 'ulementary volume sulied )1 Mln mc=yr
Potable water& 'ulementary volume sulied (1 Mln mc=yr
%nd 'uly level
4onotable water& 'ulementary volume sulied ,1 Mln mc=yr
Potable water& 'ulementary volume sulied !21 Mln mc=yr
#otal water sulied at full caacity
4onotable water %,( Mln mc=yr
Potable water %() Mln mc=yr
6stablishing a lant?s functional life san deends on the ro$ections relating to its
technical or economic obsolescence. :enerally* this time frame runs from !/ to %/
years. "t should be noted that as regards to 57# or 577# concession schemes*
normally the eriod used in the relative models does not exceed the length of the
contract itself. "n fact* when the works in these cases are comleted* the lant is
transferred back to the ublic administration free of chargeK therefore the concession
holder no longer serves any useful urose. #he time horiFon taken into consideration
has a ma$or imact on "++ @see 'ection /.%./A. #he longer the time eriod* the better
the "++* because once the debt has been comletely aid off* in the final years of the
ro$ect?s life the venture roduces cash flows earmarked exclusively for sonsors.
/.!.!.% "nitial "nvestment Cost
#he rice of the construction contract is only one of the comonents of the overall
investment* and it is the simlest to Cuantify. "n fact* this figure is secified in the
turnkey construction contract. 'eeing that this contract is normally signed only when
the ro$ect develoment hase is comlete* it is not unusual for the rice to be
changed in the interim. Along with the cost of the turnkey contract* other values
that need to be estimated for the financial model are the following&
. Cost of urchasing the land where the facility will be built
. 7wners? costs
. -eveloment costs
"n addition to these factors* which we can call the ro$ect?s direct investments* the
following indirect investments must also be taken into account&
. 0A# on the value of direct investments
. #he cost of guarantees and insurance olicies @see Chater ,A
. CaitaliFed interest
Figure /D) shows the logic behind the caital budgeting of the initial investment
cost of a ro$ect finance initiative.
While the cost of lant construction @real estate and lant facilitiesA is not usually
difficult to estimate* it is more comlicated to identify all the cost items associated
with lant construction. <sually all the outlay that derives from investments linked to
building the lant are categoriFed under the heading >>7wners? Costs*?? for examle*
the cost of excavating the land before beginning construction or of building access
roads to the facility.
-eveloment costs* in contrast* are related directly to realiFing a ro$ect finance
initiative. As we know* this form of financing is articularly onerous due to the high
number of consultants needed for ro$ect develoment. #he fees aid to these
rofessionals are the most siFeable comonent of this cost category.
5eyond comuting the absolute value of costs* it is also necessary to clarify the
timing for each investment cost. For examle* the construction contract normally
stiulates that ayments will be made when secific milestones are reached. #hese
reset deadlines ensure that the construction lan is resected and verified. Clearly*
the higher the concentration of costs in initial construction hases* the higher the
interest that the ro$ect comany will have to ay during the construction hase.
-eferred installments can lead to significant benefits for the economy of the ro$ect.
costs *TK$$,
"%rc3ase of
O6nersA costs
De;elo!ment costs
VAT on irect
$a!itali>e interests E
$ost of -%arantees
an ins%rance E
%rin- constr%ction
F " : < + 6 /D) "tems "ncluded in the Construction Cost
"n some cases* 6PC contracts include terms for deferred or advanced ayments
that imact the ro$ect?s financial needs. "n fact* the following ayment clauses are
commonly found.
. Advance ayment* which is usually !1J of the contract value. #his is aid by the
'P0 to the contractor* who invoices this amount with later milestones.
. +etention ayment* normally /J of the contract value. #he 'P0 withholds this
sum from each milestone ayment and makes it available only when the lant is
successfully tested.
. Final settlement* which is a variable ercentage of the contract value. #his is
aid by the 'P0 only when the testing hase is comlete.
#hese advanced and=or deferred terms of ayment may be included in an 6PC
contract* but they must be taken into account in the financial model when the cash
flow analysis during the construction eriod is run. #able /D) shows the Caex figures
on the "taly Water Pro$ect.
/.!.!.) 0atE0alueDAdded #ax
As mentioned in the revious section* one of the factors the financial model has to
estimate in order to Cuantify the initial investments of a ro$ect is 0A#* which is an
indirect investment. 'ince the direct investment items are Cuantified* the 0A# rate
that alies to these costs must also be determined. "n many countries* refunds to
taxayers are often delayed. As a result* the reimbursement for 0A# aid by the 'P0
during the construction eriod normally takes time. #his is financed with a secific
loan @0A# facilityK see 'ection ..(.,A* the cost of which clearly imacts the ro$ect.
#A5L6 /D) Caex on the "taly Water Pro$ect
!st 'ection
Caex ! %.1*.32 keuro %%.)J
-oubling LLLL !),*//! keuro !!./J
Potable water system LLLL !,)*))% keuro !%.)J
-esign and other costs .,*,,/ keuro /./J
6xroriation !!*./) keuro !.1J
#7#AL CAP6G !st 'ection
%nd 'ection
Caex %
.!,*..3 keuro
-oubling GGGG (!*,!, keuro 2.3J
Potable water system GGGG %/(*/,3 keuro %%.%J
-esign and other costs /!*)/% keuro ,.,J
6xroriation %)*))2 keuro %.1J
#7#AL CAP6G %nd 'ection /1.*1.3 keuro ,).)J
#otal Caex !*!%1*2). keuro (/.3J
LifeDcycle cost ,(*!%2 keuro ,.%J
#otal "nvestment !*!.(*3.) keuro !11.1J
-uring the first year of construction* the ro$ect comany will incur investment
costs sub$ect to 0A#. 'ince the ro$ect comany is not yet oerational from a
commercial standoint* it cannot issue invoices and* conseCuently* collect 0A#. For
this reason* any 0A# ayments the 'P0 makes to suliers are a credit toward the
0A# Authority* and the 'P0 has to finance these exenditures until the 0A# 7ffice
reimburses them or until 0A# credits are offset by 0A# debts from invoices to 'P0
#he legislation of various countries allows for different otions regarding 0A#*
and these alternatives imact the financial model in various ways.
!. A sonsor @holding at least /!J sharesA* which is normally in a osition of debt
toward the 0A# 7ffice due to its business* can offset the 0A# credit of the
controlled comany on its own tax return. #he 'P0 will have its 0A# debt
aid by the arent comany* which will receive comensation in the form of a
lower ayment to the 0A# 7ffice when taxes fall due. Whenever ossible* this
is the otimal solution* since the 'P0 would not have to ay interest exenses
to service the 0A# facility.
%. When the 0A# statement is comiled* the 'P0 reCuests immediate reimburseD
ment for 0A# credit* offering a suitable guarantee @for examle* a letter of
creditA. :enerally* this otion imlies that once the 0A# reimbursement is
reCuested* it would no longer be ossible at a later date to comensate this
credit with 0A# debts that may arise in the interim @and that normally emerge
when the comany is oerationalA.
). #he third otion involves offsetting the 'P0?s 0A# credits with 0A# debts
during the oerating hase.
'ome laws allow comanies to comensate 0A# credits with other debts toward
certain ublic bodies. For examle* in certain cases 0A# debts collected on ublic
grants awarded to the 'P0 can be deducted from 0A# credits accrued during
construction. "n other situations* comensation can also be made between 0A#
and cororate income tax.
/.!.!., Public :rants
"n PPP ro$ects* ublic grants reresent a key source of financing for building and
oerating facilities that serve the needs of the ublic. Legislation in several countries
can establish the fee the concession authority ays to the concession holder='P0 as
the concession rice for artial funding of the ro$ect in Cuestion. #he ayment of
this sum can be made contingent on milestones @in exchange for a guarantee rovided
by the shareholders of the concession holder='P0 for the amounts collectedA. PayD
ment can also be made at the end of the construction hase* after lant testing* or
according to other arameters based on the actual availability of funds.
#he different terms of ayment are reflected in the ro$ect?s financial model in
various ways.
. #esting grant& When the ublic funding earmarked for a ro$ect is aid out at
the end of the construction eriod* rovisions are made for bridge financing*
which is reimbursed in a bullet ayment from the funds collected.
. Milestone grant& 8ere* loans are used on the basis of the milestones achieved*
net of the ortion of the grant received and the Cuota of eCuity conferred. #he
'P0?s cash flows can be used to ay the contractor only after grants are
collected during the construction hase.
"n these cases* the shareholders and
the 'P0 are often called on to rovide bank guarantees or insurance coverage to
the concession authority for reimbursement of the funds received. Fees incurred
for this letter of credit* which has the same imlicit risk as senior debt* are also
included when the economic=financial lan is drawn u.
"n the "taly Water Case* the ublic grant is calculated as a ercentage of
construction costs and aid out during the construction hase for each work section
@see #able /D,A.
/.!.!./ Analysis of the 'ales Contract* the 'uly Contract* and 7erating 6xenses
When the financial model is being built* contracts ertaining to the sale of the
roduct* the suly of raw materials* and maintenance and oerations are still in
the drafting stage.
"n terms of financial models* it is simle to verify how effective risk allocation can
imrove the inherent Cuality of a ro$ect. 'ee Figure /D,* where oerating cash flows
are illustrated along with the ma$or forms of coverage for ro$ect risks.
When the advisor sets u the financial model and contract terms are not yet
definitive* standard rices and conditions alied by the market for similar initiatives
are included in the calculations. "n the "taly Water case* the concession holder has to
sign off taking contracts with a water sulier who buys the otable water and then
). 'ome laws may oblige the concession authority to divest assets in order to source ublic grants.
#herefore* the availability of funds for grants deends on the timing of the divestitures and the ability of the
concession authority to carry out the ublic rocedures reCuired to sell off the assets in Cuestion.
,. When the ercentage of grants is siFeable with resect to the ro$ect reCuirements* banks can issue a
standby facility on a revolving basis that covers temorary lack of liCuidity due to delays in grant disbursement
by the concession authority.
Offtake a-reements
"%t or !a& a-reements
O0M a-reements
Ins%rance contracts
#A5L6 /D, Payment of Public :rants in the "taly Water Case
%11. %11. %112 %113 %11( %1!1 %1!! %1!%
! % ) , / . 2 3
Public "nstallments .!.*,1/
!st 'ection @keuroA 2%*)2. %,1*1%3 %(.*()3 /*)%2 E E E E
#7#AL CAP6G !st
:+A4# !st 'ection
//J //J //J //J //J //J //J //J
)(*312 !)%*1!/ !.)*)!. %*()1 E E E E
%nd 'ection @keuroA .*%22 2*1(( !!3*.3. !/1*,(1 !/!*21) 2!*3!) E E
%nd 'ection
:+A4# %nd 'ection
//J //J //J //J //J //J //J //J
)*,/% )*(1, ./*%22 3%*221 3)*,)2 )(*,(2 E E
#otal :rants @keuroA ,)*%/( !)/*(%1 %%3*/() 3/*.(( 3)*,)2 )(*,(2 E E
< Re;en%es from sales
Ra6 materials an ot3er
o!eratin- costs
O0M fees
Ins%rance costs
B O!eratin- cas3 flo6C-ross
<4 Increase in 6orkin-
$a!ital e5!enit%res
B O!eratin- cas3 flo6net
*)nle;era-e free cas3 flo6,
E"$ contract
"ossible re%ction
of cas3 flo6
F " : < + 6 /D, 7erating Cash Flows and Contractual Agreements
ies it through a water suly network to end users. #he concession holder commits
to delivering a certain Cuantity of water at reset contract rices* which are readD
$usted annually on the basis of rices indices @roduction or consumtionA. A similar
situation alies for untreated water* which is sold to agricultural consortia on the
basis of variableDlength contracts with reset rices. Moreover* "taly Water will also
#A5 L6 /D/ "nuts <sed to Xuantify +evenues for the "taly Water Case
+6064<6' F+7M WA#6+
Annual escalation %.1J
+6064<6' F+7M P7#A5L6 WA#6+
Potable water already sulied @Min mc=yrA !%)
#ariff -ec. )!* %11( @6uro=111mcA %%/.%
Additional otable water at full caacity @Min mc=yrA !21
#ariff -ec. )!* %11( @6uro=111mcA ))2.3
+6064<6' F+7M 474P7#A5L6 WA#6+
4onotable water already sulied @Min mc=yrA %1(
#ariff -ec. )!* %11( @6uro=111mcA 1.1
Additional nonotable water at full caacity @Min mc=yrA ,1
#ariff -ec. )!* %11( @6uro=111mcA %21.)
0A# !1J
+6064<6' F+7M P7W6+
Annual escalation !./J
#ariffEflowing water
Power at caacity @base calculationA @:Wh=yrA )%.3
#ariff -ec. )!* %11( @6uro @111A=:WhA /2
#ariff -ec. )!* %11( @6uro @111A=:WhA .%
#ariff %/J F,
Power at caacity @base calculationA @:Wh=yrA 2).)
#ariff -ec. )!* %11( @6uro @111A=:WhA .)
#ariff -ec. )!* %11( @6uro @111A=:WhA .(
:reen Certificate #ariff
Power at caacity @base calculationA @:Wh=yrA !1..!
:reen Certificate #ariff @-ec. )!* %11(A @6uro @111A=:WhA !!.
0A# %1J
be able to use the water for ower roduction* which can be sold on the basis of longD
term takeDorDay contracts with utilities oerating in the ower sector. "n this regard*
see the inuts at the basis of sales revenues on water and energy used for the "taly
Water Case @#able /D/A.
An imortant feature in fixedDrice contracts is the escalation mechanism that
udates rices on the basis of inflation. Clearly* the ro$ect is sub$ect to risk associD
ated with the different formulae for cost and revenue indexation @which the model
must be able to identifyA. Forecasts adoted in the "taly Water model index revenues
on the sale of water to a cautious estimate of a %J annual rateK revenues from ower
are escalated at !./J annually. #he imortance of these redictions derives from
the fact that the concessions in Cuestion last a considerable length of time* and
the multilying effect of a high inflation rate* in the long run* could lead to an
overestimation of the ro$ect?s rofitability otential.
As regards determining annual cost items* this rocess deends to a great extent
on the choice of the lant oerator. #his may be an external comany or the 'P0
itself @though less oftenA. While in the latter case the ro$ect comany will bear all
tyes of costs inherent to lant oerations and maintenance* in the former situation
the key cost item for the ro$ect comany is the 7BM fee aid to the oerator.
At most* there may also be additional cost items such as insurance remiums and
other costs for other* less imortant inut used in the rocess.
8owever* it?s rare that a definitive agreement already exists with the future
oerator when a ro$ect is initially being structured. 'o* from a financial modeling
standoint* it?s best to detail all alicable categories of oerating and maintenance
costs* irresective of the fact that some of these will be absorbed in the total
remuneration aid to the thirdDarty oerator in the form of an 7BM fee.
As regards the "taly Water Case* #ables /D.* /D2* and /D3 resectively show inuts
for estimating fixed costs* variable costs* and ayments made to the ublic adminisD
tration that assigns the concession.
A dummy item* general lant exenses* is often used. 4ormally calculated as a
ercentage of budgeted costs* it?s slotted into the model under both annual costs and
investment costs. #his item* which is usually no more than /J of the cost breakdown*
serves as a >>cushion?? that can absorb small changes in cost or additional costs* when
#A5L6 /D. "nuts for 6stimating Annual Fixed Costs for the "taly Water Case
!. Personnel costs
6mloyees !)1 1J
Annual cost @6uro @111AA .1.,3
%. 7rdinary maintenance @6uro @111AA /*)// %1J
Percentage of investment 1./1J
). 7ther services @6uro @111AA %*1.. %1J
,. :eneral lant exenses @6uro @111AA !*)2( %1J
Percentage of oerating and ersonnel costs /J
!. 7erating cost of ower lants @6uro @111AA !*)/1 %1J
#A5L6 /D2 "nuts for Calculating Annual 0ariable Costs for the "taly Water Case
Water urification eCuiment
Annual cost of otable water @mcA @6uro=111mcA .1 %1J
#A5L6 /D3 Costs +elated to Annual Payments to the Public Administration
for the "taly Water Case
7erating fee for existing aCueduct @euroA %./ million
7erating fee for the new aCueduct @euroA / million
7erating fee for exloitation of hydroelectric ower @euroA / million
5y detailing variable costs as a function of the Cuantity of raw material utiliFed*
we can accurately estimate these costs as the level of oerations of the lant varies.
As a result* the model gives us correct values when simulating downside scenarios.
Lastly* in the case of ublic concessions* the concession authority may reCuire
that the concession holder ay an annual concession fee in exchange for the right to
the economic exloitation of the lant. "n the "taly Water Case* this fee is comuted
as shown in #able /D3.
#hese fees are sub$ect to annual revisionK 0A# is calculated for these amounts as a
set ercentage.
/.!.!.. #rends in Working Caital
"n light of estimates on oerating costs and revenues* the financial model has to osit
assumtions on inuts relating to the average collection eriod and the average
ayment eriod. #hese delays* in fact* have the effect of differentiating economic
margins @comuted on an accrual basisA from actual cash flows @comuted on a cash
-eending on the sign* variations in working caital reresent an outlay or a
source of cash. 'o these changes have to be estimated among the variables that
determine oerating cash flow. 4onetheless* we should remember that in numerous
ro$ect finance initiatives* the weight of investments in working caital is not arD
ticularly heavy. "n the ower sector* for instance* there are no investments in invenD
tories of finished roducts* and accounts receivable are fairly negligible given that big
offtakers normally ay on a monthly basis. Another examle is the transortation
sector* where accounts receivable are even less relevant* since retail consumers ay for
the service in cash. "n PPP ro$ects* the working caital reCuirement is linked to the
average ayment eriod of the ublic administration that granted the concession.
8owever* if the contracts with various service roviders include rovisions for a
erfect assDthrough* working caital consists solely of aying the 'P0?s insurance
olicies. #herefore* this figure is very near Fero.
"n the "taly Water Case* the estimate of the average collection and ayment
eriods is summed u in #able /D(.
/.!.!.2 #axes
#he financial modeler has to collect a solid body of knowledge on the eculiarities of
the various taxes that aly to the initiative. #able /D!1 shows the tax structure of the
#A5L6 /D( 0ariables <sed for 6stimating Working Caital
for the "taly Water Case
Water revenues .1 days
6nergy revenues .1 days
6xisting water system .1 days
Water oex @no ersonnelA .1 days
Authority fee .1 days
6nergy oex .1 days
#A5 L6 /D!1 Fiscal 0ariables in the "taly Water Case
"+6' rate )).11J
"+AP rate ,.%/J
'ubstitute tax 1.%/J
"taly Water Case. "n "taly* "+6' is the cororate income tax and "+AP is the regional
tax on roductive activities.
7ne of the key variables that must be studied to otimiFe the fiscal burden is the
amortiFation olicy for the lant. #ax law in various countries allows a certain
margin of flexibility* which should be adeCuately exloited @length of the amortiFaD
tion eriod* accelerated amortiFationA.
-eending on the tye of ro$ect* there are various kinds of taxes to consider*
such as the carbon tax* excises on natural gas* roerty taxes* and waste disosal
taxes. For this reason* when oerating in a given industrial sector it is advisable to get
information from sonsors? management or other comanies that work in the sector
in Cuestion. #he model also has to be able to identify accurately when taxes fall due.
Consider the dynamic of advances and ayments relating to various taxesK this can
drastically alter the cash flows of a given oerating eriod.
/.!.!.3 Macroeconomic 0ariables
Previously we ointed out that forecasting the inflation rate is vital for many
ro$ects. #he structure of contracts tends to steriliFe the imact of inflation on
the ro$ect?s rofitability as far as ossible. 4onetheless* is it nearly always inevD
itable that the ro$ect resents a certain level of risk in terms of variations in the
rate of inflation.
"nterest rate coverage olicies usually tend to convert a significant ortion of
financing to a fixed rate. #his ractice itself is not without risks* in as much as the
interest rate will remain unchanged even when benchmark market rates dro drasD
ticallyK in other words* the weight of the fixed comonent of ro$ect costs increases.
#he other key macroeconomic variable is the level of and fluctuation in the exchange
rate of the national currency with resect to one or more foreign currencies. #his
becomes significant when a art of the investments* costs* or revenues are stated in
foreign currency.
#he model should include macroeconomic forecasts develoed by reutable
research agencies. 0ariables tyically studied are the exected trend in the interest
rate* estimates of the national inflation rate* and* when alicable* forecasts of
secific sector indices that imact costs and revenues of the ro$ect comany.
7ne should kee in mind that some classes of costs or revenues have different
inflation dynamics. Consider* for examle* rice trends in crude oil with resect to
emloyee wages. As far as ossible* relevant inflation scenarios should be analyFed.
Another challenge for the advisor is deciding whether or not to define a correD
lation among macroeconomic variables. "n this case* the decision centers on whether
the model should automatically comute variations in interest rates given a certain
change in the rate of inflation* based on an aroriate correlation coefficient.
$ost of
/.% -efining the 7timal Caital 'tructure for the -eal
Xuantifying oerating cash flows is crucial for defining the second key asect of
ro$ect finance initiatives& the otimal mix of debt and eCuity. "n fact* financial
models work on the basis of a logical framework that takes trends in oerating
cash flows as inutK flows corresonding to financial items make u the other
inut. "n the construction hase* such items consist of the use of bank loans* bond
issues* and sonsor eCuity* and in the oerations hase* reimbursement of the
rincial and interest to lenders and ayment of dividends to the 'P0?s shareholders.
"n Figure /D/* the two key factors for setting u the otimal caital structure lie at
the center of the diagram. 7erating cash flow during the oerating life reresents
cash available for debt service* while the financial structure and assumtions regardD
ing loan reayment define the cash reCuirement.
-uring the construction hase the oerating cash flow is negative. #his results in a
financial reCuirement to be covered with both share caital from sonsors and* more
imortantly* bank loans organiFed by the arranger. Conversely* during the ostconD
struction hase* oerating cash flow becomes ositive and has to be able to suort
the debt service @rincial and interestA* the obligation to create and maintain reserve
accounts* and reimbursement on caital invested by sonsors. As a recautionary
measure* flows relating to the debt service and deosits in a reserve account are
subtracted from oerating cash flow. "f residual flows remain* they are made availD
able to sonsors as dividends. 'ee Figure /D..
As regards the reserve account* we should oint out that this is established and
maintained for the entire duration of the financing. #he amount of funds to set aside
in this account can be determined in various ways. 8owever* a rather common
ractice is to decide on an account balance by alying the following formula&
5 Q -' n
O!eratin- $osts
cas! "lo#
$e%t service
$e%t service
F " : < + 6 /D/ Process for -efining a Pro$ect?s Caital 'tructure
!!2 -efining the 7timal Caital 'tructure for the -eal
O!eratin- cas3 flo6Cnet *)nle;era-e free cas3 flo6,
Interest on
Senior loan
Interest on
Senior loan
loan re!a&ment
B $as3 flo6 a;ailable to
!ro7ect s!onsors
Debt reser;e
B Di;iens to s!onsors
F " : < + 6 /D. Waterfall 'tructure of the Possible <ses of 7erating Cash Flows -uring 7erations
where 5 is the minimum reCuired balance* -' is the monthly debt service* and n is the
number of months of debt service that the reserve account must cover. 4aturally*
over the years of oerations of the initiative* the balance at any given moment could
exceed the reCuirement exressed by the formula. "n such a case* the cash can be
freely withdrawn from the reserve account and earmarked for aying dividends to
'P0 shareholders.
"n some ro$ects* there may be a reCuest for additional funds to be set aside in an
7BM reserve account. For ro$ects that reCuire several rounds of extraordinary
maintenance during their oerating life cycle @also known as lifeDcycle costsA* ortions
of cash flows available to shareholders are channeled into this account. "n this way*
lenders safeguard against behavior by the 'P0 that may be less than otimal by
reCuesting that cash not be distributed so that the liCuidity needed to carry out
maintenance rounds is on hand when needed.
From the standoint of the financial modeler* in order to comlete #able /D.*
assumtions relating to the following oints must be clarified&
!. 6Cuity& the amount and the timing of contributions
%. 'enior debt& the amount reCuested from lenders and the stiulated terms of
). 0A# facility& the amount reCuested and terms of reimbursement
,. 'tandDby facility& the amount reCuested and terms of reimbursement
#he four sets of information are analyFed next.
/.%.! 6Cuity
'onsors usually want to confer as little eCuity as ossible and as late as ossible.
"n the first version of the model* the financial advisor normally incororates the
sonsors? reliminary suggestions* allowing for ossible changes when works are in
rogress. 6stablishing the debt=eCuity ratio is grounded in the following&
!. #he degree of economic soundness of the ro$ect
%. #he level of risk lenders are willing to accet
). Precedents on the domestic or international financial market
4ow we examine these factors individually.
!. #he model?s economic forecasts tend to worsen as the debt level rises. For this
reason* modelers must verify the breakDeven oint for indebtednessK once this
oint is exceeded* the initiative no longer has the credentials of economic
viability needed to attract lenders.
%. #he minimum level of economic viability that lenders demand deends* in
turn* on their ercetion of the degree of risk. For examle* otential investors
may not believe that the contract structure surrounding an initiative affords
adeCuate rotection for the 'P0. 7r the contractual counterarties of the 'P0
or the sonsors themselves may not be considered entirely reliable in terms of
resecting their contract obligations in the long run @erformance guarantees*
longDterm suly* longDterm urchaseA. "n these cases* lenders will want to
verify that the ro$ect has a moreDthanDsatisfactory level of rofitability in
order to confront ossible downside scenarios.
). 7nce financing is underwritten by one or a few arrangers* it must then be
resented to the market in order to be >>resold?? to articiating banks or bond
investors. #he banks that are called on to study the economic convenience in
underwriting the financing comare the features of the ro$ect with similar
initiatives already introduced on the domestic market @or* when there are no
ro$ects of reference* on ma$or foreign marketsA. 'ubstantial differences with
resect to existing ro$ects normally elicit a cold reaction from banks* unless
these disarities are $ustified by uniCue ro$ect characteristics that the
arrangers will need to market effectively. #his will be even more difficult
if there is more than one factor deemed >>aggressive?? in a financing roosal*
for instance* when a high debt=eCuity ratio is combined with longDterm financD
ing and margins lower than the market average.
'onsors have to inform the financial modeler as to the rofit level they intend
to achieve in order to ascertain that it can be reached. As we will see in 'ection /.%./*
sonsors usually state their exectations in terms of internal rate of return @"++A.
/. #here is a tradeDoff* which may also emerge irresective of the ro$ect?s level of rofitability. Consider the
fact that it?s normal to find a certain degree of constructive >>tension?? in a bank on the aroriate level of
financing arameters among the eole who serve as arrangers @i.e.* focused on valuing cash flowsA and those
who resell financing to articiating banks @the soDcalled syndication deskA* not to mention the credit commitD
tees themselves. 7n the other hand* there have been cases in which syndication transactions have failed and the
arranger banks subseCuently had to kee much more than the exected share of financing on their books.
"n these cases* sonsors suffer considerable damage to their image.
"t?s also worthwhile to include calculations of alternative rofitability arameters in
the model. "f ossible* these should be exressed in absolute terms as well and not as
ercentages* such as the net resent value @4P0A or the ayback eriod.
"t is also essential to define the timing of eCuity contributions. Caital can be
conferred at the same time as drawdowns @ro CuotaA or before or after. #his means
that the first !11 euro of costs incurred by the ro$ect comany will be financed in
art with eCuity and in art with debt or only with eCuity or only with debt.
4aturally* it is more convenient for sonsors to ostone eCuity ayments* all
other conditions being eCual. For lenders the roblem lies almost entirely in assessD
ing the creditworthiness and the reliability of the 'P0?s shareholders.
7n the other
hand* eCuity invested in the ro$ect is seen by lenders as a sign of a strong sonsor
'onsors en$oy some degree of freedom in choosing how to confer their share of
eCuity. Along with ure eCuity* within certain limits they can normally make ayD
ments through subordinate loans @i.e.* subordinate to the entire reayment of the
senior debtA that involve an imrovement in ayout.
/.%.% 'enior -ebt
#he senior debt can be broken down into several arts @tranches or facilitiesA*
deending on the uniCue reCuirements and characteristics of the ro$ect. "n the
startDu hase of the model* all that needs to be considered is a loan to cover 0A#
ayments @the 0A# facilityA* one to cover design and construction costs* 0A#
excluded @base facilityA* and a standDby facility to cover ossible ro$ect cost inD
creases. #he technical details of these facilities are discussed in 'ection ..(. As for the
financial model* the analyst must rovide a series of inuts to feed into it. #he inuts
for the base facility of the "taly Water Case are shown in #able /D!!.
#he characteristics of the loan in terms of margins* tenor* minimum accetable
ratios* and so forth reflect the caacity to ay back ro$ect financing and the
reCuests of the banks that may be interested in suorting the deal in a later*
syndication hase.
A benchmark used to comute the tenor of financing for ublic concessions is the
tail& the time remaining from loan maturity to the exiry date of the concession.
A longer tail enables banks to mitigate the risk linked to the fact that during the life of
the concession* obstacles that may come u could reclude the chance to refinance
the outstanding debt. At the end of the concession* in fact* the concession holder no
longer has the right to exloit the lant in Cuestion economically.
.. #his allows us to avoid evaluating a ro$ect solely on the basis of a single index value* which can often
lead to contradictory conclusions. #here are* in fact* mathematical roblems associated with rofitability
indices. @'imly consider that in some situations "++ gives more than one solution.A All of this aside*
shareholders can be attracted by an exonential "++ growth in circumstances in which financial leverage is
heavily used. #hey may even reach the oint of losing sight of the convenience of investing a considerable
ortion of their available funds @even at the cost of curtailing the ercentage returnA when they have no other
investment oortunities that are as lucrative @at the same level of risk* of courseA.
2. #he risk is ending u with a artially built lant* with sources of financing dried u* and with
shareholders who are no longer willing to confer eCuity. #here may even be a negative economic scenario*
which doesn?t facilitate the task of finding new sonsors.
#A5 L6 /D!! "nuts for 6stimating 'enior -ebt for the
"taly Water Case
'64"7+ FAC"L"#L
Amount conferred @6uro @111AA ).!*2%1
Average tenor @yearsA !,.3)
A0A"LA5"L"#L P6+"7-
First disbursement Han. !* %11.
Last disbursement -ec. )!* %1!!
-uration @yearsA .
PAL5AC9 P6+"7-
First reayment -ec. )!* %1!%
Last reayment -ec. )!* %1%.
#enor @yearsA !/
"nterest 6xenses
5ase rate ,./1J
Margin !./1J
Comosite +ate ..11J
Financial Fees
Commitment fee 1.21J
<nderwriting fees !.11J
#he interest rate consists of a benchmark rate @Libor or 6uriborA lus a sread*
which normally varies deending on the ro$ect hase. Financing is usually initiated
with a variable rate but is covered for the most art by interest rate risk hedging
contracts* such as swas* collars* or interest rate otions. 'uch agreements must be
included in the financial model.
#he dynamic of the debt rincial reayment follows the evolution of the 'P0?s
caacity to generate cash flows. #his is initially weakEweighed down by lants that
are not yet fully oerational and by the increase in working caitalEbut growing
stronger in the first years of oeration. #his growth is cut short abrutly at some
oint when taxes begin to increase once the lants are comletely amortiFed. Finally*
flows ick u again because rogressive reayment of the debt results in fewer
interest exenses. "n the case of the "taly Water Pro$ect* the schedule reayment for
the senior debt and the value of the annual debt service cover ratio @A-'C+K see
'ection /.)A is shown in Figure /D2.
"n the "taly Water Case* the decision was made to include extraordinary mainteD
nance costs @lifeDcycle costsA in calculating the A-'C+. #hese costs arise every two
years during the entire concession eriod. #his choice was also romted by the
absence of an 7BM reserve earmarked esecially for financing lifeDcycle costs* which
imacts the debt reayment rofile inasmuch as the flows available to service the debt
also cover these costs.
"n any case* there is room for flexibility in setting u the reayment lan* and it?s
only natural that the interests of lenders and of sonsors conflict. While sonsors
benefit financially from a lan that would delay the largest debt installments @backD
ended rofileA* lenders instead refer to cut down on their exosure as Cuickly as
+:2K +:2H
G:1E G:+E
+:ID +:ID
+:ID +:ID
/D+/ /D+1 /D+2 /D+I /D+J /D+G /D+K /D+H /D/D /D/+ /D// /D/1 /D/2 /D/I /D/J
F " : < + 6 /D2 Percent Princial +eayment and the A-'C+ of the "taly Water Case
#he average loan life is one of the arameters used to draw u the debt reayment
rofile. "t is calculated as follows&
+P t
ALL Q Average loan life
+P Q +eayment ercentage referring to time eriod t
t Q #ime eriod in Cuestion @number of the year or the
.Dmonth eriod being consideredA
With maturities eCual* the facility with a longer average life shows a higher level of
risk* since reayment of the rincial is more concentrated toward the end of the
/.%.) 0A# Facility
Previously* we looked at various otions that different legislation allows the 'P0 in
terms of refunds on 0A#. <sually an ad hoc credit line is set u that is drawn down
at the same time 0A# ayments are made on initial investments. #his credit normally
involves a flexible reayment lan* since the installment is eCual to net 0A# collected
by the ro$ect comany in every eriod.
"f the 'P0 can reCuest reimbursement of 0A# credit accrued during construction*
reayment on the credit line takes the form of refunds from the 0A# 7ffice. Among
"ai 6it3 VAT
on sales or VAT
the ro$ect?s accounts* a 0A# account might also be set u where net 0A# flows
collected every month are deosited. #he balance on this account is utiliFed to ay
back lenders at set intervals* tyically every ) or . months.
Albeit flexible* the loan amortiFation schedule essentially roves to be in line with
that shown in the model. #o establish* at the least* the maximum life of the loan* a
termination date is usually set when the outstanding 0A# credits are reaid by
sourcing cash deosited in the 'P0?s accounts. "t is imortant to noticeEfrom the
standoint of the financial modelerEthat even for interest ayments on the 0A#
facility* the ro$ect comany uses its own ability to generate cash* not the net 0A#
collected. #he reason is that these funds can be earmarked for loan reayment as long
as there is a 0A# credit. After that* the net 0A# collected is due to the 0A# 7ffice.
#his is why* unlike the base facility* the 0A# facility does not include interest
exenses related to the investment it has to financeK instead it is simly eCual to the
sum of the 0A# disbursements.
"n this regard* see Figure /D3.
-ue to the flexibility of the reayment schedule* the 0A# facility is not generally
converted to a fixed rate with swas or other derivativesK it remains a variableDrate
loan in every sense. #able /D!% shows the inut variables used for simulating the 0A#
facility in the "taly Water Case.
VAT !ai
VAT facilit&
VAT facilit&
VAT facilit&CDebt ser;ice
(%ne b&
cas3 flo6s
F " : < + 6 /D3 Logic 5ehind the 0A# Facility
3. Lenders who finance the 0A# facility essentially bear the same level of risk as those who finance the base
facility. #he assertion that the 0A# facility basically reresents a risk toward the state @i.e.* the 0A# 7fficeA is
false. Actually* a credit toward the 0A# 7ffice emerges only if the 'P0 reCuests a refund from the 0A#
Authority. "n this case* the refund can be awarded as a guarantee to lenders* even though this allocation comes
after the disbursement of the 0A# facility. "n addition* this credit offers adeCuate coverage for the amount
disbursed but not for the interest accrued. "f a termination date is set and the loan is still outstanding* at that
time reimbursement comes from the oerating cash flow of the comany. "f instead 0A# is comensated* there
is no formal 0A# credit. Clearly* then* the 0A# facility carries with it ro$ect risk rather than a state risk* and
this is reflected in the alication of an aroriate margin. 4onetheless* in light of the fact that the average
loan life is much shorter than that of the base facility* the margin is lower and usually remains constant during
the oerating life of the ro$ect.
#A5L6 /D!% "nut 0ariables for the 0A# Facility in the
"taly Water Case
Average reimbursement eriod 0A# 7ffice % yr
'tart dateE0A# reimbursement Han !* %1!%
#erminal dateE0A# reimbursement -ec )!* %1!)
"0A FAC"L"#L
#otal amount @6uro @111AA (.*1((
A0A"LA5"L"#L P6+"7-
First disbursement Han !* %11.
Final disbursement -ec )!* %1!!
-uration . yr
PAL5AC9 P6+"7-
First reimbursement -ec )!* %1!%
Final reimbursement -ec )!* %1!)
-uration % yr
"nterest Charges
5ase rate ).11J
Margin !.11J
Comosite +ate ,.11J
Financial fee
Commitment fee 1./1J
/.%., 'tandDby Facility
#he construction contract has a fixed rice* which means that the contractor can ask
for rice revisions only in excetional cases. "n addition* this tye of agreement
would* in theory* reclude any increase in the value of the total investments
reCuested. We say >>in theory?? because the concession authority might want to
modify the lant while work is in rogress. Moreover* new laws that may come
into effect could mean additional investments are needed* most often in the areas of
environmental rotection and worklace safety. #hese changes can be included in the
contract* sub$ect to rior agreement between the arties on the relative increase in the
contract rice and on aroval of the banks and=or the indeendent engineer.
Additional cost increases could result from investment items that* because they are
not secified in the contract* are only estimated in the model.
#o deal with these cost overruns* rovisions are made for ad hoc financing to be
taed only if neededK this is usually called a standDby facility. #his facility is set u in
such a way that when drawdowns are made* sonsors deosit additional eCuity at the
same time. "n this way* the debt=eCuity ratio remains constant. #he loan agreement*
then* must stiulate this commitment by sonsors. #o discourage the use of this
credit line unless absolutely necessary* margins are set higher than those of the base
facility* normally over !1N!/ basis oints. #he reayment schedule is exactly the same
as that of the base facility.
(. 6ven in cases of a standDby facility* interest rate risk coverage olicies can?t be imlemented because it
isn?t ossible a riori to determine whether or not this credit line will actually be used and* if so* to what extent.
At best* the ro$ect comany can be obliged to cover interest rate risk on every drawdown it might make.
8owever* this can?t be foreseen when building the model.
/.%./ "dentifying 'ustainable -ebt=6Cuity Mixes
for 'onsors and Lenders
< to this oint we have studied what oerating cash flow is and where it can be
channeled* but we haven?t yet mentioned how to define the debt and eCuity mix to use
to finance the structure. Clearly* without this information we can?t evaluate whether
the ineCuality in Figure /D/ @Caacity W +eCuirementsA is verified or determine the
values on which the waterfall structure in Figure /D. is based.
What?s more* from the ersective of financial models* the roblem generates a
circular calculation& #he oerating cash flow has to be used to ay the debt service
and dividends* but we don?t know how much this is until we work out the Cuantity of
debt and caital conferred for the ro$ect. 7n the other hand* the amount of the loan
actually drawn down* in turn* determines the total cash flow to cover in light of the
caitaliFation of interest and fees on the same loan during the construction eriod.
#his roblem is solved through a rocess of trial and error. 5asically* the arranger
makes note of the variables that determine oerating cash flow* along with ro$ect
risks and relative coverage. A definite caital structure is then included in the model
@usually the one the sonsors have in mind or suggestA and slotted into the framework
of the sreadsheet. #he roosed financial structure together with the hyothetical
debt reayment lan give rise to the reCuirements for debt service for the rincial
and interest. 5y comaring the debt caacity @reresented by oerating cash flowA
and debt reCuirements* we can see if the debt=eCuity mix is sustainable. "f the former
is larger than the latter* the hyothesis is technically feasible from a financial
standoint. "f the oosite is true* the roosal is re$ected. At this oint the arranger
will come u with another alternative with a lower debt comonent or with different
contract terms with resect to the rior roosal.
5y means of the simulations run through the financial model* the advisor=
arranger can come u with a series of debt=eCuity mixes that in every year of the
oerating hase satisfy the condition&
7erating cash flow W -ebt service
#he final solution chosen lies in the logical scheme illustrated in Figure /D(. #he
dotted lines in the work flowchart show a revision in the variables that determine
oerating cash flowK solid lines corresond to a change in the debt=eCuity mix or a
modification in the terms of the loan agreement. #he advisor?s main concern is to set
u the deal with a caital structure that can satisfy the demands of 'P0 shareholders
as far as "++. 8owever* a necessary comromise between the needs of the sonsors
and the interest of lenders must be found. "f this doesn?t haen* it will be imossible
to raise the caital needed for the ro$ect.
/.%./.! 7timal Caital 'tructure for Pro$ect 'onsors
#o ascertain which solution is actually chosen among the ossible otions* let?s begin
by saying that an advisor?s first concern is to set u a deal that?s consistent with the
sonsors? mandate. 6ssentially* sonsors exect a return on the caital they?ve
invested that is consistent with the degree of risk they?ve taken on in the ro$ect.
"n finance literature on caital budgeting for investment ro$ects* one of the most
commonly used indicators for measuring the return on an investment is the internal
rate of return @"++A. #his is the interest rate that makes the net resent value of a
M n
O!eratin- $as3
$a!ital Str%ct%re
Is t3e D4E
6it3 t3e s!onsorsA
Is t3e D4E
6it3 t3e lenersA
Is t3e D4E
able to satisf&
t3e co;er ratiosF
O!timal $a!ital
F " : < + 6 /D( Arranger?s Work Flow in Choosing a Financial 'tructure
ro$ect?s ositive oerating cash flows eCual to the net resent value of its negative
oerating cash flows. With ro$ect finance* the former are generated during the
oerating haseK the latter are concentrated during the construction hase.
"n other words* we have
7C F
@! R "++
@! R "++
#he term on the left is the sum of the resent value of negative cash flows from
time 1 @ro$ect startDuA to M @end of the construction hase or C7-* commercial
oerating dateA. #he term on the right* in contrast* indicates the resent value of
ositive flows roduced by the ro$ect from M @again* the C7-A to n @the last year of
the ro$ect?s lifeA.
Consider the fact that the following is true of the oerating cash flows.
. #hey are financed in art with debt and in art with eCuity during the conD
struction hase.
. A ortion is earmarked to reay the debt service* and another ortion goes to
aying dividends during the oerating hase.
M n
9eeing this in mind* it is also ossible to calculate an "++ from the viewoint of
the sonsors and of the lenders. #he "++* in this case* reresents the return on the
oeration for those who confer eCuity and the financing bank.
As for sonsors* future ositive flows are reresented by the dividends disbursed by
the 'P0 or interest and rincial reayments on the subordinate debt @see Chater .A.
4egative flows consist of eCuity in$ections for the initiative.
"n other words* we have
@! R "++
@! R "++
Q Caital contribution in year t
M Q Last year of eCuity contribution by sonsors
Q -ividends received by the sonsors in year t
Q "nternal rate of return for the sonsors
#he term on the left side of the eCuation reresents the discounting of all eCuity
contributions* which offsets the right side* the current value of all dividends collected
by sonsors starting from year M. 4aturally* if M Q 1* there would be only one eCuity
ayment at the startDu of construction and the left term would be simlified to C
When sonsors commission the advisor=arranger to set u the deal* they already
have a clear idea of the lowest accetable "++& #his is their weighted average cost of
caital @WACCA or a higher redefined threshold rate. 5elow this floor the initiative
is of little interest to sonsors* and realiFing it with ro$ect finance techniCues is no
longer economically convenient.
#he calculation of WACC for the 'P0 must take into consideration both the cost
of eCuity @k
A and the cost of debt @k
A* with weights reresented by the otimal debtD
toDeCuity ratio selected on the basis of the work flow illustrated in Figure /D(.
#he cost of eCuity for the 'P0 @this eCuity being the sonsors? investmentA* in
turn* reflects the WACC of each sonsor. Moreover* the cost of debt reflects the
financial market?s ercetion of the ro$ect?s inherent risk as well as the intensity of
cometition on the financial markets. #herefore* this cost deends on ro$ect feaD
tures* such as the economic=financial soundness of the initiative* the level of risk
coverage rovided by the contractual network surrounding the deal* and the standing
of the counterarties to these contracts.
"t follows that valuing the economic convenience of a ro$ect finance deal is more
comlicated than one involving an alreadyDinDlace comany. #his valuation must be
done by comaring the ro$ect?s "++* calculated by using oerating cash flows
A and the WACC of the 'P0. #his* in turn* is the weighted cost of the
eCuity conferred by sonsors and the cost of the loans rovided by creditors. #he
concets are summariFed in Figure /D!1.
!1. Moreover* among other future benefits* there is interest on the cash in the 'P0?s accounts that was set
aside during the oerating hase. #hese are dividends that were not distributed for lack of economic >>caacity??
of net revenues of the vehicle comany due to the weight of amortiFation during the ro$ect?s first years of life.
#his is the effect of the >>dividend tra*?? which is discussed in 'ection ..3.
-iscounted ayback:
"ro7ect IRR
S"VAs cost of ebt *k

S!onsor +
.A$$ S!onsor + D
Acce!t if9
E .A$$ S!onsor /
.A$$ S!onsor n
S!onsor /
S!onsor n
*+t , +

.A$$ s!onsor

$ + E
k =+

$ + E
F " : < + 6 /D!1 Calculation of WACC for an 'P0
#he term on the right side of the formula in Figure /D!1 is the WACC of the 'P0*
which* in turn* is given as the average of the cost funding on the debt @k
A net of the
fiscal effect @l N tA and the cost of eCuity. #his latter factor is the WACC of each
sonsor who articiates in the deal.
"n addition to the use of 4P0 and "++ for the valuation of the economic
convenience of a ro$ect finance* many sonsors often also use the ayback eriod*
which is the moment in time when the ro$ect?s outflows and inflows are eCual. #here
are two variants of the ayback eriod* one based on nominal flows and one based on
discounted flows&
4ondiscounted ayback:
Q 1
@! R iA
where F
are the cash inflows and outflows from the ro$ect* x is the ayback eriod*
and i is the selected discounting rate.
Although ayback is not an accurate criterion for evaluating the economic
convenience of investments ro$ects* it is useful as a comlementary indicator to
the "++. With eCual rates of return* in fact* a ro$ect that can achieve ayback more
Cuickly is more attractive to a riskDaverse investor.
/.%./.% 7timal Caital 'tructure for Lenders
An arranger or a articiant in a ro$ect finance deal can frame an assessment of
economic convenience in various ways.
t t
#he first is to calculate the net resent value @4P0A by using the data contained in
the financial model comiled by the advisor. Cash flows are discounted until
the moment of assessment @realistically seaking* when the arranger asks the
bank for the first disbursement of funds for the ro$ectA utiliFing one?s own cost of
-< t
4P0 Q

@! R c fundingA
@! R c fundingA
"n the formula* M stands for the year when debt reayment begins* n is the
terminal date for the last installment* -' is the debt service for each eriod t during
the oerating hase* and -< is the debt utiliFation during construction.
As we can see* the higher the 4P0* the lower the cost of funding. +etail banks
@i.e.* banks that collect deosits from ordinary customersA can often earn lucrative
margins because they can obtain a lower cost of funding than banks that would
finance the deal by sourcing the interbank market. For these organiFations* the
initiative is only evaluated in terms of the margin over the benchmark rate.
#he second way to value the economic convenience of a deal is to comute the
"++ of the flows of lenders? fees* interest* and caital contributions=reayments* once
again gleaned from the financial model drawn u by the advisor. Potential lenders
evaluate whether the ro$ect?s "++ is consistent with the degree of risk inherent to the
initiative. #he "++ for a lender who rovides >>ure?? debt caital @that is* excluding
the otion of recourse to forms of meFFanine or subordinate debtA is influenced by the
exected flows for debt service and the dynamic for the disbursement of funds during
As a mathematical formula* we have
R "
@! R "++
@! R "++
Q -rawdowns on funds in year t
M Q Last drawdown eriod on loans
Q Last ayback eriod on funds
Q Princial reayment in year t
Q "nterest reayment in year t
Q "++ for lenders
#he sensitivity and exertise of the advisor=arranger lies in the ability to inoint
an "++ that would elicit the interest of lenders? credit committees. Proosing an "++
that?s too low would work to the sonsors? advantage but would involve the risk of
taking on a siFeable ortion of the financing. Advancing an "++ that?s too high is no
doubt aealing to the banking community* but it would $eoardiFe sonsors?
satisfaction. A satisfactory level of "++ rovides an additional filter to the advisor
for the different debt=eCuity otions for the initiative in Cuestion. "n fact&
. "f the roosed financial structure satisfies the sonsors but not the lenders* it
has to be re$ected.
. "f there is no debt=eCuity mix that satisfies shareholders and lenders at the same
time* estimates on oerating cash flow should be revised. #hen further attemts
should be made to strike a balance between sonsors? and financers? interests.
. "f the debt=eCuity mix satisfies both arties* the condition of economic conveniD
ence is guaranteed. #he analysis should then be comleted by calculating the
cover ratios. "f lenders find these accetable too* then the ro$ect?s financial
structure has been found.
"f the difference between the "++ and the cost of funding for an individual bank is
ositive* this signals that undertaking the initiative would be convenient because the
4P0 is ositive. #his difference* like the 4P0* is not the same for all the banks
because it deends on the cost of the funding sourced to articiate in the initiative
and on the fee level aid to each category of bank.
#he limitation of the two methods $ust described lies in the basic assumtion that
the bank finances articiation in the deal solely with caital collected from retail
deosits @or from other banks if the funding is raised wholesale on the interbank
marketA. "n actual fact* lending also absorbs shareholders? eCuity. "n fact* the riskier
the loan* the greater this absortion should be. @"n banking $argon* we say that the
risk caital* or Ca+Ecaital at risk* should be greater.A #he shareholders? eCuity has
a much higher oortunity cost than the cost of funding* and the two revious
criteria could distort assessments on economic convenience.
#here are a number of ossible solutions to this crucial roblem. #he first is to
calculate 4P0 by discounting the flows to a rate that reresents a combination of risk
caital and loan caital @intended as the marginal cost of funding based on an
aroriate interbank rateA rather than only the cost of funding. #he rate used for
discounting can then be calculated as
WMCF Q "+ @! +W 3JA @! tA R k
+W 3J
WMCF Q Weighted marginal cost of funding
"+ Q "nterbank rate
+W Q +isk weight
t Q Cororate tax rate
Q Cost of bank eCuity
3J Q Minimum caital reCuirement coefficient
#he weighting factors @+WA can be the ercentages reCuired by suervisory
bodies in terms of caitaliFation @standardiFed aroachA* or they can be calculated
internally by the bank using its internal rating systems @see 'ection 3.,A. For examle*
suose that the interbank rate is ,./J* that k
for the bank is !1J* and that the
cororate tax rate is ,1J. "f the bank uses the risk weight roosed by the 5asel
Committee for deals Cualified as >>strong?? @21JA* the deal is suosed to be financed
with 21J 3J Q /..J eCuity and @!11J N /..JA Q (,.,J interbank deosits. #he
weighted marginal cost of funding would then be
WMCF Q ,&/J @! 1&21 3JA @! 1&,1A R !1J 1&2 3J Q ,&3!J
#he second solution would be to comare this same weighted marginal rate to the
"++ of the initiative. "f the difference between the "++ and the weighted marginal
rate is ositive* the deal is accetedK it?s re$ected if the oosite is true.
#he third solution hinges on accounting arameters* although they are less
accurate methodologically seaking. 7n the other hand* accounting data are immeD
diately understandable by credit committees or the boards of directors of lending
banks. 'ome banks take a criterion based on calculating the annual return on their
eCuity absorbed by the ro$ect. #hey then comare it with a benchmark established
by to management that reresents the cost of funding for the bank @k
A. "n some
countries* banks refer to this with the acronym +7' @return on solvencyA.
A simlified calculation of the eCuity absorbed can be done by multilying the
outstanding debt at the end of every year @7A by the coefficient of the minimum
caital reCuirement established by suervisory bodies. @For the ortion of the loan
that has actually been disbursed* this is 3JK for the ortion that has been committed
but not yet utiliFed* .J is alied* i.e.* 2/J of an 3J coefficient.A #he numerator of
the Cuotient is reresented by the margin with resect to the cost of funding @'* or
sreadA lus fees @FA.
"t would be convenient for the bank in Cuestion to articiate in the initiative
' R F
k W 1
7 3J R C .J

where C @committedA stands for the amount of financing that has not yet been
#able /D!) rovides an examle showing this calculation with reference to a
generic valuation date @-ecember )!* %11/A. 4ote that calculations are done on an
actual=).1 basis* and the return on eCuity absorbed is annualiFed under simle
caitaliFation conditions. "n this case* with a benchmark rate of !)J* the ro$ect
generates an !!.(!J return on solvency. #herefore* it should be re$ected.
#he last available otion is based on the assumtion that the bank can estimate
value at risk @0a+A* i.e.* the unexected loss on ro$ect finance initiative. #his is done
to Cuantify the maximum amount the bank could lose on a given time horiFon and
with a certain statistical level of confidence @usually ((JA. As we?ll see in 'ections
3.,.!.! and 3.,.!.%* some emirical tests show that the recovery rate on ro$ect
finance deals is statistically higher than similar cororate exosures. 'o alying
standard weighting factors @3J and .JA could result in an overestimation of the
eCuity absorbed.
:iven historical data on the robability of default @P-A and the loss given default
@L:-A* if a bank can estimate the exected loss @6LA and its freCuency distribution* a
ercentage value of unexected loss can be comuted within the chosen statistical
level of confidence interval. While exected loss should be covered by the cost of
funding @the marginA* unexected loss is a risk taken on by shareholders. #hey sustain
this risk by utiliFing their own eCuity* which has a cost of k
. "t follows that the
#A5L6 /D!) Calculation of +7' for 5anks for -ecember )!* %11/
-ays in the
0A# loanEconferred at start of eriod 3*,11 !11 !3, ,%*()
5ase loanEconferred at start of eriod ,1*2(! !/1 !3, )!%*2)
'tandby loanEconferred at start of eriod E !.1 !3, E
#otal margin )//*..
-ays in the
Commitment Fee
0A# loanEcommitted* not utiliFed !)*.11 1./1J !3, ),.2.
5ase loanEcommitted* not utiliFed 22*%1( 1./1J !3, !(2.)!
'tandby loanEcommitted* not utiliFed 2*111 1..1J !3, %!.,2
#otal commitment fees %/)./)
#otal revenues .1(.%1
6Cuity Absorbed
0A# loanEcommitted* utiliFed at end of eriod !!*)/1 3.11J (13.11
5ase loanEcommitted* utiliFed at end of eriod /(*%)3 3.11J ,*2)(.1,
'tandby loanEcommitted* utiliFed at end of eriod E 3.11J E
0A# loanEcommitted* not utiliFed at end of eriod !1*./1 ..11J .)(.11
5ase loanEcommitted* not utiliFed at end of eriod /3*2.% ..11J )*/%/.2%
'tandby loanEcommitted* not utiliFed at end of eriod 2*111 ..11J ,%1.11
#otal eCuity absorbed !1*%)!.2.
+eturn on eCuity absorbed @annualiFedA !!.(!J
5enchmark rate !).11J
interest rate the bank should charge on this deal in order to satisfy the exectations of
shareholders must take the following into account&
. #he internal transfer interest rate @"+#A used to finance the oeration* usually
close to an interbank rate
. #he exected loss on ro$ect finance deals that are comarable to the case in
Cuestion @6LA
. #he value at risk of the deal @0a+A
. #he difference between the k
and the "+# @though the deal could be financed
entirely with interbank loans* ideally* the ro$ect should absorb shareholders?
eCuity as wellA
'o we have
Q "+# R 6L R 0a+ @k
+earranging this eCuation to exress @k
"+#A* we can get a measure of return
corrected for risk* or riskDad$usted return on caital @+A+7CA.
0A# loanEdisbursed at the start of the eriod 3*,11 !11 !3, ,%.()
5ase loanEdisbursed at the start of the eriod ,1*2(! !/1 !3, )!%.2)
'tandby loanEdisbursed at the start of the eriod E !.1 !3, N
#otal margin )//...
Amount Commitment Commitment
@euro=mil.A fee -ays fee @euro=mil.A
#A5L6 /D!, 6xamle of a +A+7C Calculation for -ecember )!* %11/
@b..A @daysA
0A# loanEcommitted* not utiliFed !)*.11 1./1J !3, ),.2.
5ase loanEcommitted* not utiliFed 22*%1( 1./1J !3, !(2.)!
'tandby loanEcommitted* not utiliFed 2*111 1..1J !3, %!.,2
#otal commitment fees %/)./)
#otal revenues .1(.%1
AnnualiFed return @including feesA %.,3J
AnnualiFed return @including feesA @AA %.,3J
6xected loss @5A !./1J
0a+ @CA /J
+A+7C @@A 5A=CA !(./,J
5enchmark rate !).11J
+A+7C Q
6L 0a+
"n fact* if we know the values of the sread @+
"+#A and the exected and
unexected loss* we can calculate the return on the ro$ect corrected for risk. #his
rate should be comared with the return exected on shareholders k
to ascertain
whether the oeration is economically convenient.
+eferring again to the revious examle* the +A+7C calculations are illustrated
in #able /D!,. 7n the basis of available market data* we assume a default rate at one
year of %J and a recovery rate of 2/J. #his gives us an exected loss of !./J. We also
osit that the unexected loss @0a+A calculated at a ((J level of confidence is /J.
#he actual annual rate is comuted as the ratio of total revenues and @base R 0A# R
standDbyA loans utiliFed at the beginning of the eriodK annualiFation is done based on
simle caitaliFation. Again* we set k
at !)J. As we can see* in this case the +A+7C
is greater than the benchmark rate used* so the ro$ect should be financed.
/.) Cover +atios
#he rocess illustrated in Figure /D( includes the verification of cover ratios in the
decisionDmaking rocess. "n this section* we exlain what these indices are and why
they are used to value the bankability of ro$ect finance initiatives. An examle will
rove useful for introducing this toic.
!)) Cover +atios
We?ve seen that one of the discriminating criteria in various debt=eCuity mixes is
the "++ level. 7ne might ask then why the advisor doesn?t sto at this stage in
defining the financial structure.
Let?s say that two ro$ect finance initiatives* A and 5* have a total estimated cost
of !*111. 7f this total* 311 is financed with bank loans organiFed by an arranger and
%11 with shareholders? eCuity. Moreover* for simlicity?s sake we?ll suose that
construction will be finished on the two ro$ects in the first working eriod @year 1A
and that both begin to generate ositive flows starting from year !. #he dynamic of
the financial flows is reresented in #ables /D!/ and /D!.* and the flow of the last year
also includes the liCuidation of any remaining assets.
#A5L6 /D!/ Pro$ect AEFinancial Flows and +eturn "ndicators
1 ! % ) , /
7erating cash flows !*111 /1 !/1 3/1 !*311 %*!11
-ebt service E E E E E %*1!!
-ividends to sonsors E /1 !/1 3/1 !*311 3(
"nvestmentsEsonsors %11
"nvestmentsEbanks 311
1 ! % ) , /
Financial flowsEbank 311 1 1 1 1 %*1!!
Financial flowsEsonsors %11 /1 !/1 3/1 !*311 3(
"++Ebank %1.%J
"++Esonsors !%,J
#A5L6 /D!. Pro$ect 5EFinancial Flows and +eturn "ndicators
1 ! % ) , /
7erating cash flows !*111 /1 !/1 3/1 !*311 .*(11
-ebt service 1 )/ !!1 .11 2)1 1
-ividends to sonsors 1 !/ ,1 %/1 !*121 .*(11
"nvestmentsEsonsors %11
"nvestmentsEbanks 311
1 ! % ) , /
Financial flowsEbank 311 )/ !!1 .11 2)1 E
Financial flowsEsonsors %11 !/ ,1 %/1 !*121 .*(11
"++Ebank %1.%J
"++Esonsors !%,J
!), C 8 AP # 6 + / 0aluing the Pro$ect and Pro$ect Cash Flow Analysis
As we can see* the same result emerges for both ro$ects in terms of "++* both for
'P0 shareholders and for a hyothetical lender. "n the first case* however* the loan is
reimbursed with a bullet ayment at the end of the fifth yearK in the second* caital is
gradually collected and by the end of the fourth year the loan is aid in full.
#he examle reveals a simle conclusion* but not a trivial one& #he same "++ can
be obtained through different combinations of cash flows earmarked for debt service.
Clearly* if the arranger is making forecasts and referring to exected flows* in the first
case he or she will realiFe that ayback to lenders deends exclusively on the fact that
in year / the flow from Pro$ect A will be no less than the %*1!! debt service. "f it were
less* in fact* the ro$ect would have reached its last year of life and it wouldn?t be
ossible to renegotiate the terms of reayment. "n the case of Pro$ect 5* in contrast*
debt reayment is adated* or >>matched*?? to the dynamic of oerating cash flows.
When calculating the ratio between oerating cash flow and the debt service @which
shortly we will refer to as the debt service cover ratioA* we note that this varies from a
minimum of !.). in year % to %.,2 in year ,.
5asically* in Pro$ect 5 the arranger structured the financing so that in each year of
ro$ect?s life* lenders collect on a art of their initial investment. Moreover* Pro$ect
5?s reayment lan finishes at the end of year ,* which also makes it ossible to
renegotiate the terms of reayment* taking advantage of the key terminal value of
'umming u* then* with Pro$ect 5 there is a financial flow dynamic that is
modulated according to the trend in oerating cash flows. #his match between the
oerational and financial asects of the flows is exactly what cover ratios measure.
/.).! What Cover +atios Can #ell <s and What #hey Can?t
#o make it easier to understand the meaning of cover ratios* it?s helful to look at
what they don?t do. #hey aren?t indicators of the rofitability for lenders in articiD
ating in a ro$ect. "n fact* we have already seen that the financial model serves to
comute the "++ for lenders and sonsors.
We have to remember that along with economic convenience* an initiative should
also be valued in terms of financial sustainability. "n other words* a ro$ect can be
extremely lucrative @i.e.* offer lenders an interesting "++A* yet it might not be
financed if the timing for oerating cash flows doesn?t match the needs for debt
service ayment to lenders. Moreover* a ro$ect can generate a set "++ with various
cash flow combinations* but these mixes are not always accetable to lenders.
Cover ratios are indicators of financial sustainability. #hese arameters enable us
to recogniFe the sustainability of the caital structure @and reayments on financing
we?ve chosenA to realiFe a ro$ect finance deal. Put another way* cover ratios are
indices that can show the extent to which a ro$ect?s oerating flows match those
linked to the dynamic of financial items. A number of cover ratios are currently in
useK two are articularly interesting.
/.).!.! -ebt 'ervice Cover +atio @-'C+A
For each year of ro$ect oerations
this ratio exresses the relationshi between
oerating cash flow and the debt service on the rincial and interest. 'o we have
!!. 7bviously* this ratio is meaningless during the construction hase* when by definition the numerator
and denominator are both Fero.
!)/ Cover +atios
-'C+ Q
R "
7CF Q 7erating cash flow for year t
9 Q Payment on the rincial in year t
" Q "nterest ayment in year t
#he ratio tells us that in any given year of oerations* the financial resources
generated by the ro$ect @reresented by the numeratorA must be able to cover the
debt service to lenders @the denominator of the CuotientA.
"n theory* the lowest number the coefficient can be is !. "n this case* clearly the
entire available cash flow can be used to the advantage of lenders to service the debt.
We?re seaking theoretically because it?s eCually clear that a -'C+ seCuence of !
wouldn?t be sustainable. #his is true not so much for lenders* who would be comD
letely satisfied @assuming for the moment there is no uncertainty regarding the
outcome of the ro$ectA* but for sonsors. "n this situation* in fact* the flow of
dividends would fall to Fero for all the years earmarked for debt service. #he end
result in terms of the ro$ect?s "++ for sonsors would be extremely unfavorable* to
the oint where the ro$ect would not be economically convenient.
#he theoretical situation of a -'C+ eCual to ! is not accetable to lenders either*
if we remove the unrealistic hyothesis of total certainty of the value of future cash
flows generated by the ro$ect. #he more lenders are riskDaverse* the more they would
insist that a safety margin be established to guard against unexected circumstances
that could shrink the ro$ect?s cash flows and the greater than ! the level of -'C+
reCuired for the initiative.
"n this regard* the values gleaned from the ro$ect finance market are summed u
in #able /D!2. As one would imagine* the level of cover ratios deends on the risk
inherent to the ro$ect as erceived by lenders. #his* in turn* is closely linked to the
#A5L6 /D!2 -'C+s in 0arious 'ectors Where Pro$ect Finance "s <sed
Pro$ect 'ector Average -'C+
Merchant Plants @lants with no offtake agreementA %xN%.%/x
With a tolling agreement !./xN!.2x
"n cases involving regulated business !.)xN!./x
#ransortation=shiing !.%/xN!./x
#elecomU !.%xN!./x
Water !.%1xN!.)1x
Waste to energy !.)/xN!.,1x
PF"UU !.)/xN!.,1x
U "n the telecom sector* the average -'C+ is determined by the security ackage. #he data rovided
in #able /D!2 refer not only to ro$ect finance deals in the strict sense* but also to refinancing existing
ositions on a nonrecourse basis.
UU As regards PF"s* one should consider the makeu of the base case used as a oint of reference. #he
relevant data slotted into #able /D!2 do not take into account market risk due to revenue variables
@arking lots* shoing centers* restaurants* etc.A. "nstead* they assess only counterarty risk and the
transfer of ro$ect risk underwritten in the concession agreement to the concession awarder.
@! i A
R -+
degree with which various cash flows are secured and therefore redictable. Pro$ects
in the transortation and telecommunications sectors* where longDterm offtake conD
tracts can?t be imlemented* can generally be financed only with higher cover ratios.
As far as the actual use of the -'C+* many loans reCuire a secific average
minimum level in addition to minimum cover ratios at set intervals @i.e.* year by
yearA. #he average -'C+ is nothing more than the average of the single -'C+s
recorded in each year of oerations&
7C F
7C F
7C F
7C F
A0-'C+ Q
R "

R "
R "
tQ !
#he symbols in this formula* besides those already exlained* stand for the
A0-'C+ Q Average debt service cover ratio
n Q Length of the loan amortiFation lan in number of years
Why is a coefficient for the A0-'C+ reCuired along with the yearly minimum;
We can understand the reason by observing Figure /D!!. As we can see* both Pro$ect A
and Pro$ect 5 have a minimum -'C+ of !.)K however* no bank would choose 5
over A. "n fact* while A shows a coefficient for average debt service of !.,/ @which is
higher than the minimumA* the same figure for Pro$ect 5 corresonds exactly to the
minimum. 'o reference would go to Pro$ect A due to the fact that during the
oerating hase* the initiative guarantees that in some years the -'C+ is higher
than the minimum acceted value. #his is not the case with Pro$ect 5.
/.).!.% Loan Life Cover +atio @LLC+A
#he second cover ratio is the Cuotient of the sum of the oerating cash flows
discounted to the moment of valuation @sA and the last scheduled year of debt
reayment @s R nA @lus the available debt reserve* or -+A and the outstanding
debt @7A at the time of valuation s. #hat is&
tQ s
#he meaning of this ratio is less intuitive than the -'C+* even though it?s
interreted in a similar way.
#o understand what this ratio tells us* we should exlain that the LLC+ is
the relationshi between two discounted sums. #his is obvious at once for the
numerator. For the denominator* simly consider that in financial mathematics* the
outstanding debt at a given time s is nothing more than the discounting of the debt
services that have yet to be aid by the borrower for the entire remainder of the loan
itself. 'o we can say that
@! R i




"ro7ect A
Ann%al DS$R
Min DS$R
A;era-e DS$R
+ / 1 2 I J G K H +D ++ +/
=ear of o!eration
"ro7ect B
A;era-e DS$R
Min DS$R
Ann%al DS$R
+ / 1 2 I J G K H +D ++ +/
=ear of o!eration
F " : < + 6 /D!! 'ignificance of the A0-'C+
where -' reresents the installment due at time t and i is the interest rate on the loan
alied by the lender.
'econdly* consider that the LLC+ is a ratio of the sums of two discounted
flows. As such* an LLC+ greater than ! can be interreted as a surlus of cash freely
available to ro$ect sonsors if they were to ot to liCuidate the initiative immediately.
#hey could
#A5L6 /D!3 -etermining the LLC+
Lear 7CF -ebt 'ervice -'C+ 4P0 7CF @!1JA 4P0 @-'A @!1JA LLC+
1 E E
! 3,*111*111 .1*111*111 !.,1 2.*).)*.). /,*/,/*,//
% )2*/11*111 %/*111*111 !./1 )1*((!*2). %1*..!*!/2
) ,%*(11*111 ))*111*111 !.)1 )%*%)!*,1/ %,*2()*)33
Average -'C+ !.,1 !)(*/3.*222 !11*111*111 !.)(.
reimburse the entire outstanding debt with the net revenue generated during the
remainD ing loan reayment eriod. Let?s look at #able /D!3 as an examle.
"n the table* we assume that the ro$ect generates the oerating cash flows shown
in the 7CF column @during the years marked for reaying a !11 million loan with
variable installmentsA. 4ext is the debt service @-'A column. #he relationshi beD
tween the figures in the 7CF and -' columns gives us the -'C+. #he average
-'C+ over the time horiFon considered here is !.,.
#he next two columns contain the 4P0 of oerating cash flows @4P0 7CFA and
the debt service @4P0 -'AK both figures are calculated at a !1J rate. As one would
exect* if we add the resent values of the debt service* we immediately get the
nominal value of the loan again @!11 millionA. #he discounted value of oerating
cash flows* in contrast* amounts to nearly !,1 million. "f we were to liCuidate the
investment ro$ect today* considering only flows freely generated in years !* %* and )*
the 'P0 would be able fully to reimburse the !11 million loan and could distribute
around ,1 million to its sonsors.
#his simlified calculation is measured by the LLC+. For the ro$ect in Cuestion*
this figure is !.)(. available euro for every single euro of outstanding debt at the time
of valuation.
A third and final consideration regarding LLC+ ertains to the rate utiliFed for
discounting the numerator. As we saw in 'ection /.%./.%* the most accurate solution
would be to calculate the marginal cost weighted for each articiant bank in the
initiative and to use this when discounting.
"n ractice* however* we use the nominal rate alied by lenders in a given year.
"f this is the case* then if discounted rate of the flows in the numerator is eCual to that
used to discount the flows in the denominator and all the -'C+s have the same value
during the loan amortiFation eriod* then obviously the two cover ratios are eCual.
#his is clearly illustrated in #able /D!(.
#A5 L6 /D!( 6Cuivalency of -'C+ and LLC+
Lear 7CF -ebt 'ervice -'C+ 4P0 7CF @!1JA 4P0 @-'A @!1JA LLC+
1 E E
! 3,*111*111 .1*111*111 !.,1 2.*).)*.). /,*/,/*,//
% )/*111*111 %/*111*111 !.,1 %3*(%/*.%1 %1*..!*!/2
) ,.*%11*111 ))*111*111 !.,1 ),*2!1*2,, %,*2()*)33
Average -'C+ !.,1 !,1*111*111 !11*111*111 !.,11
#A5L6 /D%1 LLC+ in 0arious 'ectors Where Pro$ect Finance "s <tiliFed
Pro$ect 'ector Average LLC+
Merchant lants @i.e.* lants with no offtake agreementA %.%/xN%.2/x
With tolling agreement !./xN!.3x
"n cases involving regulated business !.)xN!./x
#ransortation !.,xN!..x
#elecom n.a.
Water !.)1xN!.,1x
Waste to energy !.31xN!.(1x
PF" !.,/xN!./1x
We can see that the -'C+s in the three years are all !.,* so they are all eCual to
the average -'C+. #his figure* in turn* is exactly the same as the value of LLC+.
"f instead* as haens in real life situations* the different -'C+s diverge over time*
the average -'C+ and the LLC+ would not be eCual. #he latter can only be higher
or lower as a function of the different distributions over time of the available cash
flows during the loan amortiFation eriod.
"n actual fact* as we saw with the -'C+* the minimum value of the
reCuested LLC+s is a direct function of the ro$ect?s inherent risk. "n this regard* see
#able /D%1.
/.).% Cover +atios as an Alication of the Certainty
6Cuivalents Method
< to this oint* we?ve exlained the need for cover ratios higher than ! simly by
referring to lenders? aversion to risk. We?ve said that the greater the margin of
guarantee against unforeseen future events that lenders want* the higher the ratios
they will demand.
#o be more recise* we can use a numerical examle to illustrate this reasoning.
Let?s take the case of a hyothetical investment ro$ect. #wo lenders @Alfabank and
5etabankA are willing to accet !.) and !.. -'C+s* resectively* for all years of the
loan reayment lan.
5ased on the -'C+ formula* we know that&
R "
Q !&)
R "
Q !&.
!%. #his result derives from the linear roerties of the 4P0. "f an investment resents a seCuence of flows
that differs from another only by a constant multilier @!., in our examleA* the 4P0 of the first investment is
eCual to the 4P0 of the second multilied by the given constant. 'o we have 4P0@IAA Q I4P0@AA.
+earranging the terms in the two eCuations* we get&
Q 9
R "
for Alfabank
Q 9
R "
for 5etabank
At this oint* note that in any given year of the loan amortiFation* the oerating
cash flows generated by the ro$ect are multilied by a number between 1 and !.
"n fact* we have 1.2.( @or 2..(JA for Alfabank and 1..%/ @.%./JA for 5etabank.
"n other words* having reCuested a -'C+ of !.)* it is as if Alfabank were to weight
each nominal flow roduced by the initiative at aroximately 22J of its value.
5etabank* the more riskDaverse lender* actually uses a weight of .%./J.
We can easily see from this examle that* in order to accet articiation in
the financing* the debt service for each year is eCuated to a ercentage of the available
cash flow that can be drawn from the ro$ect each year. 4aturally* we use the same
reasoning in considering the loan life cover ratio.
<ncertainty regarding the dynamic of flows exected from a ro$ect finance deal
is measured by a coefficient @lA. #his eCuals the inverse of the values of the cover
ratios taken into consideration* so the lower this coefficient* the higher the value of
the cover ratio in Cuestion.
Cover ratios can be interreted as an alication of the method of certainty
eCuivaD lents for dealing with uncertainty in investment=financing decisions.
According to this
method* an investment=financing ro$ect characteriFed by a seCuence of cash flows
known to the evaluator a riori must be acceted or re$ected on the basis of the 4P0
criterion. "n estimating this factor* the figures regarding exected ro$ect cash flows
are weighted by coefficients reresenting the evaluator?s aversion to risk. 'o we have
4P0 Q
with l falling between 1 and !.
@! R iA
/., 'ensitivity Analysis and 'cenario Analysis
7nce a balance is struck that makes it ossible to achieve all the ob$ectives of the
contract counterarties @sonsors? and lenders? "++ and minimum levels of -'C+
and LLC+A* the next ste is to verify the ro$ect?s robustness in the face of negative
scenarios. #he result of these tests involves the following&
. #he generation of various scenarios* each of which will show the ro$ect?s
erformance when a series of arameters change @scenario analysisA
. #he use of simulation techniCues @such as Monte Carlo simulationsA alied to
a set of key variable* and the creation of the robability distribution of outut
variables considered critical @usually the "++ for sonsors or -'C+sA
!,! 'ensitivity Analysis and 'cenario Analysis
Variations in9
8 tariffs4%nit re;en%es
8 "ro;isionin- costs
8 Ot3er o!eratin- costs
CA() *+O,(
$e%t service capacit -
$e%t service re&uirements.
F " : < + 6 /D!% Logic 5ehind 'ensitivity Analysis
'cenario analysis is art of the family of sensitivity analyses that serve to rovide
otential financers with a ossible sectrum of cases @from a base case to a worst
caseA. #his is done to determine the level of ro$ect solidity when negative contingenD
cies emerge.
'ensitivity analysis is based on logic illustrated in Figure /D!%.
Carrying out sensitivities* i.e.* generating several eCually ossible scenarios* is not
articularly comlex. "n fact* the same model used to draw u a base case is used
again to roduce scenarios. #he difference lies in the inut values* while obviously the
algorithms for calculating and determining results are the same.
8owever* $ust as it is theoretically ossible to generate an infinite number of
scenarios* we must also limit this number to a manageable level. "n fact* with too
many scenarios we risk creating confusion for a otential articiating bank or
shifting the focus away from the evaluation of the real risk factors that imact the
For this reason* the sensitivity analyses conducted by the advisor are limited to a
few alternative scenarios derived by maniulating only a small number of key
variables. #he logic behind sensitivity analysis is to verify the ro$ect?s degree of
resistance to adverse changes in the factors that determine cash flows. "nstead of
assigning a definite robability of verification to a given event* which is always rather
sub$ective* sensitivity analysis should focus on coming u with the maximum ossible
variation in a key variable that still allows the debt service caacity W debt service
reCuirements condition to be met. #hen it is u to the individual intermediaries
invited to articiate in the ro$ect to decide if this extreme variation should be
seen as likely or unlikely @on the basis of their own risk aversionA.
/.,.! Which 0ariables 'hould 5e #ested
in 'ensitivity Analysis;
#he guiding rincile for advisors in generating scenarios is relevance. "n fact* it
makes no sense to offer scenarios roduced by modifying variables with little
#A5L6 /D%! -ownside 'cenarios in the "taly Water Case
!. -ecrease in water tariffs
#ariff on drinking water %1J
#ariff on nondrinking water %1J
%. -ecrease in rice of :reen Certificates %1J
). "ncrease in oerating costs R%1J
,. "ncrease in base tax R!11 basis oints
/. "ncrease in investment costs R!1J
.. -ecrease in ublic funding %1J
2. -ecrease in duration of concession / yrs
imact on the values of oerating cash flows. "t is much more logical* instead* to
ascertain which values* when altered only slightly* are at to cause significant
variations in total available cash flows for debt service. 4ormally* these variables
are the ones that determine the comonents of oerating cash flow* such as sales
revenues and oerating exenses Consider* for examle* inflation rates to which
sales rices are indexed* or the cost of sourcing inut that isn?t covered by utD
orDay contracts.
#able /D%! rovides an examle of variables that can be tested in sensitivity
analysis. 4aturally* though these variables are linked directly to the "taly Water
Pro$ect* it is worthwhile to study them closely to give yourself a feel for conducting
>>what if?? analysis.
-ro in Water 'uly #ariffs& 7ne of the most critical variables in choosing the
referred bidder in a call for ublic tender is the fee structure for the service
offered* although this is the most effective tool in determining the rofitability of
the ro$ect. For this reason* the definitive fee structure is set u $ust before >>the
sealing of the enveloes?? containing the offers resented to the ublic concession
authority. "n the "taly Water Pro$ect* the difference between the fee for water
for nondrinking water @!11 euro er !111 mc of water suliedA and for drinking
water @)11 euro er !111 mc of water suliedA is due to the cost variables for water
-ro in the Price of :reen Certificates& #he "taly Water Pro$ect also involves the
roduction of around !1. :Wh=year of hydroelectric ower when the lant is fully
functional. #hese facilities take advantage of the oortunity to sell :reen
Certificates for the first 3 years of oerations at an estimated riceK the actual value
is contingent on market trends underlying the sales of these certificates. #o comute
the otential imact of a rice reduction of :reen Certificates in %11(* we arbitrarily
decided on a ercentage dro in the sales rice.
"ncrease in Fixed Costs& 'ome fixed costs can be established in contractsK others*
such as general exenses or ersonnel costs* are only estimates and as such are sub$ect
to change. #he same considerations can be made as regards variable costs* in light of
the fact that an increase in water treatment costs triggers a rice hike for the suly of
drinking water.
0ariation in the "nterest +ate& #he "taly Water simulation is based on the assumtion
that interest rates will rise at the same rate as inflation. #he outcome of the
simulation deends largely on the coverage olicy adoted for interest rate risk.
"f most of the debt is converted to a fixed rate* a rate increase would lead to an
increase in the oerating margin @assuming that costs and revenues rise
roortionally to the same degreeA along with a negligible uswing in interest
exenses. Conversely* a dro in rates would cause the oerating margin to shrink
considerably* with a limited decrease in interest rates. #he ro$ect tends to
downslide as rates fall. #he oosite occurs with variableDrate financing* for it is
more likely that the growth in the oerating margin will be more than comensated
by the increase in interest ayable.
"ncrease in the 6PC Contract Price& 6ven though the 6PC contract is normally a
fixedDrice agreement* conditions may arise that would necessitate raising the rice
during the construction hase. All arties might agree to an increase to ay for
imrovements on the initial ro$ect* for examle. 7r extra funds may be needed to
contend with force ma$eure events @costs linked to imlementing new safety
standards* or new regulations on emissions* etc.A. "n any case* increases @debiting
ancillary charges such as 0A# and interest as wellA have to be limited to the total
available standDby funds @standDby eCuity and standDby loanA. "f the cost increase
exceeds available funds* a default event would result. #herefore* when this simulation
is run* we have to make sure the standDby facility is not entirely drained.
Cut in Public :rants& #he variable that Cuite robably has the greatest influence
on the concession authority in choosing an offer is the economic=financial
eCuilibrium of the ro$ect. With 57# concessions for building and oerating ublic
services* rivate financing @meaning conferring of debt and eCuityA is not enough to
guarantee an adeCuate return on investment and total reimbursement of the loan.
For this reason* this tye of sensitivity lays a key role in decisionDmaking olicies of
rivate sonsors. A cutback in ublic grants during the construction hase has to be
comensated by a steDu in financing* where financial ratios are adeCuately robust*
and a bigger contribution from sonsors.
-ecrease in the -uration of the Concession& #he length of the concession is Cuite a
significant variable for the ublic concession authority when choosing the winning
roosal* though this factor does not greatly imact the financial=economic
eCuilibrium of the ro$ect. "n fact* in the case of concessions running over %1 or )1
years* extending or comressing the life san of the contract does not affect the rate
of return on the ro$ect or on investment caital a great deal. As regards the ro$ect?s
financial sustainability* instead* desite the obvious condition that the final maturity
of the loan must redate the exiration of the concession* limiting the duration of the
concession increases the risk of the ro$ect. #he reason is that if downside scenarios
occur that call for additional funds* the ossibility to refinance the loan is artly
7nce variables are singled out* an accurate range of variation has to be set for
each one. Whenever ossible* common sense should be substantiated by assessments
conducted by various consultants* for secific areas of exertise @how much oerating
costs could actually fluctuate* the lowest ossible level of lant efficiency* the real
risks of rice increases for the 6PC contract* etc.A. 'imulations on single variables
should not show excessive sensitivity to results of the ro$ect initially measured by
-'C+* LLC+* and "++.
An even more imortant result emerges from simulations that take into account
several downside conditions in the same scenario. #his is done to test the ro$ect?s
robustness when adverse circumstances coincide. #he combined downside scenario
has to demonstrate that the ro$ect can reay the loan installments on the rincial
and interest. "n terms of the model* this means that the minimum -'C+ level has to
be at least !. A lower figure would imly that cash flows generated are not enough to
reay the debt.
#he scenario resented in #able /D%% roduces unaccetable financial results from
a financial ersective and in terms of earnings @minimum -'C+ !.1.x* minimum
LLC+ !.13x* ro$ect "++ 2.2/J* shareholders? "++ ..,2JA. 8owever* here it?s
crucial to understand the meaning of the analysis. A downside scenario has to be
>>validated?? by the bank?s technical consultant* and in any case it has to be roerly
mitigated through commercial contracts and the concession contract.
Moreover* in these circumstances the outcome of the model should be interreted
carefully. For examle* suose we come u with a minimum -'C+ of 1.(/x and an
average -'C+ of !.)1x. 7n average the ro$ect can readily reay the debt in full
@with a margin of )1JA. 8owever* in at least one oerating year the available cash
flow is inadeCuate. #his is easily dealt with by redefining the ayback lan* as we see
in 'ection ..(. "f the new lan is also aroriate in the >>normal?? situation
#A5 L6 /D%% Combined -ownside 'cenario in the "taly Water Case
0ariables 5ase Case J -ownside 'cenario
"ncrease in Caex @keuroA
-ecrease in Water #ariff
#ariff on otable water @6uro=111 cubic metersA
#ariff on nonDotable water @6uro=111 cubic metersA !!) / !12.,
"ncrease in 7ex @keuroA %!*21! 2 %)*%%1.!
:reen Certificate @-ec. )!* %11(A @:wh=yrA !!. / !!1.%
Water Authority Fee @keuroA /*111 !1 /*/11
6nergy Authority Fee @keuroA /*111 !1 /*/11
Public :rant @J on CaexA
'ection ! //J %./1 /%./J
'ection % //J %./1 /%./J
'enior Facility 5ase rate ,./1J !./1 ..11J
Min !.,3 !.1.
Average !./! !.1(
Min !./) !.13
Average !.// !.1(
Pro$ect (./,J 2.2/J
6Cuity !%.,%J ..,2J
+:2K +:2H
+:ID +:ID
+:ID +:ID
+:I1 +:I1 +:I1
+:I2 +:I2
/D+/ /D+1 /D+2 /D+I /D+J /D+G /D+K /D+H /D/D /D/+ /D// /D/1 /D/2 /D/I /D/J
F " : < + 6 /D!) -'C+ and LLC+ #rends in the "taly Water Pro$ect
/D+/ /D+1 /D+2 /D+I /D+J /D+G /D+K /D+H /D/D /D/+ /D// /D/1 /D/2 /D/I /D/J
F " : < + 6 /D!, +eimbursement #rend for the 'enior Facility in the "taly Water Pro$ect
in the base case* it can be adotedK otherwise* contract terms can be considered
that allow for a certain margin of flexibility @albeit limitedA in the reayment lan.
An alternative and comlementary method for verifying a ro$ect is to change
each relevant variable until we find the value that gives us a minimum -'C+ of !*
!). Modeling the otimal ayback lan can be done by calculating the loan installment beginning with the
available cash flow estimated by the model* rather than by carrying out endless trials. Assuming a minimum
-'C+ of !.)1x* the loan installment @rincial R interestA should be roortional to the available cash flow by
a ratio of !&!.)1. 'ubtracting interest due from the figure obtained by this calculation* we get the installment on
caital. 'ee 'ection ..(.2 for more information.
which is inherent to the situation described earlier of a missed installment ayment
@assuming an otimal reayment lanA. "f the variation needed to trigger a ro$ect
default is so extreme as to be highly imrobable* the ro$ect would rove sufficiently
robust in the face of events that could give rise to such changes. 7n the other hand* if
the variable stays at a lausible value* this signals the need to find adeCuate structures
to mitigate this risk. For examle* if the ro$ect tends toward default when Cuite
lausible interest rate increases are considered* hedging olicies should be reviewed*
and the fixedDrate comonent of financing should be given more weight.
"n designing the model* we should kee in mind the imortance of visualiFing the
economic factors of the ro$ect through images and grahs. 7ften this makes it
ossible to understand the roblem Cuickly.
#he -'C+ and LLC+ rofiles @such as the ones shown in Figure /D!)A rovide a
snashot of ossible inefficiencies of the ayback lan.
5y visualiFing the reayment lan itself* instead* we can clearly see if the rofile is
excessively backDended* i.e.* if the final installments are too heavy. 'ee* for examle*
Figure /D!,.
C 8 A P # 6 +
Financing the -eal
Funding a ro$ect finance deal is extremely comlex. "n both the case of bank loans
and recourse to the caital market @bond issuesA* the siFe of ro$ects means that
a large number of banks or very many bond investors must articiate. For an
examle* see the tombstone in Figure .D!.
#his chater reviews how syndicated loans and bond issues are organiFed and also
analyFes the various alternatives sonsors have for obtaining funds to invest in
their ro$ects. #he first three sections investigate the structure of syndicated loans* the
most common form of funding used for ro$ect finance deals. #he analysis covers the
activities of advisors* arrangers* and other roles and the various fees aid for
organiFation of the ool itself. "nternational ro$ects syndicates often include
multilateral banks @ML5sA and exort credit agencies @6CAsA @'ections .., and
../A. #heir involvement means rivate banks can en$oy rivileged creditor statusK this
has considerable advantages from the standoint of credit risk and eCuity absortion.
'ection ... gives a summary of other financial intermediaries who may articiate in a
ro$ect finance deal* whereas 'ections
..2 to ..!! analyFe the various forms of funding. 'ection ..2 covers eCuity rovided
by sonsorsK 'ection ..3 analyFes meFFanine financing and subordinated debtK senior
debt and refinancing are covered in 'ection ..(K and leasing is covered in 'ection ..!1.
#he chater ends with 'ection ..!!* which examines the ro$ect bond market and
the rocess for issuing these securities.
..! Advisory and Arranging Activities for
Pro$ect Finance Funding
'ervices offered for ro$ect finance deals by financial intermediaries fall into one of
two ma$or categories& advisory services or financing services. #he first category
!,3 C 8 AP # 6 + . Financing the -eal
F " : < + 6 .D! #ombstone for a +efinancing Pro$ect Finance Facility
includes soft services used to define the risk rofile for a deal* its time schedule* and
its siFe in order to make it bankable* that is* to model the deal so that it can be
roosed to otential lenders. 5ecause such services don?t reCuire huge amounts of
caital* they can be rovided by arties not reresented by financial intermediaries&
consulting firms* auditing firms* largeDscale constructors* engineering firms* and
individual rofessionals who often lay an imortant role in terms of consultancy
for structuring deals. "n certain cases the sonsors themselves carry out a large art of
the studies concerning technical* legal* and financial asects. #hey then contact the
arranger bank for the sole urose of organiFing financing terms and conditions.
#he second category of services concerns lending activities and consists of grantD
ing loans and* sometimes* roviding eCuity based on indications in the feasibility
study reared by consultants. 5ecause this activity reCuires the availability of
caital* clearly it is a business area in which financial intermediariesEarticularly
commercial banksElay a leading role.
!,( Advisory and Arranging Activities for Pro$ect Finance Funding
#A5 L6 .D! #yes of 'ervices Proosed by Financial "ntermediaries
Advisory @consultancy servicesA Analysis of technical asects @together with technical advisorsA
Analysis of regulatory and legislative asects @together with lawyersA
-ue diligence reorting as regards arties involved in the deal
-eveloment of assumtions for risk allocation
Prearation of the business lan and erforming sensitivity analyses
6stablish financial reCuirements and methods to fund these
"dentify methods to obtain debt and eCuity caital
7rganiFe and negotiate terms of financing @arrangingA
7rganiFe and negotiate terms of bond issues @global coordinationA
Lending @financing servicesA :rant bridge financing
<nderwrite bank financing
:rant ool financing @lendingA
:rant leasing for lant
Contribute to eCuity
Contribute to meFFanine finance
"ssue guarantees and suretyshis
Manage technical relations with the 'P0
Act as agency* maintaining documentation and monitoring use of funds
by the borrower
#able .D! shows the main tyes of activity for each of the two ma$or service
Advisory and arranging services are mainly rovided by commercial and
investment banks. Although for many years there has been dee division between
commercial banks and investment banks in many countriesEwith the excetion of
6uroean countries in the :ermanDseaking bloc and Haan* where the universal
banking model has always revailedEtoday this clearDcut division between
commercial and investment banks
has all but disaeared* given that constraints osed by legislation have been
8owever* the division does in effect still exist* owing to years of secialiFation in
certain tyes of financial services. "nvestment banks have found and still find it more
convenient and rofitable to secialiFe in the advisory field* namely* business areas
marked by a high service level that are more similar to consultancy than financial
intermediation in a strict sense. #his is why sonsors of international ro$ect finance
deals traditionally use the services of 5ritish merchant banks or American investment
banks for advisory suort during the initial hases of structuring a deal. 7n the
other hand* the financial intermediation and lending services area is the referred
field for commercial banks* given that they have more stable* lowDcost deosits.
5ecause some of these banks are resent at an international level* this makes them
articularly well suited to rovide international arranging services* whether in the
form of syndicated loans or bond issues.
..!.! Advisory 'ervices
Advisory services include all studies and analyses reCuired to make a reliminary
valuation of the financial feasibility of a ro$ect and also to outline an initial
assumtion as to how the funding reCuired to sustain a 'P0 can be obtained.
!/1 C 8 AP # 6 + . Financing the -eal
#he advisor?s tasks are&
. #o understand fully the sonsors? ob$ectives and then to identify alternative
solutions to achieve these
. #o evaluate risks inherent in the ro$ect and to attemt to find strategies to
mitigate* manage* and allocate these risks
. #o assist sonsors in rearing and negotiating ma$or contracts concerning the
. #o assist sonsors as regards certification of all ermits* licenses* and authoD
riFations obtained
. #o assist sonsors in rearing the business lan or by reviewing the lan
already reared by them
. #o highlight roblems sonsors have not considered but that must be resolved
to ensure the deal?s success
Advisory services in the initial stages concern gathering technical* legal* and fiscal
information regarding the ro$ect* the arties involved* the localiFation of the venD
ture* and olitical and administrative factors it involves. #his activity is freCuently
erformed in association with a team of advisors from different organiFations who
have the necessary exertise as regards the legal* technical* and insurance asects
concerned @as seen in Chater ,A.
#he gathering and initial rocessing of basic information forms the foundation of
inut for the business lan. "n essence the advisor must translate information gathD
ered into figures to evaluate what imact the many variables will have on cash flows*
rofitability* and the eCuity structure of the 'P0. #he business lan must enable the
advisor* together with the sonsors* to devise the mix of financing sources to be set u
to ensure that the ro$ect has the financial suort it reCuires @see Chater /A.
#he final outcome of the financial advisor?s work is the information memoranD
dum* that is* the document with which the advisor contacts otential lenders and
begins to negotiate the credit agreement and loan documentation with the arrangers
until the financial close is reached @see Chater 2A. #he advisory stage has a heavy
service content and doesn?t reCuire a commitment for lending from the arty conD
ducting the activity.
#he factors that sonsors focus on when selecting an advisor are usually the
organiFation?s reutation* cometitive standing* exertise in secific sectors or seD
cific geograhical locations* and ossibly already existing relations with the sonsors
@excet* of course* in cases where they are able to reare the business lan without
needing assistance from external artiesA.
Figure .D% shows a league table for the to twenty advisors worldwide for the
eriod %11!N%11,. Considering the entire eriod analyFed* this reresents more than
(1J of total mandates awarded. "n fact* the market shows Cuite a high level of
concentration* even though the trend for this ercentage is decreasing as a result of
a rogressive fragmentation in the sector.
At a world level* PricewaterhouseCooers is the leader figuring in one of the two
to laces in the league table during the fourDyear eriod considered. Also the second
and third ositions are almost always occuied by 6rnst B Loung and MacCuarie*
although the latter was overtaken in %11, by 9PM:. As for the remaining ositions*
they show a much greater turnover* with a resence of both ure advisors @tyically the
cororate finance divisions of ma$or auditing firmsA and integrated commercial banks*
as in the case of A54 Amro* 'ocieMteM :eMneMrale* +oyal 5ank of 'cotland* or "4:.
Int: A;isor& 0 (inance
$reit A-ricole Inos%e>
Bank of America
De%tsc3e Bank
Ro&al Bank of Scotlan
BN" "aribas
Babcock 0 Bro6n
ABN Amro
In;estec E%ro!ean $a!ital
Ta&lor e #on-3
Ernst 0 =o%n-
D /D 2D JD KD +DD +/D
Korea De;elo!ment Bank
In;estec E%ro!ean $a!ital
De%tsc3e Bank
Ta&lor e #on-3
Babcock 0 Bro6n
ABN Amro
S%mimoto Mits%i
Grant T3ornton
Da;i .&le "(
Ernst 0 =o%n-
D /D 2D JD KD +DD +/D +2D
Korea De;elo!ment Bank
In;estec E%ro!ean $a!ital
Es!irito Santo In;estment
S%mitomo Mits%bis3i
Da;i .&le "(
Mi>%3o (inancial Gro%!
Ta&lor e #on-3
Grant T3ornton
ABN Amro
Ernst 0 =o%n-
D /D 2D JD KD +DD +/D +2D +JD
Ro&al Bank of Scotlan
BN" "aribas
In;estec E%ro!ean $a!ital
Ta&lor e #on-3
Grant T3ornton
Ro&al Bank of $anaa
ABN Amro
Ernst 0 =o%n-
D /D 2D JD KD +DD +/D
F " : < + 6 .D% :lobal Advisors by 4umber of Pro$ect Finance -eals @%11!N%11,A
'ource& Pro$ect Finance "nternational.
!/% C 8 AP # 6 + . Financing the -eal
#rends seem to be reasonably clear&
!. #he rogressive leadershi of the cororate finance divisions of ma$or consulD
tancy and auditing firms @PricewaterhouseCooers* 9PM: Cororate FiD
nance* and 6rnst B LoungA as credible cometitors to financial intermediariesK
%. Leading names in the international investment banking @Morgan 'tanley*
HPMorgan* Lehman 5rothers* Credit 'uisse First 5oston* Merrill LynchA* who
figured in league tables in the first half of the !((1s* have been overtaken by the
grou of large* integrated commercial banks. #his situation would seem to
confirm the cometitive sueriority of the >>integrated?? intermediary model
illustrated later in 'ection ..!.).
..!.% Arranging 'ervices
As oosed to advisory services* which reresent a business area oen to a wide range
of cometitors* arranging services is a cometitive area covered exclusively by comD
mercial banks that&
. 8ave good international coverage @this hels when structuring loan ools
involving banks from different countriesAK
. 8ave considerable financial strength and a huge amount of eCuity& in ro$ect
finance there is a symmetry between the siFe of the ro$ect and the siFe of the
intermediary that structures and negotiates the financing ool. And so it is
evident that even in smaller ro$ects @but that still will involve tens of millions of
dollarsA a bank must have a solid financial standing.
Arranging consists of a mandate from the 'P0 borrower to structure and manage
the financing contract. #he arranger @or mandated lead arrangerEMLAEas it is
often knownA must therefore be able to contact the widest ossible number of banks
interested in articiating in the deal and must then be the coordinator reresenting
all lenders. "n technical language this is referred to as syndication* and ro$ect finance
loans are a secial category of the wider grou of syndicated lending @'LA. When the
deal isn?t very large* common ractice is to grant the mandate to a sole arranger. 5ut
when the deal is siFeable and has an international scoe it is certainly more usual to
create a team of arrangers* each of which has a secific role @contacts with lawyers*
handling tax matters* gathering and udating documentation* etc.A.
Arranging always means that sonsors are given an underwriting guarantee of
availability of funds* even if no lenders are found who are interested in suorting
the ro$ect. "n order to grant an underwriting guarantee* the arranger bank must
have significant financial strength& "f the arranger should fail to lace the loan in the
market* the weight of the entire commitment would have to be borne by its financial
statements* with the conseCuence that it would have to back it u with eCuity.
Furthermore* underwriting all or art of the financing is also a guarantee much
areciated by banks asked to rovide funds for the 'P0* inasmuch as it imlies that
the arranger has confidence in the 'P0?s venture.
'onsors select arrangers based on factors similar to those used to choose the
. 6xerience gained in revious deals
. +eutation and track record
!/) Advisory and Arranging Activities for Pro$ect Finance Funding
. Flexibility as regards both unforeseen events arising after the mandate has been
given and ossible needs to revise the basic conditions @refinancingA underlying
the financing contract during the life of the ro$ect
. Cost of the financing
For many years this last oint was certainly considered the ma$or discriminating
factor. 8owever* cometition in the sector has recently been very heavy* and so
ricing differences have tended to be $ust a few basis oints. :iven this situation it
is the remaining factors that make the difference when selecting an arranger.
Market data for the to twenty arrangers worldwide classified in terms of amount
of arranged loans
indicate that they have a market share ranging from /)J to 2)J
of the total market for the eriod %11!N%11/ @Figure .D)A. #his share* however* is
droing and confirms the fact that there is rogressive fragmentation under way for
lending* as was already seen for advisory services. #his may indicate that the market
is growing faster than traditional lenders are caable of exanding their activities*
which means conditions are right for new cometitors to enter the market. "t should
be noted that* as oosed to the situation in the case of advisors* the grou of best
arrangers is highly homogeneous* inasmuch as the large ma$ority are clearly comD
mercial banks* in addition to the investment banking divisions of large banking
grous. As would be exected* there are no cororate finance divisions of large
consultancy and auditing firms.
Citigrou is the market leaderK it was number one three years out of four and was
still among the to five arrangers in %11!. 8owever* 6uroean banks are firmly
entrenched in the to art of the league and are greater in number than the American
..!.) "ntegration of Advisory and Arranging 'ervices
We have analyFed the roles of financial advisors and arrangers searately. "t is now
time to clarify if the same bank @whether an investment bank or commercial bankA
can simultaneously be both the financial advisor and the arranger of the deal*
rovided* of course* that the advisor has the financial strength to take on the task
of organiFing the ool of lenders.
As for the 'P0Dborrower* there are three alternatives.
!. #he first is to maintain a clearDcut division between the roles of financial
advisor and arranger& #he borrower decides not to allow its financial advisor
to articiate in the loan ool once this is structured @secialiFation modelA.
!. #his criterion was referred to the alternative of using loan amounts effectively disbursed. #he reason is
that each ro$ect necessarily has a mandated lead arranger @or more than one if the siFe of the deal warrants thisA*
who later sells more imortant or less imortant shares of the syndicated loan to other articiants. ClassificaD
tion by amount of arranged financing leaves total resources effectively invested unchanged but offers the
advantage of highlighting the more active intermediaries in the most imortant role for the success of the
deal. "t could be said that a classification by amount financed distorts ercetion of cometitive interaction in
the international syndicated loan arranging business field. "n fact* the risk would be to find banks with only
modest exertise in arranging but with massive balance sheet caabilitiesEure lendersEtoward the to of the
league* whereas less >>robust?? banks from a financial standoint but with the necessary exertise to structure
deals would be way down the list.
$reit A-ricole Inos%e>
Santaner $entral His!ano
Ro&al Bank of Scotlan
$reit L&onnais
Bank of America
Barcla&s $a!ital
De%tsc3e Bank
ABN Amro
#" Mor-an
BN" "aribas
Llo&s TSB Gro%!
#" Mor-an
Korea De;elo!ment
$a7a e A3orros
$reit L&onnais
$reit A-ricole Inos%e>
ABN Amro
Mits%bis3i Tok&o (inNl
De%tsc3e Bank
BN" "aribas
Mi>%3o (inancial Gro%!
Barcla&s $a!ital
Ro&al Bank of Scotlan
In 0 $omm Bank of $3ina
ABN Amro
De%tsc3e Bank
Banco Bilbao Vi>ca&a Ar-ent
Barcla&s $a!ital
Korea De;elo!ment Bank
Mits%bis3i Tok&o (inNl Gro%!
BN" "aribas
Ro&al Bank of Scotlan
$reit A-ricole@ $reit L&onnais
Santaner $entral His!ano
Banco Bilbao Vi>ca&a Ar-ent
Kookmin Bank
Mi>%3o (inancial Gro%!
$3iao T%n- Bank
Barcla&s $a!ital
ABN Amro
Mits%bis3i Tok&o (inNl Gro%!
BN" "aribas
Banco Bilbao Vi>ca&a
$a7a Mari
Barcla&s $a!ital
Mits%bis3i Tok&o (inNl
Santaner $entral His!ano
ABN Amro
Ro&al Bank of Scotlan
BN" "ribas
#an%ar&O#%ne /DDI
F " : < + 6 .D) :lobal Mandated Lead Arrangers for Pro$ect Financing -eals @%11!N%11/K in millions of <' dollarsA
'ource& Pro$ect Finance "nternational.
!// Advisory and Arranging Activities for Pro$ect Finance Funding
%. #he second alternative is exactly the oosite* in which case the borrower
decides beforehand that the chosen financial advisor will also be the arranger
in the second hase @integration modelA.
). #he third situation lies somewhere between the revious two* namely* where
the borrower decides to allow its financial advisor to comete with others for
the role of arranger.
#he advantages and disadvantages for each alternative are clearly exactly ooD
site in the case of total searation between advisor and arranger or integrated
management of the two mandates.
'earating roles between two different intermediaries has the ma$or merit of
reducing otential conflict of interest between the arty assigning the mandate @the
'P0A and the arty receiving it @the bankA. #he ure advisor simly rovides
a consultancy service where the aim is to get the ro$ect off the ground in order to
earn the associated success fees. "n this case the advisor has no interest in setting a
rice for the financial ackage that would be more remunerative in the absence of
cometitive offersEwhich might haen if the two roles are integrated. "n essence the
advisor should in rincile ensure imartiality so as to guarantee a balance between
the 'P0?s interests and those of lenders who will later disburse funds to the ro$ect
8owever* the secialiFation model has its significant drawbacks. First of all the
ure advisor doesn?t invest money in the deal* and so banks called on to suort the
ro$ect have no credible oints of reference* such as an underwriting commitment.
For this reason banks may fear that the advisor is trying to sell them an excessively
risky deal. #his in turn means the borrower will find it difficult to source the
necessary funds. Furthermore* the advisor may handle the mandate in a articularly
rudent manner and structure the security ackage in favor of lenders* with the aim
of making it easier to sell articiation in the loan during the syndication hase. #his
would naturally be a disadvantage for the borrower because the cost of borrowed
funds would be higher* making the deal less rofitable for sonsors. As a third oint*
the decisive disadvantage of the secialiFation model is that dulication of roles is in
any event costly for borrowers* even if the issues mentioned earlier were to be
7nce the advisor has comleted the mandate* the entire documentation is delivD
ered to the arranger. 5efore making contact with lenders* the arranger must review all
the legal* fiscal* technical* and administrative asects* which will often reCuire further
oinions on secific issues. Clearly this leads to additional costs that could be avoided
if the roles of advisor and arranger were combined within a single organiFation. #he
Cuestion of increased initial costs is a very touchy issue in smaller ro$ects* for which
cash flows generated in the oerations stage may not be sufficient to absorb strucD
turing costs and at the same time rovide an accetable return on the share caital
ut u by sonsors.
For all these reasons* data available indicate that a growing number of banks
oerate in the dual role of advisor and arranger* offering their clients convenient oneD
stoDshoing solutions and abandoning more extreme forms of secialiFation.
"n #able .D%* reared based on Pro$ectWare?s -ealogic data* information in the
advisor and arranger league tables are crossDmatched to verify the number of
arrangers who figure among leaders in the advisory market. For the first twenty
ositions* excluding %11%* the match between advisory and arranging roles is always
in the /1N.1J range. #he grou of integrated intermediaries comrises a more or less
!/. C 8 AP # 6 + . Financing the -eal
#A5L6 .D% 'trategic :rous of Financial "ntermediaries in the
Pro$ect Finance 5usiness @%11!N%11,A
4umber of #o %1 Arrangers in Position of #o %1 Advisors
%11! %11% %11) %11,
3 / / 3
"ntegrated "ntermediaries
HPMorgan Chase B Co
Citigrou "nc 5ank of
America Cor
-eutsche 5ank A:
'ocieMteM :eMneMrale
Credit 'uisse First 5oston @C'F5A
5arclays lc
A54 Amro 8olding 40 -resdner 9leinwort
Wasserstein @-9WA Australia B 4ew Zealand
5anking :rou Ltd #orontoD-ominion 5ank
Focusing on Arranging 'ervices
Canadian "merial 5ank of Commerce
Credit Lyonnais
4ational Australia 5ank
WestL5 A:
54P Paribas
"4: :roe
+oyal 5ank of 'cotland
Focusing on Advisory 'ervices
MacCuarie 5ank Ltd
Merrill Lynch B Co. "nc.
Morgan 'tanley
Lehman 5rothers "nc
'ource& Authors rocessing of Pro$ect Ware?s -ealogic data.
stable nucleus of !1N!% banks that resectively account for a significant /1J and //J
of the total worldwide advisory and arranging markets. "ntegration between comD
mercial and investment banking also seems to be beneficial for caital market
activities. Many integrated oerators also figure in leading league ositions for
ro$ect bond bookrunners @see 'ection ..!!A and so are making inroads on a market
segment traditionally dominated by investment banks* which tend to have much
more exerience in the bond market.
4arrowing the ga between the advisory and arranging business areas aears to
be much more aealing to banks with a strong commercial background* traditionD
ally focused on lending and therefore relatively more cometitive in arranging
services. "n fact* it is understandably less costly for the latter banks to extend their
!/2 Fee 'tructure
range of activities to include advisory services than it is for an investment bank to
increase its lending otential.
..% 7ther +oles in 'yndicated Loans
Comared to advisory and arranger roles* there is very little to say about other roles
layed by banks in ro$ect finance deals. #he reason is that these articiants only
lend money to the 'P0 or merely have a cash management and agency role. "t must
be said that not all roles mentioned will necessarily be found* esecially in smaller
deals* and many times the same roles are referred to by a different name from deal to
deal* deending on the MLA. "n any event* the tombstone for the deal shows the
name chosen for a given category of lender& #he recise role layed by each arty is
indicated in the credit agreement @see Chater 2A.
. Lead manager* manager* and comanager& #hese are banks that grant art of the
loan structured by the arranger. #he difference between the various categories is
based on the amount of articiation. <sually a minimum lending commitment
@tickerA is established to acCuire the status of lead manager* manager* or
comanager. A further differenceEbut only in some casesEis that lead manD
agers and managers can be called on to underwrite art of the loan together
with the arranger.
. Particiant& #his is a bank or financial intermediary that lends an amount below
the threshold established for the lending commitment. "t lays no other role
than to make funds available in accordance with the agreed contractual terms.
. -ocumentation bank& #his is the bank resonsible for the correct drafting of
documents concerning the loan @of course* roduced by legal firmsA as agreed by
the borrower and arranger at the time the mandate was assigned. #his role is
very delicate indeed. Whereas many documents are drafted in a relatively
standard manner* others* like those concerning covenants in favor of lenders
or default by the borrower @see Chater 2A* must be drafted ad hoc. "t is
essential that the latter guarantee lenders adeCuately and cannot be imugned
by sonsors or other articiants in the deal in the event of changes in the
market or the borrower?s situation.
. Agent bank& #his is the bank resonsible for managing the 'P0?s cash flows and
ayments during the ro$ect lifecycle. 4ormally the loan agreement establishes
that cash flows received are credited to a bank account from which the agent
bank draws funds based on riorities assigned to ayments.
..) Fee 'tructure
When a syndicated loan ool is organiFed* sonsors of the 'P0 agree to ay fees to
banks articiating in the funding in addition to interest on the funds used. 'onsors
basically ay two fees in a ro$ect finance deal& one for the advisory services and one
%. "n addition to this* the abolition of the :lassD'teagall Act in the <nited 'tates* which for years had
revented commercial banks from oerating in the investment banking field* has led to a reform of regulations
and thereby accelerated the trend toward integration as regards <.'. intermediaries.
!/3 C 8 AP # 6 + . Financing the -eal
for arranging services. #hese fees are only aid to the advisor=arranger* who then
transfers art of them to other banks articiating in the ool based on their role.
'o sonsors only have to make ayments to two artiesEthe financial advisor and
the MLAEunless of course both roles are covered by the same bank* in which case
fees are aid to only one arty. #he lead arranger then ays other banks in the ool
by returning art of the fees received to them. #he terms governing this rocedure
are established by the lead arranger in a fee letter that* if acceted* is returned
countersigned by each bank articiating in the ool.
..).! Fees for Advisory 'ervices
#he structure of fees ayable by sonsors to the financial advisor @aart from sums
reimbursed for exenses incurredA includes retainer fees and success fees.
. +etainer fee& #his covers the advisory?s costs during the study and rearation
hase of the deal. Hustification for the advisor?s reCuest for a retainer fee is based
on the need to use analysts? time to study the feasibility of the deal and maintain
contacts with arties initially involved in lanning it. "n certain cases* however*
reliminary studies can take a long time* and this leads to costs that will not be
aid if the ro$ect cannot be funded. #he retainer fee is intended to cover such
costs artiallyK market standards for this fee call for a monthly ayment by
sonsors ranging from !/*111 to %/*111 euro* established on a lumDsum basis.
. 'uccess fee& #his fee is aid by sonsors once the study and lanning mandate
has led to a successful conclusion. As oosed to the retainer fee* the success fee
is established on a ercentage basis* to rovide an incentive for the advisor not
only to structure the deal but also to organiFe it based on the most favorable
terms and conditions for sonsors. As for market standards* success fees range
from 1./J to !J of the debt valueEnot the ro$ect value.
#here are two ossible exlanations for this ractice.
!. "ntuitively* it wouldn?t make sense for sonsors to ay a fee on funds they
contribute themselves* which would be the case if the ercentage were calcuD
lated on the total investment. "t is much more logical to base the success fee on
the loan value.
%. Linking the fee to the loan amount gives incentives to the advisor to lan deals
with the highest ossible debtDtoDeCuity ratio* with obvious benefits on the rate
of return for the 'P0?s sonsors.
#he ercentage negotiated between the advisor and the sonsors will deend on
various factors. #he siFe of the ro$ect and the degree of innovativeness of the venture
will be two determining factors. #he level of the success fee will be inversely roorD
tional to the siFe of the ro$ectK a smaller ro$ect will command a higher ercentage.
#he degree of innovation inherent to the ro$ect will* in contrast* affect the fee
directlyK an extremely innovative venture will reCuire a greater effort by the advisor
and therefore will $ustify the reCuest for a more generous fee.
"f advisory and arranging services are rovided by the same intermediary* then
there will be a single fee structure to remunerate both roles. Again in this case there
will be reimbursement of exenses and a retainer fee for the study and reliminary
!/( Fee 'tructure
lanning hase. 8owever* the success fee will be established as a single ercentage.
Furthermore* it is normal ractice for the arranger to discount art of the retainer fee
@usually the eCuivalent of fees for two=three monthsA from the success fee agreed on
with the sonsors of the venture.
..).% Fees for Arranging 'ervices
'onsors ay a oneDtime arranging fee to the MLA as comensation for activities to
finaliFe structuring of the financing. "n certain cases a retainer fee is aid too*
although this doesn?t haen very often. Again* in this case the arranging fee is
established as a ercentage of the debt @for the same reasons discussed with reference
to advisory feesA. Market standards range from 1.2J to !J of the syndicated debt.
#he arranging fee can in turn concern the following.
. A ure arranging fee& "n this case the MLA oerates on a bestDeffort basis. #he
arranger commits to sonsors that best efforts will be made to syndicate
the loan but without guaranteeing a market resonse sufficient to cover fully
the financing reCuirements for the ro$ect.
. A fee for underwriting and arranging services& "n this case the mandated lead
arranger oerates on a committed basis. #hat is* as in the revious case* every
effort will be made to syndicate a ool of lenders. 8owever* in this case there is
the guarantee that the necessary funds will be made available in the event it
becomes imossible to find intermediaries interested in articiating in the deal.
#his guarantee is undoubtedly beneficial for the borrower but has a cost in the
form of a higher arranging fee.
After the sonsors ay the arranging fee* the mandated lead arranger returns art
of it to other banks articiating in the ool. "f the deal calls for other arrangers
@coarrangersA* then they are aid art of the arranging fee* usually roortional to the
amount underwritten. #he ercentage* however* is usually lower than that earned by
the lead arranger @on average between 1./J and 1.3J of the art of the loan
underwrittenA. "n essence the lead arranger earns a ercentage of the arranging fee*
calculated on the amount it has underwritten* and the sread between the ercentage
aid by sonsors and that recogniFed for coarrangers* calculated on the art not
underwritten by the lead arranger.
..).) Fees to Particiants and the Agent 5ank
Particiating banks @lead managers* managers* and comanagersA receive an uDfront
management fee ranging from %1 to ,1 basis oints on the amount each of them
lends. #he uDfront management fee also comes out of the arranging fee aid by
sonsors to the MLA.
Particiants are also entitled to a commitment fee* calculated on the basis of time*
with reference to the difference between the maximum amount made available to
the 'P0 @committed amountA and the amount disbursed at the beginning of each
reference eriod @for instance* a halfDyearA. #his means
CF Q @CL 6
A cf
!.1 C 8 AP # 6 + . Financing the -eal
where CF is the commitment fee aid* CL is the maximum committed loan to the
borrower* cf is the ercentage of the annual commitment fee* 6
is the amount
disbursed at the beginning of eriod t* and t is the number of days for calculating
the reference eriod. "n essence* the 'P0 ays lenders interest calculated at the agreed
rate on that art of the loan effectively used* whereas it ays a commitment fee on the
amount committed but not used. #he reason for this ayment is that while lender
banks may not have materially disbursed certain funds* they are reCuired to set aside
art of their caital for committed loans based on eCuity coefficients established by
each country?s banking suervisory authority @see Chater 3A. :iven that the bank?s
eCuity caital should be remunerated* the commitment fee should enable lenders to
obtain comensation to cover art of this notional cost. #he 'P0 ays the commitD
ment fee eriodically to the agent bank* which then returns it to banks articiating
in the ool based on funds each of them has committed. Lastly* the agent bank
receives a fixed annual ayment ranging from ,1*111 to !11*111 euro. #he amount of
this agency fee will deend on the number of banks articiating in the ool because
this is the variable determining the intermediary?s administrative task.
..)., 6xamle of Fee Calculation
#able .D) shows salient information as regards the structuring and syndication of
a ro$ect finance loan for an amount of %11 million euro. #he deal has been organiFed
by an advisor @5ank AA as a syndicate in which 5anks 5 and C are resectively
mandated lead arranger and coarranger on a committed basis @so the latter $ointly
underwrite the entire loan amountA. 5anks -* 6* and F articiate in the role of
managers for an amount of !/1 million euro. #his means that after the selling
rocess* the mandated arranger and coarranger will articiate as lenders for the
remaining /1 million euro @subdivided based on the underwriting agreement for an
amount of %/ million eachA.
Amounts recogniFed for each articiant are calculated as follows. #he adD
visor receives a success fee of 2/ basis oints calculated on %11 million* therefore
#A5 L6 .D) Particiating "ntermediaries and 'tructure of the -eal
'yndicated amount
Advisor success fee
%11*111*111.11 euro
Arranging fee !J
Coarranging fee 1.31J
<Dfront management fee 1.%1J
Members of the 'yndicate +ole Fee
Amount @euroA
Amount @euroA
5ank A Advisor 'uccess fee n.a. n.a.
5ank 5 Lead arranger Arranging fee !11*111*111.11 %/*111*111.11
5ank C Coarranger Arranging fee !11*111*111.11 %/*111*111.11
5ank - Manager <Dfront fee n.a. ,1*111*111.11
5ank 6 Manager <Dfront fee n.a. /1*111*111.11
5ank F Manager <Dfront fee n.a. .1*111*111.11







!.! Fee 'tructure
#A5 L6 .D, +eturn of the Arranging Fee @in euroA
Fee 5ank 5 5ank C 5ank - 5ank 6 5ank F
Arranging fee %*111*111.11
Coarranging fee 311*111.11 311*111.11 n.a. n.a. n.a.
<Dfront management fee )/1*111.11 /1*111.11 31*111.11 !11*111.11 !%1*111.11
#otal fees 3/1*111.11 3/1*111.11 31*111.11 !11*111.11 !%1*111.11
Arran-in- fee9 / million4e%ro
Total recei;e b&
manate arran-er9
D:KI million4e%ro
F " : < + 6 .D, Fees :ained by the MLA
!./ million euro. #he mandated lead arranger receives a total of % million euro @!J
of %11 millionA and then roceeds to return the fee to the other articiants as
indicated in #able .D,.
"n essence the arranger?s osition is as outlined in Figure .D,.
Clearly the ercentage return on caital invested @calculated in #able .D/A is
certain for managers* whereas it deends on the amount of the loan financed by
articiants for the arranger and coarranger. #his can be seen by comaring amounts
in the last line of #able .D, with those shown in the column >>Financed Amount?? in
#able .D).
"t should also be noted that the mandated lead arranger?s strong negotiating
osition means it can return lower ercentages for coarranging fees and uDfront
management fees* resectively* to coarrangers and managers. "n the receding
examle* the sum of coarranging fees and uDfront management fees is exactly !J.
#A5 L6 .D/ Percentage +eturn on Caital "nvested for Members of the Pool
5ank 5 5ank C 5ank - 5ank 6 5ank F
).,1J ).,1J 1.%1J 1.%1J 1.%1J
!.% C 8 AP # 6 + . Financing the -eal
#A5L6 .D. Allocation of Fees in the 6vent of a Low +eturn of the Coarranging and <DFront
Management Fees @in euroA
Fee 5ank 5 5ank C 5ank - 5ank 6 5ank F
Arranging fee %*111*111.11
Coarranging fee 211*111.11 211*111.11 n.a. n.a. n.a.
<Dfront management fee %.%*/11.11 )2*/11.11 .1*111.11 2/*111.11 (1*111.11
#otal fees !*1)2*/11.11 2)2*/11.11 .1*111.11 2/*111.11 (1*111.11
5ank 5 5ank C 5ank - 5ank 6 5ank F
,.!/J %.(/J 1.!/J 1.!/J 1.!/J
And so the MLA?s return on the deal is exactly the same as that of the coarrangers if
their bargaining ower is so strong that they manage to wrest the entire !J from the
lead arranger. <sing the same examle* but in this case assuming that only 1.2J is
returned to coarrangers as their fee and that the uDfront management fee is 1.!/J*
the distribution of income and ercentage returns would be as shown in #able .D..
.., "nternational Financial "nstitutions
and Multilateral 5anks
A secial category of bank that often articiates actively in international syndicated
loans is the international financial institution @"F"A* which lays a leading role in
ro$ect finance deals in develoing countries. #here are many of these institutions*
diversified in terms of their role* function* mission* investment caacity* and area of
activity. 5ut before illustrating the art they lay* it is necessary to describe briefly
the role of "F"s and how they have evolved.
A glance at data reared by the World 5ank @see #able .D2A shows that the role
of "F"s* including those formed in !(,, on the wave of 5retton Woods* have changed
over time. 'uort for develoment has seen a decrease in official financial flows
toward oor countries in favor of flows coming from the rivate sector. "n !((1
official flows accounted for /.J of flows to develoing countriesK in %11, the World
5ank estimate indicates a marginal weight of around 2J.
#A5 L6 .D2 4et Caital Flows to -eveloing Countries* !(21N%11, @in <'I billionsA
!(21 !(31 !((1 !((. %111 %11,e
4et flows of resources !!.!2 3%.3! ((.!, )!!.31 %1!.!1 )%).31
7fficial net flows @subsidies and loans grantedA /.)3 ),.(( //..1 )1./1 %).11 %%./1
4et rivate flows @eCuity and loansA /.2( ,2.3% ,).// %3!.)1 !23.!1 )1!.)1
7fficial flows @J of total flowsA ,3.%J ,%.)J /..!J (.3J !!.,J ..(J
Private flows @J of total flowsA /!.3J /2.2J ,).(J (1.%J 33..J ().!J
'ource& :lobal -eveloment Finance* various years.
!.) "nternational Financial "nstitutions and Multilateral 5anks
#A5 L6 .D3 4et 7fficial Financing to -eveloing Countries* !((1N%11) @in <'I billionsA
World 5ank "nstitute !((1 %111 %11! %11% %11)e
:rants @subsidies and aidA %2.21 %3.21 %2.(1 )!.%1 ),.)1
4et financing %../1 /.(1 %..(1 ,.!1 ..)1
Multilateral organiFationsU !/./1 1.(1 ),..1 !,.21 ../1
Concessional ..2 /.. 2.) 2./ ..,
4onconcessional 3.3 ,.2 %2.) 2.% 1.!
5ilateral organiFations !!.1 ..3 2.2 !1.. !%.3
Concessional 3./ 1.2 !.. !.3 !.1
4onconcessional %./ 2./ (.) 3.3 !!.3
#otal /,.%1 %%.31 /,.31 )/.)1 %3.11
U"nternational Monetary Fund @"MFA included.
'ource& :lobal -eveloment Finance* various years.
#he reason for the lower weight of official flows comared with a growth for
rivateDsector flows is due to budget roblems in industrialiFed countries and much
stronger resistance by the <.'. Congress as regards the financing and management of
international agencies that have Cuestioned financing for international aid organiFaD
#he effect of this dro in availability of funds for bilateral and multilateral
banks has been to make cooeration olicies more selective* and at the same time it
has reduced the amount of funding available for this urose. #his modified scenario
has led to a change in the role of banks* whereas the financial needs of develoing
countries have remained stable over time& 5anks no longer lend directly but instead
romote investments coming from the rivate sector by means of guarantees granted
by the latter @#able .D3A.
As we can see in #able .D3* disbursements by official sources @including grantsA
droed from I// billion in %11! to I%3 billion* based on the World 5ank estimate
for %11). #his dro reflects raid swings in multilateral loans in order to rovide
rescue ackages to countries facing crises and not a reduction of funds destined for
loans to develoing countries.
+aid growth of ro$ect finance in develoing countries in the !((1s was faciliD
tated by direct aid in the form of loans* guarantees* and insurance from bilateral and
multilateral agencies. At that time* an official agency articiated in the ma$ority of
ro$ect finance deals* even though the amount of official aid varied according to
the ro$ect sector and country concerned. "n resonse to the growing conviction that
rivate ro$ects are what really fuels develoment* many bilateral and multilateral
organiFations have changed their ob$ective* moving away from financing governD
ments of develoing countries and toward financing rivate deals. #heir willingness
to invest in highDrisk countries and sectors has certainly contributed to the growth of
ro$ect finance in recent years.
). A criticism made of "F"s @even bilateral onesA concerns their role* which ought to focus more on financing
sustainable develoment. As oosed to their rivate counterarties* these organiFations base their decisions on
olitical ressures as oosed to financial return on the investment. When the 5retton Woods organiFations
were set u* their >>tasks?? were to articiate in largeDscale* risky ro$ects. #oday their role has changed* both as
a result of increased flows of rivate financing and because of the realiFation that large infrastructure ro$ects are
not the best way to achieve sustainable develoment. 'ee Pearce and 6kins @%11!A.
!., C 8 AP # 6 + . Financing the -eal
..,.! Multilateral 7rganiFations
Multilateral financial organiFations lay a very imortant role in ro$ect financing
for develoing countries* for three reasons.
. #heir institutional mandate allows taking on financial commitments even in
countries with a high olitical risk.
. #hey have layed a leading role in rivatiFation olicies.
. #hey continue to romote financing in the rivate sector and rivate investment
in the infrastructure sector.
"n rincile* multilateral financial organiFations should counterbalance the trend
for rivate financial flows by increasing loans in eriods of reduced interest from the
financial market. Among the multilateral financial organiFations* the most imortant
in terms of olitical weight and financing volume is the World 5ank :rou.
"t comrises four ma$or agencies through which the World 5ank contributes to
develoment in member countries in a wide variety of ways* working together with
both rivate and ublic arties& the "5+- @"nternational 5ank for +econstruction
and -evelomentA* "-A @"nternational -eveloment AssociationA* "FC @"nterD
national Finance CororationA* and M":A @Multilateral "nvestment :uarantee
AgencyA. "n addition to the World 5ank* which oerates at global level* there are
other international multilateral financial organiFations @ma$or regional develoment
banksA that focus their activities on a secific geograhical area. 'ome have a
continental scoe and mission @6uroean "nvestment 5ank in Luxembourg* Asian
-eveloment 5ank in Manila* African -eveloment 5ank in Abid$an* "nterDAmeriD
can -eveloment 5ank in WashingtonA. #hen after the fall of the 5erlin Wall* the
6uroean 5ank for +econstruction and -eveloment @65+-A* based in London*
was added. #he regional bias of these banks is also seen in their governing bodies*
given that stakeholders reflect the continental focus of their activities.
#able .D( shows the financial contribution of multilateral financial organiFations
at the end of %11,. #he differences between the various agencies are Cuite evident.
From the standoint of amounts* the most exosed are the World 5ank and 6"5*
whereas in terms of investment in the rivate sector "FC @!11JA and 65+- @2/..JA
lay a leading role.
#A5 L6 .D( Financial Contribution of Multilateral 5anks* %11, @in <'I billionsA
5ank Portfolio Amount "nvested in Private 'ector J "nvested in Private 'ector
"5+- and "-A !1,.,1 n.a. !2.11J
"FCU 3.(1 3.(1 !11.11J
Asian -eveloment 5ank /.)1 1./) !1.11J
African -eveloment 5ankUU !.%. n.a. ..11J
65+- ..!( ,..3 2/..%J
6"5 (3.)% n.a. !%./1J
"nterDAmerican -eveloment 5ank /.,. 1.!( ).,3J
U +efers to FL ending -ec. )!* %11/.
UU Loan arovals.
'ource& Multilaterals? Annual +eorts* various years. Where data are missing* estimates have been made by the author.
!./ "nternational Financial "nstitutions and Multilateral 5anks
#A5 L6 .D!1 Multilateral 5ankNCommitted Funds for "nfrastructure Works* !((/N%11% @in <'I billionsA
!((/ !((. !((2 !((3 !((( %111 %11! %11%
#otal funds committed /%.)3 2,.12 ,/.(/ ,).!2 ,,.%% ,).() ,).1% ,%.),
#otal funds for "nfrastructure works !2.3 !3.) !... !2.2 !).3 !/.1 !,.2 !../
J of total committed funds )).(3 %,.2! )..!) ,!.11 )!.%! ),.!/ ),.!2 )3.(2
Asian -eveloment 5ank ).,% %.3/ !.(1 %.)) !.2/ %... %.%. %.33
African -eveloment 5ank 1.!2 1.13 1.%! 1.)2 1.%3 1.!. 1.)2 1.,.
65+- !.,1 !..) !.12 1.32 1.(% 1.2( 1.!. !.,.
6"5 %... %.,) ).1. ).,3 %.(( ).2, ).// ,.,1
"5+-="-A 2.)3 2.(/ ...! ...2 /.%3 ,.%( ,.(3 ,..1
"nterDAmerican -eveloment 5ank %.%% %..2 %.31 ).!! !.23 !.21 1.(( !.11
"FC 1.)) 1.). 1.,( 1.)( 1.%( 1.,2 1.)% 1.,(
"slamic -eveloment 5ank 1.%! 1.!/ 1.%( 1.%. 1.)/ 1.,2 1.,3 1.,/
M":AU 1.!, 1.!/ 1.!, 1.!3 1.%1 1.2/ 1./2 1.3.
U Political risk insurance coverage.
'ource& :lobal -eveloment Finance* %11,.
"n contrast* #able .D!1 shows multilateral bank commitments for loans to develD
oing countries concerning investments in infrastructures.
#he table reveals that funds committed for infrastructure works saw a slowdown
in !((( but then grew rogressively in terms of both amount and ercentage inciD
dence. A further asect the table highlights is that as oosed to the early !((1s*
when the World 5ank was the ma$or source of multilateral financing to emerging
countries* in recent years the ma$or regional develoment banks taken together have
rovided about the same level of resources as the World 5ank.
..,.!.! World 5ank :rou
#he World 5ank was founded in !(,, at 5retton Woods during a conference that
saw the articiation of the governments of ,/ countries. 7riginally called the
"nternational 5ank for +econstruction and -eveloment @"5+-A* it was set u
rimarily to finance ostwar reconstruction in 6uroe. 8owever* comared to the
early days* the aim to reduce overty in the world has taken on greater imortance.
#he World 5ank :rou includes five interlinked agencies in which the stakeholders
are governments of member countries that have ower to make final decisions. 6very
agency has a distinct role in the common mission to fight overty and romote
sustainable growth in less develoed economies* even though from the standoint of
ro$ect finance the two most significant are "FC and M":A* because they focus
,. #he World 5ank?s most recent strategic goals were agreed on in %11% by !3( countries during the
Millennium 'ummit of the <nited 4ations* at which the Millennium -eveloment :oals were defined. More
recisely these were& @!A to eliminate the roots of overty and hungerK @%A to ensure universal rimary educationK
@)A to romote eCuality between men and women and give more ower to womenK @,A to reduce infant mortalityK
@/A to combat A"-'* malaria* and other diseasesK @.A to ensure a sustainable environmentK @2A to develo global
cooeration for growth.
!.. C 8 AP # 6 + . Financing the -eal
#A5L6 .D!! #arget for "ntervention of World 5ank :rou Agencies
4umber of
Main Activity
#arget for
"5+-& "nternational 5ank
for +econstruction and
"-A& "nternational
-eveloment Association
"FC& "nternational
Finance Cororation
M":A& Multilateral
"nvestment :uarantee Agency
"C'"-& "nternational Center for
'ettlement of "nvestment -isutes
!(,, !3, Loans* guarantees*
eCuity investments*
!(.1 !., Loans at heavily
subsidiFed conditions
!(/. !2/ Loans* eCuity
arranging of loan
syndicates* indirect
methods of suort
!(33 !.) 'timulates foreign
investment in
develoing countries
by offering guarantees
against olitical risks
!(.. !)( -eveloing foreign
investments in
emerging markets
by means of legal
advice and settling
disutes on investment
Cuestions at
international level
countries with
average income
and high credibility
Poorest develoing
6ntirely rivate
ro$ects in
Potential investors
in develoing
#arget investment
countries for
foreign oerators
mainly on rivate investment. #able .D!! gives a summary of certain elements that hel
understand the mission of the different agencies.
"5+- @"nternational 5ank for +econstruction and -evelomentA& "5+- is*
effectively seaking* the World 5ank because both share the same mission and
intervention strategy.
'ecifically with regard to ro$ect finance deals* the agency oerates by means of&
. -irect loans
. Partial risk guarantees
. Partial credit guarantees
. 6nclave guarantees
-irect loans encourage the rivate sector by means of cofinancing deals* known as
5Dloans. "n direct loan schemes the rivate sector makes loans to develoing country
governments together with "5+- @which grants an ADloanA and benefits from the
rivileged status of the bank?s loans. #o finance ro$ects directly in the rivate sector
the bank must use governments as intermediaries& "5+- and rivate banks @resecD
tively with the AD and 5DloansA finance governments that* in turn* finance rivate
arties. An alternative is that "5+- and rivate banks lend directly to the 'P0 after
obtaining guarantees from the host government. 7erations of the 'P0 are artly
conditioned by limits and rules imosed by "5+-* in conformity with international
cometitive bidding @"C5A rocedures.
#he artial risk guarantee covers olitical risks and is available for all countries
entitled to receive World 5ank loans* with the excetion of very lowDincome countries
that can be insured by guarantees roosed by M":A @see later in this chaterA. #he
guarantee is available for investors that enter into financing contracts directly with
host governments @in other words* the borrower is a government bodyA or with 'P0s
guaranteed by the host government or with counterarties of the 'P0 backed by
government guarantee.
#hese conditions exlain why this facility is used in very few ro$ect finance deals.
Wherever ossible the World 5ank tries to use instruments made available by its
other agencies @above all "FC and M":AA* thereby avoiding direct intervention*
which only occurs in the form of a guarantee of last resort if&
. 4o rivate financing is available
. Financing from "FC or risk coverage from M":A is insufficient
'o the ro$ects concerned are very large and comlex and intervention of the World
5ank is indisensable in order to structure the total financial ackage. #he guarantee is
granted to the 'P0?s lenders and covers the following risks @see Chater )A&
. Currency convertibility risk
. #ransferability and exroriation risk
. Change in law
. 5reach of contract risk
"nstead the artial risk guarantee doesn?t cover the risk of olitical violence* war
and exroriation* which must be handled directly with the host government by
means of rules defined in the government suort agreement.
#he artial credit guarantee is a facility used to resolve a significant roblem in
the syndicated loan market for financing infrastructure ro$ects. 'ome* esecially
very comlex ones* reCuire very long reayment lans that rivate banks find very
difficult to finance. "n this case* the World 5ank can oerate as the guarantor for
caital reayments and interest due in eriods beyond those that credit committees of
rivate banks consider accetable* given constraints imosed by their internal credit
olicies. #he same guarantee can also cover bullet caital reayments @namely*
a single reayment at the end of the loan eriodA that the 'P0 intends to refinance.
-esite its imortance as a catalyst for rivate caital investment* only limited use
has been made of this instrument.
#he enclave guarantee is a facility reserved for soDcalled enclave ro$ects* that is*
ro$ect finance deals set u to realiFe ro$ects focusing on exorts @freCuently seen in
the oil and gas sector for realiFation of ielines to exort natural gas or oil
roduction in offshore sitesA. +evenue flows for these ro$ects are in foreign currency
from a source outside the host country @for instance* from an escrow account outside
the country or from an 'P0 domiciled outside the host country boundariesA and so
rotect the ro$ect from two basic risks.
. Foreign currency is never transferred to the host country* and therefore there is
no ossibility to limit its transfer to countries where the sonsors and creditors
are residentK furthermore foreign exchange available outside the country can be
withheld directly to service the debt @transferability riskA.
. +evenues are stated in foreign currency* and so sonsors and lenders have no
currency risk. 5ecause both currency risk and transfer risk are covered* the
enclave guarantee can be reCuested to cover additional risks* such as exroriD
ation* civil war* or changes in regulations.
"-A @"nternational -eveloment AssociationA& "-A rovides financial suort for
oorer countries that fail to meet criteria for access to World 5ankD"5+- financing.
-eveloment finance suort is in the form of very longDterm loans @)/N,1 yearsA*
with long grace eriods @u to !1 yearsA and with no interest ayment* which is
relaced by an annual servicing fee of 1.2/J. #he scoe of interventions
is develoment of human caital* basic infrastructures* suort for setting u stable
olitical structures* and institutions in very oor countries in order to romote
sustainable growth. #he main aim is to reduce ineCualities between countries and
within countries themselves* articularly as regards rimary education and
availability of water and health services. "5+- and "-A are managed based on the
same guidelines* share the same staff and facilities* and use the same criteria when
evaluating ro$ects. #he only difference is that they are financed by different sources.
Whereas the World 5ank obtains funding in international financial markets* most of
"-A?s oerating resources come from contributions made by the governments of
develoed countries.
5earing in mind the target countries and sectors concerned* "-A?s role in the
ro$ect finance field is limited to indirect loans* similar to those offered by "5+-* and
a guarantee rogram for ro$ects that fail to Cualify for enclave guarantees. "-A also
rovides rivate investors with guarantees against currency convertibility risk in the
event such guarantees for investments are unavailable.
"FC @"nternational Finance CororationA& "FC is the multilateral agency that
rovides financing @loans and eCuityA for rivate ro$ects in all sectors in
develoing countries. 7f all World 5ank agencies* this is the only one that doesn?t
reCuire the direct intervention @or a guaranteeA of the host government to roceed
with financing a venture. 6ven though "FC focuses mainly on rivate ro$ects* it can
also rovide financing for a comany that has a ublicDsector artner* rovided there
is a rivate investor involved and that the comany is managed as a rofitDmaking
venture. "t can finance !11J locally owned comanies or $oint ventures with local
and foreign artners.
"FC romotes sustainable growth in the rivate sector mainly by doing the
. Financing rivate ro$ects in develoing countries
. 8eling rivate comanies in develoing countries to obtain financing in interD
national financial markets
. Providing consultancy and technical assistance services to comanies and govD
As far as ro$ect finance deals are concerned* "FC offers a series of financial
roducts and services to comanies in member develoing countries* it hels to
structure financial ackages* to coordinate financing from foreign banks* from
local banks* from comanies* and from exort credit agencies @6CAsK see 'ection
../.%A. #o be eligible for "FC financing* ro$ects must be rofitable for investors*
generate benefits for the host country?s economy* and observe environmental and
social guidelines imosed by the agency.
'ervices offered to investors are&
. Loan rograms
. 6Cuity investments
. -erivatives to set u hedging olicies
. :uarantees
Loan rograms involve "FC cofinancing with rivate funding. #o ensure articiD
ation of rivate investors and creditors* "FC cas the share of financing it makes
available for each ro$ect& 7n average* for every I! financed by "FC the other
investors ut u over I/. #he current limit is a ca of I!11 million er individual
ro$ect* and with a limit of %/J of total costs for new ro$ects* )/J for smaller
ro$ects* and /1J for exansion of reexisting ro$ects. "FC finances are based
on market conditions. @#here are no subsidies for borrowers.A Moreover* there is
no reCuirement for direct guarantees from the host country government* as oosed
to other World 5ank agencies. #he term of loans can be u to %1 years.
"n addition to financing by means of direct loans* "FC also has a 5Dloan rogram.
@5Dtye loans are syndicated loans.A #his is based on similar rinciles to the World
5ank rogram discussed earlier in this section. "n 5Dloan rograms "FC sells shares of
the loan to commercial banks but continues to act as if it were the lender of record*
administering the loan and being the reciient of guarantees. "n this way a borrower
cannot ay "FC and declare default as regards other members of the ool* given that
all ayments are divided roortionately between ADloans @granted directly by "FCA
and 5Dloans. -efault on a 5Dloan eCuates to breach of contract with "FC. #he fact
that "FC is lender of records as far as 5Dloans are concerned has ositive effects for
members of the ool* inasmuch as rivileged creditor status alies to loans granted
as art of the 5Dloan rogram. "n this way banks can avoid setting u risk rovisions
if the country in which the ro$ect is financed is insolvent* given the rivileged status
assigned to such lenders.
"n addition to direct loans and cofinancing in AD and 5Dloan rograms* "FC can
hold a minority stake @usually between /J and !/J* u to a maximum of )/JA in the
eCuity of 'P0s as a assive investor according to the rivate eCuity investor aroach
@eCuity investment rogramA. "n other words* "FC doesn?t intervene in the 'P0?s
strategic and oerating decisions. #he average duration of investments is longer than
in the rivate eCuity market and can extend u to 3N!/ years. Preferably sale of eCuity
takes lace on the stock exchange in the country where the 'P0 is set u. 6Cuity
investment is rather conservative and usually reCuires ayment for shares at ar value
without any share remium reserve to reay sonsors for study* initial develoment*
and startDu costs. #here is always a otential conflict of interest in deals where "FC
is both an eCuity investor and lender of record for a 5Dloan rogram for the same
ro$ect. 'onsors and lenders clearly have oosite interests as regards the amount of
eCuity in a ro$ect?s financial structure& #he former want to minimiFe it* whereas the
latter subordinate high financial leverage to erfect mitigation of ro$ect risks. "f "FC
were an eCuity investor* it could roose a more aggressive debtDtoDeCuity ratio and
lower cover ratios @see Chater /A to banks articiating in the 5Dloan rogram.
#he third tye of assistance* which "FC began offering in the early !((1s*
concerns derivatives. #hese involve swas to hedge interest and exchange rate risks*
otions* forward contracts* and other derivative roducts to hel clients manage
financial risks in the best ossible manner. -erivatives are offered because 'P0s in
develoing countries find it difficult to access international caital markets. "FC acts
as an intermediary. "t mobiliFes articiation of commercial banks in these deals by
sharing risks and romoting develoment of local caital markets.
#he fourth tye of aid rovided by "FC is the guarantee rogram. "n fact* artial
credit guarantees are given similar to those issued by the World 5ank* which cover all
credit risks during a secific eriod of the loan and can therefore be used to extend
the reayment eriod of rivateDsector loans.
As can be seen in #able .D!%* even today the ma$ority of "FC?s financial activities
concerns loans* which account for over 21J of total funds allocated in the years
analyFed. Commitments in terms of eCuity contribution have instead decreased
rogressively as a ercentage of the total committed ortfolio. Furthermore* starting
in %11) there has been a constant increase in the number of ro$ects.
M":A @Multilateral "nvestment :uarantee AgencyA& M":A contributes to the
World 5ank?s mission by roviding olitical risk coverage to lenders and investorsK
in this way it makes investment in develoing countries more attractive for rivate
foreign caital.
M":A offers coverage for all !.) World 5ank member countries. "ts own caital
is for the most art rovided by members and a smaller roortion by the World
5ank as a contribution to caitaliFe M":A. Within the World 5ank :rou* and
including regional develoment banks* it is the only agency that offers coverage for
investments against olitical risks. "n addition to this main activity* M":A has
a secial section dedicated to consultancy @"M'* "nvestment Marketing 'ervicesA*
the aim of which is to hel develoing countries attract foreign investment. "n this
area M":A offers both consultancy services on reCuest and investment information
and tries to hel comanies in member countries by develoing necessary skills.
As a World 5ank :rou agency* M":A only offers coverage based on an
agreement with the host country. "n line with its aims to romote economic growth
and develoment* investment ro$ects must be financially and economically viable.
Coverage for olitical risks includes both debt financing and eCuity investments* u
to a maximum coverage of (/J of debt service @rincial reayment lus interestA
and eCuity investment* with a maximum limit of <'I%11 million er ro$ect and
<'I,%1 million er country. #he insurance remium ranges from 1./J to !.2/J of
the insured sum* and the contract has a duration of !/ years* with a ossibility of u
#A5 L6 .D!% "FC "ntervention in the Private 'ector by #ye of Facility* %11!N%11/ @in <'I billionsA
%11! %11% %11) %11, %11/
4ew ro$ects committed %1/ %1, %1, %!2 %).
#otal financing committed ).(1 )..1 /.11 /..) ..,/
Financing committed for "FC?s own funds %.21 ).!1 ).(1 ,.2/ /.)2
#otal committed ortfolioU /., /.3 /., !2.( !(.)
6Cuity as J of ortfolio %/J %)J %!J %1J !2J
Loans as J of ortfolio 2/J 2!J 2!J 2,J 22J
'tructured finance roducts @including guaranteesA as J of ortfolio n.d. /J .J /J /J
+isk management roducts as J of ortfolio n.d. !J %J !J !J
U "ncludes offDbalanceDsheet roducts such as structured finance and risk management roducts.
'ource& "FC* Annual reort* various years.
to %1 years in excetional cases. #he insured arty has an otion to cancel the
coverage after ) years.
"n addition to direct insurance* M":A manages the soDcalled C<P @Cooerative
<nderwriting ProgramA. #his rogram is very similar to the 5Dloan rograms manD
aged by "5+- and "FC* with the difference that it concerns insurance contracts and
not loans. M":A cooerates with rivate insurance comanies by taking on risks
itself and then reinsuring them with rivate insurers. :iven that M":A rovides
coverage for olitical risks* the following are the negative events covered.
. Currency convertibility and transferability& "f convertibility becomes imossible*
the investor can deliver the nonconvertible currency to M":A* for which the
agency ays in a guaranteed currency. -amage caused by delays in transferring
funds can also be covered.
. 6xroriation& "f eCuity investments are exroriated* M":A reimburses the
net book value of the insured investment. As for exroriation of funds* M":A
ays the amount insured for blocked funds. "n the case of loans and loan
guarantees* M":A insures the outstanding rincial and interest due but not
aid. 8owever* M":A guarantees do not cover measures taken by host govD
ernments acting in good faith and relating to a legitimate right to regulate and
control its own country.
. War* civil war* terrorism* sabotage& 'hould such events occur* M":A insures
both hysical damage to the ro$ect and damage caused by business interruD
tion that can comromise the ro$ect?s viability. "n these cases M":A reimD
burses the net book value of the eCuity investment and the value of the
outstanding rincial and interest due not aid as a result of the damaging
. Failure to ay damages awarded by arbitration& "f the host government causes
a breach of contract and the 'P0 has been awarded damages by a court or in
international arbitration roceedings* in some cases the host government chalD
lenges the award and ayment of damages is delayed. "n such cases M":A can
ay comensation and also an advance while awaiting the final outcome of
..,.% +egional -eveloment 5anks
+egional develoment banks are also multilateral financial agencies* but they oerate
in a more restricted geograhical area than the World 5ank. #hey focus on one
geograhical area only @usually a continentA* and their share caital is held by
governments of countries in the area concerned.
..,.%.! 6uroean "nvestment 5ank @6"5A
#he 6uroean "nvestment 5ank* the 6uroean <nion?s @6<?sA financial agency* was
set u in !(/3 by the #reaty of +ome. Members of the 6"5 are 6< member countries
that subscribed to the bank?s eCuity caital. #he agency is both legally and financially
indeendent from the 6uroean <nion* but its mission is to romote the 6<?s
ob$ectives by offering longDterm financing for secific ro$ects meeting strict criteria
in terms of evaluation and selection of the ventures concerned. "n this way* it contribD
utes to economic integration within 6uroe and greater economic and social cohesion.
6"5 articiation in financing investment ro$ects is based on a reliminary
evaluation and ongoing monitoring of the venture concernedK therefore* 6"5 oerates
according to best ractices in the rivate banking sector. #o receive 6"5 suort*
ro$ects must be viable from the economic* technical* environmental* and financial
standoints. 6"5 loans are essentially financed by funding on caital markets. :iven
its secial ownershi structure* it has a maximum @AAAA international bond market
rating* and so the bank can roose advantageous ricing to ro$ect comanies.
Furthermore* as in the case of "FC* 6"5 continually seeks to involve rivate caital in
ro$ects it finances* acting as a catalyst for rivate lenders in order to exand
available funds.
#he scoe of 6"5?s activities can best be exlained by dividing them into two
. 0entures within the 6uroean <nion
. 0entures outside the 6uroean <nion
0entures Within the 6uroean <nion& As regards 6< countries* 6"5 finances
ro$ects that contribute to economic growth and benefit cohesion within the 6<.
:uidelines for financing are very recise& Particiation can cover u to /1J of the
total ro$ect cost for a duration of u to !% years for industrial ro$ects or %1 years
for infrastructure ro$ects. "n the case of PPP ro$ects @ublicNrivate artnershisK
see laterA* the duration can exceed %1 years @a common situation in the social
infrastructure sector* such as hositalsA and even extend to )1 years for urban
develoment and local transort ro$ects. At the end of %11)* PPP ro$ects with
a duration exceeding %/ years accounted for about oneDCuarter of the 5ank?s PPP
Conditions roosed to 'P0s are more favorable than those offered by the
rivate banking sector* thanks to 6"5?s ability to obtain funds in the bond market
at a lower cost. A further feature of these loans is that there is no arranging fee* as is
normally the case with syndicated loans* but only an agency fee to cover the bank?s
oerating costs. As in the case of rivate bankingDsector loans* the bank can lend at a
variable or fixed interest rate.
While there are clearly financial advantages* borrowers obtaining funds from 6"5
have to accet some very stringent conditions.
. Pro$ects undergo an inDdeth reliminary analysis to determine whether they
are technically sustainable and what benefits can be obtained from the venture*
even when there are guarantees from the rivate banking sector.
. Pro$ects must meet 6< environmental standards and follow the 6<?s rocureD
ment rules and rocedures.
. As oosed to rivate banks* 6"5 doesn?t take on ro$ect comletion risk* in
other words* risks associated with extra costs* delays* or erformance before
comletion of the ro$ect and its startDu hase @see Chater )A. #he bank may*
however* accet risks in the ro$ect?s ostcomletion stage* although not imD
mediately after oerations begin and after an evaluation of initial erformance.
#he only excetion from these guidelines is the 'tructured Finance Facility
@'FFA* created in %111 for the urose of roviding senior debt* meFFanine debt*
and derivative instruments to hedge risks. <nder the terms of this facility and
deending on funds set aside* the 6"5 can take on recomletion risk and also
oerating risk during initial ro$ect startDu hases.
. #o cover this very restrictive olicy as regards riskDtaking* 6"5 reCuests comD
mercial bank guarantees to cover its own commitments at risk. #hese guarantees
must cover outstanding debt at a certain date* interest ayments for . months*
and a figure to cover breachDofDcontract risk. 5anks must be able to meet eligible
criteria based on a minimum rating level or rovide cash guarantees.
0entures 7utside the 6uroean <nion& 7utside the 6<* 6"5 finances ro$ects based
on mandates received from the 6< defining the maximum amount that can be
financed in every area. #hese mandates concern&
. Future memberDstates of the 6<
. Certain countries in the Mediterranean area* develoing countries* and the
For loans outside the 6<* 6"5 takes on the olitical risk in its most restricted
sense* namely* the risk of currency convertibility and transferability* olitical
violence* and exroriation risk. "nstead it doesn?t cover breachDofDcontract or
creeingDexroriD ation risk @see Chater )A. 'o the bank reCuires comlete bank
guarantees to cover business risks. Furthermore* 6"5 doesn?t cover subsovereign
risks and so reCuests a guarantee from the host government or lends directly to that
government @in which case it can have a direct interest in the ro$ectA* which in turn
loans the funds to the 'P0.
6"5 Particiation in PublicNPrivateDPartnershi @PPPA Pro$ects& As art of its
olicy to rovide suort for growth of 6< member states* starting in the second
half of the !((1s the bank increased its articiation in ublic infrastructure ro$ects
financed with rivate caital* with the aim of enabling the ublic sector to benefit
from advantages deriving from 6"5?s articiation in financing these tyes of
ro$ects. For PPPs the bank alies the same valuation and selection criteria used
for other ro$ects. 0entures must be financially sound* economically and technically
viable* and comatible with the bank?s 6< environmental guidelines* and
rocurement contracts must be awarded based on cometitive rocedures and rules
established by the 6<. "n fact the bank articiates right from the early stages by
working with otential bidders during the cometitive hase running u to award of
contract so that bidders can ass on art of the benefits deriving from 6"5?s
articiation as a lender to the ublic sector.
As far as lending olicies are concerned* however* a PPP ro$ect has to comly
with the same rules alying to a !11J rivate ro$ect. PPPs financed by 6"5 need to
resent guarantees from the banking or monoline insurance sectors @see Chater ,A*
excluding recomletion and early oerating stage risks @excet ro$ects financed by
a 'tructured Finance FacilityA* which must ass stringent tests in terms of cover
ratios. #he involvement of the ublic sector as the final debtor is considered very
imortant. "n many PPPs* in fact* the ublic sector is the sole urchaser of the
roduct or service @take* for instance* the case of hosital or school constructionA*
and so there is no market risk. "t should also be noted that the average amount of
articiation in PPPs is not very significantK this means the bank is able to limit
concentration risk as regards its loan ortfolio.
..,.%.% Af-5 @African -eveloment 5ankA
Af-5 is a multilateral regional develoment bank whose stakeholders are the /)
African nations and %, nonDAfrican countries from the Americas* 6uroe* and Asia.
"t was set u in !(., and began oerations in !(.2 to romote the economic growth
and social rogress of its regional members* both individually and collectively. #he
bank romotes ro$ects in the infrastructure field and with a articular emhasis on
PPPs* for which it rovides financial suort in the form of loans and eCuity
investments. "t also rovides&
. Advisory services to rivate arties as regards structuring deals
. Advisory and suort services to ublic bodies to hel them create a favorable
institutional environment from the legal and regulatory standoints and to
ensure that they are caable of managing their relations efficiently with rivate
As with other multilateral agencies* the bank?s role is to integrate rather than
relace sources of rivate caital. "t stimulates and rovides suort for industrial
investors and rivate lenders by sulying financial assistance to financially sound
ro$ects. "n this way the bank acts as a catalyst to obtain resources from the rivate
sector @articularly from multilateral and bilateral artnersA.
Loans& "n the ro$ect finance field Af-5 mainly articiates as a lender in its own
right* as regards both infrastructure and PPP ro$ects and those in which no ublic
body is involved. #he Private 'ector -eartment @7P'-A handles direct loan deals
without a sovereign guarantee and rovides technical assistance services. -irect
financing* which includes senior debt financing and roviding guarantees* has been
used to finance imortant rivate infrastructure ro$ects in Africa in the ower*
telecom* and windDfarm sectors.
"n the ro$ect finance field the bank can arove loans to create* exand* and
moderniFe lant in various sectors @excluding the real estate and commerce sectorsA.
#he total amount of assistance for each 'P0* including loans* guarantees* and
underwriting* doesn?t normally exceed oneDthird of the total ro$ect cost* whereas
the bank?s eCuity investment will usually not exceed %/J of the 'P0?s caital stock.
Furthermore* it will not act as the sole large lender for the ro$ect. #otal ro$ect costs
must not be less than <'I( millionK the only excetion is if smaller ro$ects have high
growth otential and roduce significant sinDoffs for the rest of the economy.
#he bank can lend longDterm in hard currency. Loans are available in <.'.
dollars* euro* ounds sterling* and yen. #here is also a growing number of loans in
local currency* esecially the 'outh African rand. "nterest rates @established with
reference to L"57+ or 6uribor interbank ratesA and other fees are established based
on market conditions in accordance with the risk level of the ro$ect being financed.
Fees include those usually alied in the case of syndicated loans @see 'ections ..).!
and ..).%A. Loans granted by the bank are guaranteed to limit credit risk. #he
standard security ackage @see Chater 2A* reresented by mortgages on lant*
ledges* and floating charges on the 'P0?s cash balances* inventories* and other
current assets* is normally reCuested and evaluated case by case according to the
risk level of the venture. :uarantees can also be reCuested from lenders or sonsors
of the 'P0. Maturities generally range between / and !/ years* with adeCuate grace
eriods consistent with trends for ro$ect cash flows. Longer maturities are an
excetion and mainly involve comlex infrastructure ro$ects.
:uarantees& #he bank can issue guarantees to lender banks or business artners
@domestic and internationalA to cover servicing the debt. Claims are settled by the
bank in currencies available for direct lending activities.
6Cuity& #he bank can invest in an 'P0 with an eCuity contribution for common or
referred stock or other articiating securities* mainly in local currency. As with
other multilateral and bilateral agencies* the bank acts as a assive stockholder and
doesn?t intervene in the management of the 'P0?s business. +ight at the outset*
however* it does establish the way to exit from the investment* which is referably
by selling stock held on the local market and only after the ro$ect becomes
oerational and shows a good track record in terms of erformance.
..,.%.) "-5 @"slamic -eveloment 5ankA
#he "slamic -eveloment 5ank was founded in !(2) to romote economic growth
and social rogress in member countries and "slamic communities* both individually
and $ointly. #he bank must abide by rinciles of "slamic law* which rohibits the
charging of interest on loansK for this reason it has a limited range of action comared
with other develoment banks. #he bank articiates in its own caital and in
subsidies for ro$ects in addition to offering other forms of financial assistance to
member countries to further their economic and social growth. "t offers technical
assistance by financing reinvestment studies and valuations and feasibility studies
in less develoed countries. Financing is rovided in the form of a grant u to
a maximum of )11*111 "slamic dinars
or in the form of a FeroDinterest loan for a
maximum eriod of !. years* with a ,Dyear grace eriod.
0arious forms of articiation are available as regards ro$ect financing.
Loans& LongDterm loans are offered for ro$ects that will have a strong imact from
the economic and social standoints @even if they are not articularly rofitableA.
Loans are granted to rivate comanies* governments* and ublic bodies* and though
they are FeroDinterest loans they do carry a fee of u to %./J to cover the bank?s
administrative costs. Loans cannot exceed 2 million "slamic dinars er ro$ect and
have a maturity ranging from !/ to %/ years* with a grace eriod from ) to 2 years.
Leasing @i$araA& Leasing is used to finance caital investments in rofitable ro$ects.
#he bank acCuires the asset and then allows the beneficiary to use it based on a
leasing agreement for a given eriod of time during which the latter ays . monthly
installments. At the end of the eriod ownershi is transferred to the beneficiary. #he
maximum amount financed in leasing is )/ million "slamic dinars.
"nstallment 'ale @murabahaA& #his is used to finance fixed assets. #he bank
urchases an asset @u to (1J of the total ro$ect valueA that the beneficiary reays
by installments. #he amount reaid is the asset cost lus a rofit margin of .JK there
is no commitment fee or enalty in the event of late ayment. #otal duration of the
installment sale @from urchase of the asset to the end of the reayment eriodA can
be as long as !/ years. 'imilar to the murabaha is the istisna?a* a structure whereby the
lender ays for the availability of an asset @for instance* an industrial lantA before it
is built. #he maximum loan eriod is !/ years.
6Cuity& #he bank can articiate in a memberDcountry comany?s eCuity* rovided
the terms and conditions are comatible with "slamic law. Maximum articiation is
oneDthird of the comany?s caital. "n addition* the bank can set u $oint ventures
with the sonsors of an 'P0 @musharakahA.
/. #he "slamic dinar is a fictitious unit of account eCuivalent to an "nternational Monetary Fund '-+
@secial drawing rightA @aroximately <'I!./1A.
..,.%., A-5 @Asian -eveloment 5ankA
#he Asian -eveloment 5ank was founded in !(.. as a regional develoment bank.
'tarting in !(3) with the creation of a P'7- @Private 'ector 7erations -eartD
mentA* the bank began to rovide direct assistance for investments in the rivate
sector that have a strong social and economic imact in member countries.
As with other multilateral agencies* the role of the bank is to act as a catalyst for
rivate caital for investments in areas where it is active. Furthermore* the bank lays
a romotional role toward governments in countries that are stakeholders in the
bank* to encourage them to introduce favorable olitical and institutional frameD
works that can attract rivate caital. "n addition* as in other cases* the action of
a regional bank like A-5 rovides a guarantee for rivate lenders* which in turn
means longDterm loans are easier to set u and also increases the amount of funding
available. "n the ro$ect finance field the bank focuses on strategic sectors such as
telecommunications* ower and energy* water* and transort infrastructures @orts*
airorts* and toll roadsA* often in favor of 'P0s that have 577# or 57# concessions.
#here are various forms of suort for rivate investors* for instance* eCuity
investment* loans* guarantees* and credit enhancement. A referential condition for
obtaining A-5 suort is that ro$ects be comliant with rocurement rules estabD
lished by the bankK in articular* sonsors must be selected by a cometitive bidding
tye of rocess. "n any event the maximum financial suort for a single ro$ect is
limited to the lesser of %/J of total ro$ect cost and <'I2/ million.
Loans& Loans to the rivate sector are granted at conditions that reflect the risk
level of the ro$ect concerned. Pricing is based on a sread above L"57+ or 6uribor*
although fixedDrate loans can also be made at the fixed rate Cuoted at the time of
financing for swas against floating rate. "n addition* standard fees for syndicated
loans are alied @frontDend fee !JN!./J and commitment fee 1./JN1.2/JA. #he
bank can ask for guarantees for the loan based on a caseDbyDcase analysis. #here are
no rigid guidelines as regards duration. 4ormally there is a grace eriod of %N) years*
while final maturity is established based on the ro$ect?s cash flow rofile. As in the
case of "FC* A-5 offers a 5Dloan rogram @syndicated loansA known as comD
lementary financing schemes @CF'A* in which the bank acts as lender* lender of
record* and agent bank. "n this way a rivate lender obtains the same rivileges and
immunity guaranteed for a loan disbursed directly by A-5 @for instance* exemtion
from withholding taxes or extension of restrictions imosed by the host government
on caital and interest aymentsA and also referred creditor status in the event of
sovereign risk.
:uarantees& A-5 offers rivate investors credit enhancement schemes to imrove
the ability to attract rivate caital. #he first tye of guarantee is a artial credit
guarantee @PC:A* which rovides coverage for both business and olitical risks. #he
guarantee covers that art of debt service maturing beyond the normal tenor of a
rivate lender and all instances of failure to ay caital and interest. #his is esecially
useful @!A for ro$ects that reCuire very longDterm funding and @%A in countries with
more severe caital rationing conditions.
#he second tye of guarantee is a olitical risk guarantee @P+:A* which aims to
facilitate investment of rivate caital in cases where there are sovereign or olitical
risks. #his rovides coverage for risks of breach of contract* exroriation and
nationaliFation* nonconvertibility or nontransferability of currency* and olitiD
cal violence. #he P+: can be issued without counterguarantees from the host
government for an amount not exceeding a minimum of <'I!/1 million and /1J of
the ro$ect cost.
6Cuity investments& A-5 can make rivate eCuity investments u to a maximum of
%/J of the 'P0?s caital stock. -ivestment of shares occurs once the ro$ect has
entered the oerating stage and can entail either a sale to the other sonsors or listing
on the local stock exchange.
..,.%./ 6uroean 5ank for +econstruction and -eveloment @65+-A
#he 65+- was set u in !((! and oerates in %. countries in central and eastern
6uroe lus countries that were once art of the 'oviet bloc. As with other
international financial agencies* its role is to romote infrastructure systems in target
countries. #he bank also stimulates target countries to imrove their regulatory*
institutional* and olitical framework. "n the largeDscale ro$ect sector 65+- is
involved in those with a value ranging from / million to %/1 million euro* with an
average in the area of %/ million. #he bank finances u to )/J of the total ro$ect
cost @in the case of :reenfield ro$ectsA or u to )/J of longDterm investments in the
case of alreadyDexisting comD anies. Pro$ects must be localiFed in one of the bank?s
target countries and be sufficiently rofitable to be adeCuately caitaliFed with eCuity
from sonsors @at least oneDthird of the cost must be eCuity financedA. Furthermore*
ro$ects must have externality within the economy and conform to the bank?s
environmental standards. "ts forms of intervention are* again* loans* eCuity
investments* and issuing guarantees.
Loans& Loans are granted based on a valuation of a ro$ect?s ability to generate cash
flow. #he amount can range from / million to !/ million euro and aly to either
fixedD or variableDinterest loans. Maturities vary between / and !/ years and can also
include grace eriods negotiated on a caseDbyDcase basis. #he bank can also
establish subordination clauses or grant meFFanine or convertible debt. Loans are
without recourseK however* the bank can ask sonsors to rovide secific
erformance or comletion guarantees* as is normally the case in limitedD
recourse ro$ect finance deals. 'imilarly* sonsors must stiulate insurance
contracts and rovide the usual security ackage* which may include mortgages*
ledges* floating charges* and assignments in favor of creditors. #he bank has
also set u an AD=5Dloan rogram similar to the "FC?s* in which 65+- acts as
lender of record for rivate lenders involved in the ool* who also benefit from
referred creditor status granted to international financial agencies.
:uarantees& #he bank rovides both allDrisk guarantees against default as a result
of whatsoever cause and artial riskNsecific contingent guarantees that cover default
originating from secific events.
6Cuity "nvestments& 65+- can rovide eCuity for ro$ectsEdirectly or through its
own investment fundsEacting as a minority stockholder and with a clear exit strategy.
"t can invest in ordinary stock or secial categories of instrumentsK however* the
secific terms of the investment deend on the nature of the ro$ect financed.
..,.%.. "nterDAmerican -eveloment 5ank @"A-5A
#he "A-5 was founded in !(/( and oerates in 'outh America and the Caribbean*
articiating in the rivate sector with loans and guarantees. 8owever* eCuity arD
ticiation is through funds @M"FEMultilateral "nvestment FundEand ""CE"nterD
American "nvestment CororationA.
Loans& Loans are granted at market conditions to the rivate sector without sovereign
guarantees* in key sectors such as ower* transort* health* and
telecommunications. Also* "A-5 has an AD and 5Dloan rogram similar to that
offered by "FC that aims to romote involvement of rivate caital in financing
:uarantees& #he bank can rovide guarantees for loans granted by thirdD
arty creditors* denominated in either <.'. dollars or local currency. :uarantees
can aly to all or only some of a loan?s maturities and can be issued alongside
guarantees from other multilateral agencies or rivate banks. Conditions are
established case by case but in general have a maturity ranging between 3 and !/
years. Political risk guarantees are rovided against breach of contract* currency
transferability and convertibility* and olitical violence* for an amount not exceeding
the lesser of /1J of the ro$ect cost and <'I!/1 million. "A-5 also rovides a
credit guarantee against all risks run by commercial banks as regards loans. "n this
case the limit is the lesser of <'I2/ million and %/J of the total ro$ect cost. For
smaller countries or those with less develoed caital markets* coverage can reach as
much as ,1J of the total ro$ect cost.
../ 5ilateral Agencies& -evelomental Agencies
and 6xort Credit Agencies @6CAsA
5ilateral agencies are those linked to governments of individual countries for ecoD
nomic olicy uroses and commercial and international romotion of the countries
businesses. "n this category it is normal to distinguish between develomental agenD
cies and exort credit agencies.
../.! -evelomental Agencies
#hese are agencies that ursue industrial and financial develoment aims based on
market rinciles and ractices* as oosed to the concessional aid model. #hey are
referred to as bilateral because they must ursue aims linked to foreign economic
olicy or commercial romotion and internationaliFation of businesses in the
agency?s home country. #hey act as financial investment houses that grant loans
@even when not linked to exorts of lant or eCuimentA and invest in the eCuity
caital of comanies @often $oint ventures romoted by sonsors resident in countries
in which the develomental agency oeratesA in develoing countries when these are
of secial interest to domestic industry.
#he following are some of the more active develomental agencies.
A5 @'wedenA& 'wedfund "nternational is owned by the 'wedish government and
rovides its eCuity and debt caital to $oint venture ro$ects in which there is a
'wedish artner.
Abu -habi Fund for -eveloment @Abu -habiA& #his is an autonomous ublic body
that rovides direct loans* subsidies* and its own caital to Arab* African* and Asian
develoing countries. Loans range from 2 to %/ years and offer favorable interest rates.
C-CECommonwealth -eveloment Cororation @<nited 9ingdomA& < until %111
this was a stateDowned comany. 4ow it has been transformed into a mixed ublicN
rivate comany. Previously it invested in ro$ects aimed at develoment in emerging
countriesK now it focuses on investing in eCuity caital.
!2( 5ilateral Agencies& -evelomental Agencies and 6xort Credit Agencies @6CAsA
-6: @:ermanyA& -eutsche 6ntwicklungs :esellschaft is a :erman government
financial institution that rovides longDterm debt and eCuity.
FMX @the 4etherlandsA& 4ederlandse FinancieringDMaatschai$ voor 7ntwikkeD
lingslande is /!J government controlled* whereas the remaining stakeholders
are ma$or -utch banks and several rivate investors. "t focuses its activity on Asia
and Latin America.
9uwait Fund for Arab -eveloment @9uwaitA& #his fund oerates in a similar
manner to the Abu -habi fund.
76CF @HaanA& #he 7verseas 6conomic Cooeration Fund is the Haanese
government?s bilateral develoment agency that reinvests the ma$ority of its balance
sheet surlus abroad. As a develoment agency it grants loans at aid conditions to
governments based on intergovernmental agreements. "t can also grant loans and take
eCuity ositions in the rivate sector. :eograhically it focuses on Asia.
P+7PA+C7 @FranceA& #he 'ocieMteM de Promotion et de ParteMciation our la
Cooeration 6conomiCue is 2!J owned by AF- @Agence Franc[aise de
-eveloementA* and the remainder is in rivate hands. "t offers eCuity and debt
caital for ro$ects in develoing countries that don?t reCuire the resence of a French
'audi Fund for -eveloment @'audi ArabiaA& #his agency rovides loans and
guarantees for ro$ects in develoing countries.
'"M6'# @"talyA& #he 'ocieta\ "taliana er le "mrese all?6stero is a stateD
controlled finance agency founded in !((1. "t lends to commercial banks and rovides
loans and eCuity to comanies controlled by "talian investors.
#able .D!) gives a list of bilateral agencies that in terms of volume have the most
imact on develoment in emerging countries. 8owever* "FC makes a greater conD
tribution and is more incisive in this field.
../.% 6xort Credit Agencies @6CAsA
"f the 'P0 is based in a develoing country and imorts lant or eCuiment necessary
to construct and oerate the ro$ect* 6CAs can rovide olitical risk coverage* total
coverage* or direct loans to exorting comanies oerating in their home country.
6CAs can also rovide financial suort by means of interest rate eCualiFation to
commercial banks. 5y roviding direct loans or subsidiFed interest rates* 6CAs enable
exorters to be cometitive in international rocurement rocesses or to articiate
in ro$ects in which the element of risk would otherwise not be sustainable. 6CAs
also insure eCuity investments against olitical risks.
#A5 L6 .D!) Financial Contribution of the Ma$or 5ilateral -eveloment Agencies* %11/ @in <'I millionsA
"nvestment 0olume J in Private 'ector Portfolio of "nvestments
C-C @<nited 9ingdomA ).2 !11J !*2)3
-6: @:ermanyA .(3 !11J )*1(1
FM7 @4etherlandsAU 2/1 !11J !*%(1
P+7PA+C7 @FranceAU %%( %%JUU .!.
U -ata referred to FL %11,.
UU Author?s estimates.
'ource& Comany web sites and www.edfi.be
!31 C 8 AP # 6 + . Financing the -eal
#A5L6 .D!, Activity for 5erne <nion Members @in <'I billionsA
!((/ !((. !((2 !((3 !((( %111 %11! %11% %11)
6xort credits )(3 ,12 ),( )2) ,./ ,(! ,,% ,2) /2.
J medium=longDterm 32 2( ., .! .% 2) .1 /. ..
7utstanding amounts of exort credits at year endU /21 /.! ,.( ,3% ,,. ,2! ,)1 ,/1 .%)
"nvestment insuranceUU !1 !/ ( !% !, !) !. !, !/
"nsured=guaranteed amount of investments at year end ). ,) ,1 ,) .! /2 ./ ./ .(
U 4ot yet due for reayment.
UU "ncludes new amounts of foreign investments insured=guaranteed against olitical risks.
'ource& 5erna <nion Learbook* 0arious years.
#hese agencies utiliFe the various forms of financing made available to them by
their governments to encourage exorts of goods and services and also to ursue their
mission by offering olitical and=or business risk insurance and a mix of insurance
and lending activities @a model above all used by 5ritish agenciesA. All ma$or 6CAs
@together with M":A and some rivate insurersA are members of the 5erne <nion
@"nternational <nion of Credit and "nvestment "nsurersA* which romotes interD
national coordination and exchange of information in this sector. As can be seen in
#able .D!,* the ma$ority of 6CA ortfolios focus on shortDterm business and are
therefore not articularly significant for ro$ect finance. 6xosure for exort credits
as regards 5erne <nion members at the end of %11) stood at around )1J of the over
I%.) trillion of debt in develoing countries in that same year.
../.%.! Financing Activity
#he 6CAs use three different methods of financing& direct lending* intermediary @or
indirectA lending* and interest rate eCualiFation. -irect lending is the simlest* most
traditional structure& #he imorting ro$ect comany is the borrower of funds*
whereas the 6CA is the lender. #he loan is* of course* granted exclusively for the
urchase of goods or services from the agency?s country of origin* a condition that
also alies to the other financing methods emloyed.
#his method is used by
countries such as the <nited 'tates* Canada* and Haan* and loans are made at
a fixed subsidiFed interest rate. "ndirect lending is in the form of financial intermediD
ary loans @bank to bankA& #he agency lends funds to a financial intermediary @for
instance* a commercial bankA* which in turn lends to the 'P0 imorter at a low fixed
interest rate. #his techniCue is used by the "talian @"'AC6A* French @C7FAC6A* and
5ritish @6C:-A exort credit agencies. Lastly* interest rate eCualiFation means that
the loans are made to imorting comanies by commercial banks at lowerDthanD
market interest rates. #he difference is reimbursed to the banks concerned by the
exort credit agency.
#he entire financing activity of 6CAs is regulated by a document signed by
76C- members and is known as the 76C- Consensus.
#he aim of this document
.. Loans not sub$ect to this urchase agreement* used* for instance* by other bilateral or multilateral
agencies* are referred to as untied.
2. #he Arrangement of :uidelines for 7fficial 6xort Credits dates from !(23 and was signed by the world?s
ma$or exorting countries& Australia* Canada* 6uroean countries* Haan* 9orea* 4ew Zealand* 4orway*
'witFerland* <nited 'tates.
!3! 5ilateral Agencies& -evelomental Agencies and 6xort Credit Agencies @6CAsA
is to ensure an orderly exort credit market by avoiding cometitive battles between
various countries seeking to offer the most favorable financial conditions for exorts.
#hus* cometition between 6CAs is limited to the Cuantity of credit suort availD
able* that is* how much credit risk an 6CA is willing to accet in order to finance a
secific ro$ect in a given country. #he main guidelines for the 76C- Consensus are
as follows.
. 6xort credit granted is limited to 3/J of the contract value* and therefore a
cash down ayment is reCuired for the remaining !/J.
. #he maximum duration of the loans is 3./ years from the start of the ro$ect
@C7-* commercial oerating dateA for Category ! countries
and !1 years for
Category % countries. Loans for ro$ects concerning ower lant construction
can be reaid over twelve years.
. +eayment must be by constant* at least six monthly* installments that must
begin no later than the sixth month after erformance tests on the 'P0?s
. "n !((3 a more flexible temorary agreement was decided on for ro$ect finance
that allows for longer reayment terms.
. #he interest rate alied cannot be lower than that calculated every month by
the 76C-. #his rate is known as the C"++ @commercial interest reference rateA
and is eCual to a !J sread on the return of longDterm government bonds in the
same currency. #he sread is the same for every currency* regardless of the
country roviding the financing.
:iven the comlicated mechanisms with which one must contend to obtain
suort from an 6CA @comliance with the Consensus limitsK greater comlexity
when there is an additional layer in the ro$ect finance structureK high initial
remiums to be aid to the 6CAA* it is worth resorting to these agencies only if
there is no other way to attract commercial banks to finance the ro$ect. +ecourse to
6CAs offers two main advantages.
. #he C"++ interest rate is subsidiFed and fixed.
. Particiation of an 6CA offers a certain intangible olitical suort for the
ro$ect and therefore makes lenders and investors feel more secure.
../.%.% "nsurance Activity
Although all 6CAs adot the common guidelines dictated by the 76C- Consensus*
their activities differ from many standoints. Certain 6CAs only offer their services
to national banksK others make services available to all banks oerating in the target
country @therefore also to branches of foreign banksA or even to any bank wherever
located. Following are highlights of different olicies in the insurance field as regards&
. Percentage of risk coverage @maximum coverage and exemtion ayable by the
insured artyA
. +isk coverage during the construction hase
. 5usiness risk coverage
3. Category ! countries are those with a er caita :-P in excess of <'I/*.3/ @World 5ank data for %11,AK
all other countries belong to Category %.
!3% C 8 AP # 6 + . Financing the -eal
. Political risk coverage
. -irect agreements with most governments
. Level of insurance remiums ayable by insured arties
. 6nvironmental risk coverage
Percentage of +isk Coverage& 'ome 6CAs don?t cover the entire risk they are
insuring* the aim being to avoid moral haFard on the art of the insured arty. For
instance* if 3/J of the contract value is financed by a commercial bank with coverage
by an 6CA* the insurance could cover only (1J of this 3/J* thus leaving the
commercial bank with a !1J exosure* or 3./J of the contract value. #his is a way
of making sure commercial banks @or lenders in generalA take the 6CA?s interests in
the ro$ect into account* as oosed to ignoring them because of rotection rovided
by the insurance. "nstead* other 6CAs cover !11J of the risk. "n the case of ro$ects
in develoing countries* the residual ercentage not covered by 6CAs @e.g.* 3./JA can
be too risky and therefore unaccetable for a bank. "n such cases a ossible solution
is to force the ro$ect comany to deosit the exosed ercentage in cash in a
collateral account and thereby guarantee the bank @cash collateraliFationA.
7bviously* this guarantee is also subdivided so as not to disturb the eCuilibrium in
terms of ratios of resonsibility for the bank and the 6CA& #he 6CA takes (1J of the
guarantee and the bank !1J.
Comletion +isk& 'ome 6CAs don?t accet ro$ect comletion risk. "n fact this
risk is under control of the exorter if the latter is the 6PC contractor and insurance
cannot affect the exorter?s erformance. 'o during the construction hase* 6CAs
only guarantee olitical risk and exect commercial banks to assume the comletion
risk* namely* the risk of oor erformance by the 'P0?s business artner. When
they make a direct loan* 6CAs ask commercial banks to lend directly in the
construction hase @6CAs cover olitical risk in this haseA* and then later they
refinance the loan once the construction hase is comlete. +egarding the
construction hase* some 6CAs can also insure interest caitaliFed u to the end
of construction.
5usiness +isk& 'ome 6CAs only offer coverage for olitical risk* some for all risks
run by lenders during the entire ro$ect life and* therefore* also for business risks @soD
called full coverAK others* in contrast* cover (/J of the olitical risk and 3/J of the
business risk. Lately 6CAs have tended to offer full cover because it is difficult to
distinguish between olitical risk and business risk. Clearly an 6CA that rovides a
direct loan takes on both risks.
Political +isk& #he various 6CAs also have different olicies as regards olitical risk.
. All 6CAs cover standard olitical risks& currency availability and transferabilD
ity* exroriation* and olitical violence.
. 'ome 6CAs don?t cover creeing exroriation.
. 6ffects of a change in law are usually covered indirectly by including indemniD
fication clauses in one or more of the ma$or ro$ect contracts.
. 'ome 6CAs cover contract risk if the host government has made commitments
in a government suort agreement.
-irect Agreements with the 8ost :overnment& When the offtaker is an organiFation
controlled by the host government* some 6CAs reCuire signature of a direct contract
with the host country government. 5ased on this contract the government agrees to
!3) 7ther Financial "ntermediaries "nvolved in Pro$ect Finance
accet a commitment for any ayment to lenders made by the 6CA in cases in which
the counterarty of the 'P0 is considered to have low creditworthiness.
Premium Level& "nsurance remiums to be aid to the 6CA for risk coverage can
be costly. #hey must be aid on the financial close date but cover risks for the entire
life of the ro$ectK a oneDtime ayment reresenting the 4P0 of all future annual
insurance remiums must therefore be made immediately. Premiums vary deending
on the risk level of the country concerned and tye of coverage reCuired. For tyical
coverage in a develoing country the remium can be as much as !1J of the sum
6nvironmental +isk Coverage& 'ome 6CAs only cover risks as regards comliance
with certain environmental rotection standards. #he American 6CAs @<.'. 6xim and
7P"CA reCuire an 6nvironmental "mact Assessment @6"AA for ro$ects they financeK
others are less strict excet in cases where the host country imoses secific rules.
#able .D!/ shows factors differentiating the various exort credit agencies* which*
as can be observed* have Cuite a variety of olicy guidelines even though they all
comly with the 76C- Consensus guidelines. #his leads to what are often significant
differences in the way they oerate.
"n terms of cometitiveness* offering greater coverage can be the determining
factor for 6CAs. "n 6uroe the only agency to offer total cover is the 6C:-.
A further factor that can be a lus in terms of an agency?s cometitiveness is coverage
for comletion risk. "n %11% C7FAC6 decided to offer this coverage in order to be
able to comete with other agencies.
"n addition* 6CAs often work together closely in cases where exorts come from
various countries and therefore several agencies are involved in the same ro$ect.
"n such situations the tyical structure is to aoint a lead 6CA @usually the one
linked to the ma$or ro$ect contractorA that rovides all the financing and guarantees.
All other 6CAs involved then reinsure the lead 6CA for their share of the risk. "n this
way the structure of the deal is not excessively burdened and the 'P0 has to deal with
only one agency. An examle was the +ussian 5lue 'tream ro$ect* in which "'AC6
reinsured with 6C:- in !(((.
... 7ther Financial "ntermediaries "nvolved
in Pro$ect Finance
A final remark is dedicated to the remaining categories of financial oerators often
involved in ro$ect finance deals and who freCuently articiate in realDlife business
Leasing Comanies& While leasing is a roduct that can be offered by both
commercial and investment banks @either directly or by subsidiaries within the same
grouA* banks have been ket searate from intermediaries oerating in leasing* given
that for 'P0s this reresents an alternative source of financing to bank loans or bond
issues. Leasing as one of the funding otions is covered again in 'ection ..!1.
"nsurance Comanies& Private insurance comanies and insurance brokers
and advisers @as oosed to insurance activities erformed by multilateral and
bilateral banks and by 6CAsA lay a key role in ro$ect finance deals. As seen in
Chater ,* insurance comanies come into lay when none of the 'P0?s contractual
counterarties wants to remain exosed to a risk. #he reCuest for insurance coverage
can ertain to a
#A5 L6 .D!/ Comarison of the Ma$or 6CAs
<.'. 6xim 7P"C 6-C 46G"=H5"C C7FAC6 "'AC6 6C:-
Legal status Private Public Public Private Private Public Public
-irect lending Les Les Les Les 4o 4o 4o
"ntermediary lending Les Les Les
"nterest rate eCualiFation
"nsurance activity
J of ro$ect
cost coverage
Lesser of 3/J of
contract value
and !11J
of <.'. share
/1J for new
2/J for
E E /1J )/J .1J
Comletion risk 4o 4o 4o 4o Les @case
by caseA
4o Les
J of risk covered
5usiness risk Les Les Les Les Les Les
J of risk covered (1J 31J (/J (/J !11J
Political risk Les Les Les Les Les Les Les
J of risk covered !11J !11J (1J (2./J (/J (/J !11J
Currency availability Les Les Les Les Les Les Les
Currency transferability Les Les Les Les Les Les Les
6xroriation Les Les Les Les Les Les Les
Political violence Les Les Les 4o Les Les Les
Creeing exroriation Les Les 4o 4o 4o 4o Les
War 4o 4o Les 4o 4o Les
Civil war 4o 4o Les 4o 4o Les
+evolution 4o 4o 4o Les 4o 4o Les
Change in legislation 4o 4o 4o 4o 4o 4o 4o
5reach of contract 4o Les 4o 4o 4o 4o 4o
For bonds Les Les Les 4o 4o 4o
6ligibility Also <.'. Canadian E 5anks Commercial 5anks
nonD<.'. investors and other oerating banks oerating
banks or lenders banks in France within and
outside "taly
in the <9
"-C Les 4o
<ntied guarantees 4o 4o 4o Les 4o 4o 4o
<ntied loans 4o 4o 4o Les 4o 4o 4o
6Cuity insurance 4o Les Les 4o Les Les 4o
J of risk coverage E (1J E E E
!3. C 8 AP # 6 + . Financing the -eal
very wide range of risks* although it can rarely eliminate every ossible risk for
the insured arty.
"nstitutional "nvestors& #he last category of financial intermediaries considered is
institutional investors with asset allocation olicies to invest in securities issued by
arties realiFing deals marked by a mediumDtoDhigh risk level and long duration.
#hese are mutual funds that invest savers? funds mainly in infrastructure works and
in bonds and eCuity issued by an 'P0 oerating in the largeDscale ro$ect field or in
securities issued by securitiFation vehicles of large infrastructure ro$ect ortfolios.
FreCuently these investments focus on a very secific sectorK today* for instance* it is
Cuite common to find mutual funds investing in new ro$ects in the ower sector or in
assetDbacked securities @A5'A issued in securitiFations of PPPs ventures.
8owever* involvement of institutional investors is not a significant art of funding
for ro$ect finance deals. As we see in 'ection ..!!* financing ro$ects by issuing highD
yield bonds @known in America as $unk bondsA* that is* securities with a low rating to be
sold to institutional investors* reresents a much lower figure than the volume financed
by banks loans. #his is articularly true as far as 6uroe is concerned.
..2 Funding 7tions& 6Cuity
#he remaining ages of this chater cover the various forms of funding that define
the deal?s debtDtoDeCuity ratio* starting with eCuity rovided by sonsors.
#he Cuestion of eCuity is often overlooked when discussing ro$ect finance. Let
the role of share caital in the initial stages of the deal is very imortant.
. "t is the means to suort and finance the lanning* study* and feasibility analysis
stages u to rearation of the business and financial lans to be submitted to
lenders. Costs for initial develoment are recorded as ro$ect costs and so
contribute to increasing the initial amount of investment for the venture.
. "t makes the ro$ect safer for lenders. #he greater the eCuity* the higher the risk
borne by sonsorsK this means less risk for lenders. An increase in eCuity
imroves the cover ratio level reCuired by lenders* although it has a negative
imact on the sonsors? internal rate of return @"++A.
..2.! #iming of the 6Cuity Contribution and 'tandDby
6Cuity and 6Cuity Acceleration
#yically an 'P0 is a cororation or limited artnershi in which the sonsors ut u
eCuity. 7ur aim now is to clarify when shareholders must ay in eCuity to the ro$ect
comany. #he law in many countries reCuires a minimum amount of initial caital
that sonsors must confer when the 'P0 comany is formed* but normally this is a
rather small amount. 5ut there are three alternatives to ay in the ma$ority of the
eCuity* each of which must be negotiated beforehand with the ool of lenders&
!. Paying in the remaining caital before starting to draw on the loan granted by
%. Paying in the remaining caital after the loan facility has been fully utiliFed
). A clause establishing roDrata ayments.
-ebt 6Cuity Payments -ebt 6Cuity Payments -ebt 6Cuity Payments
! %!%./ )2./ %/1
% %!%./ )2./ %/1
) %!%./ )2./ %/1
, %!%./ )2./ %/1
!11 !/1 %/1
%/1 1 %/1
%/1 1 %/1
%/1 1 %/1
%/1 1 %/1
%/1 1 %/1
%/1 1 %/1
!11 !/1 %/1
!32 Funding 7tions& 6Cuity
Whereas the first alternative is easy to understand* the second and third need to be
reviewed more carefully.
#he second alternative is used only when sonsors are of the highest creditworthiD
ness @otherwise lenders would bear an excessive level of credit riskA and only when
sonsors rovide lenders with a backu guarantee in the form of a letter of credit or
other form of insurance bonding. 'ince such guarantees have a cost that must be aid
until the eCuity is not rovided* sonsors must assess the tradeDoff between an early
eCuity contribution and the oortunity cost of alternative foregone oortunities
lus the cost of the guarantee.
#he third alternative can be analyFed by means of an examle. Let us assume a
ro$ect with a value of !*111 is financed for !/J by eCuity and 3/J by borrowed
caital. "t will also be assumed for simlicity?s sake that ayment for the construction is
made in four eCual installments of %/1 at the end of each year during the construction
eriod. #he stageDayment clause establishes that each ayment will be subdivided into
borrowed caital and risk caital in a roortion corresonding to the weight of each
source in total financing. "n this case the creditors ask the sonsors to make stage
ayments and to issue a letter of credit to cover future ayments.
#able .D!. gives a comarison of the timing for aying in eCuity according to the
three alternatives mentioned.
6ach of the three alternatives imlies a different advantage for sonsors. Final
ayment means shareholders only have to ay in caital after a certain eriod of
time* but this also forces them to incur higher financing costs for use of credit lines
and letters of credit in the initial years of the ro$ect. 7n the other hand* initial
ayment means saving on interest aid but generates an oortunity cost because the
funds concerned are not available for investment for other uroses. Comared with
the revious solutions* the use of a stageDayment clause reresents a comromise
falling between the two extremes.
Aart from the Cuestion of advantages for sonsors* the different timing for
conferring eCuity is dictated by the lenders? inclination as regards risk. #he latter
will always ush for an initial eCuity contribution to limit risk inherent to the venture.
#his consideration also exlains why only those sonsors with a strong bargaining
ower and high creditworthiness can roose financing solutions to banks that call
for aying in caital after credit lines have been fully exloited. "n all other cases* the
stageDayment solution is the one that artially reduces conflict of interests between
shareholders and creditors.
As we will see in 'ection ..(* in ro$ect finance deals a standard business ractice
is the subdivision of the debt into an initial tranche* or base facility* and an additional
tranche* or standDby facility* only utiliFable on fulfillment of certain condition receD
dents. "n cases where share caital has been defined on a stageDayment basis and the
#A5L6 .D!. Alternative Ways of Paying in 6Cuity
'tage Payment "nitial Payment Final Payment
!33 C 8 AP # 6 + . Financing the -eal
'P0 were also to use the standDby facility* then the debtDtoDeCuity ratio would change.
#he borrower could then use the additional debt without making further eCuity
contributions. #his roblem is resolved by the standDby eCuity clause. #his states
that if the standDby facility is used* then more shareholders? eCuity must be aid in so
that the 'P0?s debtDtoDeCuity ratio remains unchanged.
Lastly* mention must be made of the eCuity acceleration clause* a selfDexlanatory
term indicating the condition that allows lenders to ask sonsors to ay in the full
amount of the 'P0?s eCuity immediately. #his is an excetional measure that can
arise if the ro$ect is in default and is limited to certain events of default established in
the credit agreement as indicated in Chater 2.
..2.% Can 'hares in an 'P0 5e Listed on a 'tock 6xchange;
"t is imortant to clarify whether the 'P0?s shares can be listed on a stock exchange.
Whenever ossible* a stock exchange listing is an oortunity not to be missed* for it
means turnover of shareholders involved in the venture is easier. "n addition* listing
facilitates both access to funding and a greater Cuantity thereof from institutional
and retail investors for the future. <sually* however* the ownershi grou comrises
a stable nucleus of nonfinancial shareholders @constructors* buyers* suliers* and
oeratorsA. "n such cases* listing is not very likely and the 'P0?s ownershi structure
remains stable throughout the life of the ro$ect. Furthermore* in the case of a PPP*
ublic authorities in a country may imose further restrictions on the circulation of
'P0 shares or even forbid their listing on the stock exchange.
8owever* in certain cases it can haen that a sonsor withdraws or the shareD
holding structure for one or more sonsors changes. 'uch events are considered as
default for the ro$ect itself because if a key arty sells its share in the 'P0?s caital to
third arties then there is less incentive for the ro$ect to be erforming @see Chater
,A. #he only real change in the ownershi structure could be a change in the
'P0?s financial shareholders* tyically rivate eCuity funds* when resent.
Clearly a combination of industrial and financial arties would considerably
broaden the range of deals that can be financed using the ro$ect finance aroach.
"ndustrial shareholders would remain the stable nucleus throughout the life of the
ro$ect* whereas financial shareholders could change as a result of stock exchange
transactions. 8owever* the investment horiFon for institutional investors interested in
these ventures hardly ever exceeds !1 years @and is more often /N. yearsA* while
investment ro$ects financed by ro$ect financing on average last for %1 years or
more. #his means it would be reasonable to list the 'P0?s shares /N. years after the
venture becomes oerational so that institutional investors can launch a secondary
offer to sell the securities in their ortfolio.
..3 Funding 7tions& MeFFanine Financing
and 'ubordinated -ebt
When a sonsor uts u eCuity* remuneration is in the form of a residual flowE
reresented by dividends. 'onsors are aid only after the rights of all other arties
involved in the deal have been satisfied. #he right of creditors* however* is uneCuivocal.
#he 'P0 has made an irrevocable commitment to them to service the debt as
!3( Funding 7tions& MeFFanine Financing and 'ubordinated -ebt
established in the credit agreement. We know that cover ratios guarantee creditors a
certain margin of flexibility in the event the deal should roduce lower cash flows than
indicated in the budget. Lenders? rights as creditors are certain. 8owever* they don?t
en$oy the benefits of erformance imrovements that the ro$ect may achieve during
the oerating hase. 'uch imrovements* in fact* are entirely for the benefit of the 'P0
and* therefore* its shareholders.
-ebt and eCuity caital offer their contributors oosite frameworks as regards
incentives and remuneration. #he former is a combination of low risk and low returnK
the latter is closer to a highDrisk=highDreturn tye of aroach. An intermediate
solution between these two extremes is meFFanine financing* which can also attract
lenders who are more oen to risk but whose investment guidelines or articles of
incororation don?t allow them to contribute eCuity. 5ut meFFanine finance can also
be used by sonsors themselves to reduce their eCuity commitment artially. #his
form of financing was launched on the <.'. market in the midD!(21s. "t came on the
wave of merger and acCuisition @MBAA deals achieved by massive recourse to debt
and took the form of a subordinated loan. #his debt can also take the form of a bond
issue and is characteriFed by the fact that it is reimbursed after senior debt has been
reaid. "n essence* oerating cash flows are alied immediately to service nonsuborD
dinated debt* then for subordinated loans* and lastly for aying dividends to sonsors.
MeFFanine financing can be structured and adated to suit the secific needs of
the ro$ect and can* as necessary* incororate larger >>shareDtye?? or loan contract
comonents. An examle can be debts that ay a minimum guaranteed interest and
ay subordinated creditors a share of ro$ect cash flows available for sonsors. 'o
the role layed by meFFanine financing is more similar to that of share caital than to
that of debt caital. 7n the one hand* in fact* the guarantee level for ure lenders is
higher @given that the denominator in the ratio of debt to eCuity lus CuasiDeCuity
increasesA. 7n the other* lenders who are more willing to take a risk will receive a
fixed and certainly attractive remuneration and will* above all* rofit from the
enhanced ro$ect value if it should erform really well.
6xamles may rove useful to better understand the advantages shareholders and
creditors can obtain from meFFanine financing or subordinated debt. #he first
examle @#able .D!2A comares a ro$ect with a value of !11 financed by two different
#A5L6 .D!2 Advantages of MeFFanine FinancingE'hareholders? Position
Caital 'tructure ! Caital 'tructure %
Assets !11 Assets !11
'enior debt 2/ 'enior debt 2/
Hunior debt 1 Hunior debt !/
6Cuity %/ 6Cuity !1
65"# !1.11 65"# !1.11
"nterest on senior debt ..11 "nterest on senior debt ..11
"nterest on $unior debt 1.11 "nterest on $unior debt !./1
6arnings before taxes @65#A ,.11 6arnings before taxes @65#A %./1
#axes ] /1J %.11 #axes ] /1J !.%/
4et income %.11 4et income !.%/
+76 3.11J +76 !%./1J
Cost of senior debt @9
A& 3J.
Cost of meFFanine debt @9
A& !1J.
!(1 C 8 AP # 6 + . Financing the -eal
financing structures. #he first consists of senior debt only* the second calls for lower
eCuity and use of subordinated @$uniorA debt. Hunior debt has a subordination clause
and therefore reCuires a higher remuneration @!1J instead of 3J aid on the senior
trancheA. #he ro$ect generates an 65"# @earnings before interest and taxesA of !1 and
is taxed at a rate of /1J. #able .D!2 shows that the return for shareholders assuming
financial structure % @accounting +76A is higher than that obtained when adoting
structure !. #he reduction in net rofit* in fact* is more than offset by the eCuity
saving. 4ote that the shareholders? advantage would be the same even if the shareD
holders themselves also contributed to the $unior debt. "n this case* in fact* the sum of
gross cash flows received would be eCual to the sum of interest on $unior debt and net
rofit @!./ R !.%/A to be divided by the total caital emloyed. #he return on the deal
is !!J* as oosed to 3J when only senior debt is used.
"n contrast* the second examle considers the advantages for senior creditors as a
result of releverage of the comany by means of a subordinated loan. Let us assume
the initial situation of the comany was as indicated in the leftDhand side of #able .D!3.
#hen a calculation is made of the loss incurred by senior creditors if comany assets
were to be sold off at different values* corresonding to the book values of these assets.
As we can note* the only case when creditors do not incur a loss is when the sales value
for assets is greater than 2/J of their book value. 4ow consider a new ro$ect with a
value of !1 financed entirely by a new subordinated loan of the same amount and then
recalculate the outcome. "n this case* it is easy to see that senior creditors are fully
reaid if the value realiFed for assets is lower than in the revious case. Assets need
only be sold off at about .3J of their book value to ensure that the senior creditors?
loans are reaid in full. #his is the case because the subordinated loan is the first to
absorb losses from the unfavorable business situation.
0ery often sonsors of a ro$ect finance deal use meFFanine and subordinated
debt. #here are a number of reasons why they refer to finance the ro$ect by means
of a combination of debt and eCuity.
. A subordinated loan reCuires ayment of interest after senior debt service but
before dividends. #his means the sonsors? remuneration is more certain than
$ust relying on dividends and also reduces volatility of returns on total funds
contributed to the ro$ect.
. "nterest aid on subordinated debt is tax deductible in many countries. :reater
financial leverage generates a higher tax saving that benefits sonsors of the
venture directly. "t should also be noted that in some countries when the
subordinated loan is made by sonsors=shareholders in the comany* the tax
shield on interest due can be limited to a certain degree based on thinDcaitalD
iFation* or thinDca* regulations.
. 6secially during the initial years of the ro$ect?s life* recourse to subordinated
debt means the soDcalled >>dividend tra?? can be avoided.
A simlified examle will clarify the dividend tra concet. Let us assume
that sonsors must finance a total investment of ,*111* with a senior debt=eCuity ratio of
, to !.
"n addition the following information is known&
. #he investment can be amortiFed over !1 years in eCual annual installments*
each amounting to !1J.
. For tax uroses* sonsors can use accelerated dereciation with a rate of %1J
during the first ) years.
#A5 L6 .D!3 MeFFanine FinancingEAdvantages for 'enior Creditors
Financial 'tructure ! Financial 'tructure %
Assets !11
'enior debt 2/
Hunior debt 1
6Cuity %/
Assets !!1
'enior debt 2/
Hunior debt !1
6Cuity %/
Payoff for Payoff for Loss for
J LiCuidation LiCuidation 'enior Hunior 'hareholders? 'enior
0alue 0alue Creditors Creditors Payoff Creditors
Payoff for Payoff for Loss for
J LiCuidation LiCuidation 'enior Hunior 'hareholders? 'enior
0alue 0alue Creditors Creditors Payoff Creditors
%1J %1 %1 1 1 2)J
)1J )1 )1 1 1 .1J
,1J ,1 ,1 1 1 ,2J
/1J /1 /1 1 1 ))J
.1J .1 .1 1 1 %1J
21J 21 21 1 1 2J
31J 31 2/ 1 / 1J
(1J (1 2/ 1 !/ 1J
!11J !11 2/ 1 %/ 1J
%1J %% %% 1 1 2!J
)1J )) )) 1 1 /.J
,1J ,, ,, 1 1 ,!J
/1J // // 1 1 %2J
.1J .. .. 1 1 !%J
21J 22 2/ % 1 1J
31J 33 2/ !1 ) 1J
(1J (( 2/ !1 !, 1J
!11J !!1 2/ !1 %/ 1J
Cost of senior debt @9d A& 3J.
Cost of meFFanine debt @9sub A& !1J.
!(% C 8 AP # 6 + . Financing the -eal
#A5 L6 .D!( 5ase CaseEPro$ect Financing <sing 7nly 'enior -ebt
1 ! % ) , / . 2 3 ( !1
-ereciation J %1J %1J %1J !1J !1J !1J !1J 1J 1J 1J
-ereciation 311 311 311 ,11 ,11 ,11 ,11 E E E
Accumulated dereciation 311 !*.11 %*,11 %*311 )*%11 )*.11 ,*111 ,*111 ,*111 ,*111
+esidual book value )*%11 %*,11 !*.11 !*%11 311 ,11 E E E E
Princial reayment !1J !1J !1J !1J !1J !1J !1J !1J !1J !1J
Princial reayment )%1 )%1 )%1 )%1 )%1 )%1 )%1 )%1 )%1 )%1
Loan reaid )*%11 %*331 %*/.1 %*%,1 !*(%1 !*.11 !*%31 (.1 .,1 )%1 E
"nterest exenses %/..1 %)1., %1,.3 !2(.% !/).. !%3.1 !1%., 2..3 /!.% %/..
+evenues !*!%/.1 !*!2/.1 !*%%/.1 3,1.1 3//.1 3./.1 33/.1 3(/.1 (%/.1 (%/.1
7erating costs !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1
-ereciation 311.1 311.1 311.1 ,11.1 ,11.1 ,11.1 ,11.1 E E E
Q 65"# !/1.1 %11.1 %/1.1 %./.1 %31.1 %(1.1 )!1.1 2%1.1 2/1.1 2/1.1
"nterest exenses %/..1 %)1., %1,.3 !2(.% !/).. !%3.1 !1%., 2..3 /!.% %/..
Q 65# !1..1 )1., ,/.% 3/.3 !%.., !.%.1 %12.. .,).% .(3.3 2%,.,
#axes E E !,.( %3.) ,!.2 /)./ .3./ %!%.) %)1.. %)(.!
R #ax credit !1..1 )1., E E E E E E E E
Loss carryforward !,.( %3.) ,!.2 /!./ E E E E
Q 4et "ncome !1..1 )1., ,/.% 3/.3 !%.., !.1.1 !)(.! ,)1.( ,.3.% ,3/.)
65"# !/1.1 %11.1 %/1.1 %./.1 %31.1 %(1.1 )!1.1 2%1.1 2/1.1 2/1.1
#axes E E E E E %.1 .3./ %!%.) %)1.. %)(.!
-ereciation 311.1 311.1 311.1 ,11.1 ,11.1 ,11.1 ,11.1 E E E
Q Free cash flow (/1.1 !*111.1 !*1/1.1 ../.1 .31.1 .33.1 .,!./ /12.2 /!(., /!1.(
"nterest exenses %/..1 %)1., %1,.3 !2(.% !/).. !%3.1 !1%., 2..3 /!.% %/..
Princial reayment )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1
Q Cash flow to eCuity )2,.1 ,,(.. /%/.% !./.3 %1.., %,1.1 %!(.! !!1.( !,3.% !./.)
. #he senior rincial is reaid over !1 years in !1 eCual installmentsK interest at 3J
is aid annually* calculated on the outstanding debt at the end of the rior year.
. Any losses can be carried forward to future years and so reduce tax liability.
@#his is normal ractice* with various limitations and conditions* in numerous
. #he tax rate is ))J.
#able ..!( resents data for the ro$ect?s first !1 years of life. #he uer section of
the table shows calculations for dereciation* debt reayment* and interest. #he
middle and lower sections* resectively* refer to income statement and cash flows
generated by the ro$ect. 7bserving the data* it will be noted that dereciation is very
high in the first ) years because the sonsors use the accelerated method and this
generates a loss in the first % years. 'o dereciation has two effects&
!. "t leads to losses that can be carried forward to future years and thus reduce the
'P0?s tax liability.
%. #he income statement is affected by this cost* which* however* is not a cash
outlay. #his means the ro$ect shows a loss on an accrual basis but not on a
!() Funding 7tions& MeFFanine Financing and 'ubordinated -ebt
cash basis. "n fact* the table shows that right from the very first year the ro$ect
is able to generate a ositive cash flow for sonsors.
6ffect % clearly is created only when dereciation is higher than debt service
@interest on senior debt and subordinated debtA* whereas the effect is oosite @rofits
are higher than cash flowsA when debt service is greater than dereciation. "n
theory* therefore* sonsors could receive dividends right from the first year. 8owever*
legislation in many countries clearly establishes that dividends cannot be distributed if
the comany makes a loss* even if there are ositive cash flows available for
shareholders. #his situation is known as the dividend tra. "n the examle*
shareholders can only receive dividends starting from year ). 5ut dividends
distributed will not be eCual to rofits* given ossible allocations to the debt reserve or
legal reCuirements to make a minimum reinvestment in the ro$ect. @"n "taly* for
instance* the mandatory figure is /J of rofits until such time as the reserve reaches
%1J of the comany?s share caital.A 'o* given the same eCuity contribution* the
dividend tra enaliFes their "++. #able .D%1 summariFes the sonD sors? ayoff if
only senior debt is used.
#he dividend tra can be avoided by using subordinated debt rovided by the
'P0?s sonsors. 'uose the same ro$ect value of ,*111 is financed by a structure
calling for senior debt of )*%11 and also subordinated debt of /11* which means
eCuity can be reduced to )11. #he subordinated debt is reaid in ten eCual installD
ments after the senior debt has been reaid* and ays interest at a fixed rate of !/J.
#his interest is tax deductible. #able .D%! summariFes the data used and shows
calculations for rofits and cash flows.
Clearly* in this case the ro$ect income statement shows a loss for the first
three years. 8owever* the figure for dereciation is higher than debt service for
the senior lus subordinate debt* and so cash flows are ositive right from the
first year. 5ut in this case the dividend tra is avoided* given that interest on
subordinate debt is deductible in the income statement and is aid before dividends.
'onsors can therefore start to recover their investment from the first year and
imrove their "++* given the same figure contributed for eCuity lus subordinated
debt. #able .D%% shows the subordinated debt=dividend ayoff.
While subordinated debt is a good solution for the dividend tra roblem* using
it can cause the further roblem of negative eCuity. "nterest on subordinated debt is a
cost that generates losses* which* in turn* must be covered by sonsors? caital. "f
it is assumed that the sum @eCuity lus subordinated debtA of the investment
reCuired remains fixed* then a higher amount of subordinated debt will mean a
lower eCuity value. 8owever* higher subordinated debt will also mean that interest
costs rise and that there will be lower rofits=higher losses* and so erosion of the
sonsors? caital base will
#A5L6 .D%1 'onsors? Payoff "f 7nly 'enior -ebt "s <sed
1 ! % ) , / . 2 3 ( !1
5egin with year eCuity 311.1 .(,.1 ..).. ../.( .21.% .2../ .3,./ .(!., 2!).1 2)..,
4et income=loss !1..1 )1., ,/.% 3/.3 !%.., !.1.1 !)(.! ,)1.( ,.3.% ,3/.)
/J reserve rovision E E %.) ,.) ..) 3.1 2.1 %!./ %)., %,.)
-ividends to shareholders E E ,%.( 3!./ !%1.! !/%.1 !)%.! ,1(., ,,,.3 ,.!.!
6nd year eCuity .(,.1 ..).. ../.( .21.% .2../ .3,./ .(!., 2!).1 2).., 2.1.2
!(, C 8 AP # 6 + . Financing the -eal
#A5 L6 .D%! Financing the Pro$ect with a Mix of 'enior -ebt and 'ubordinated -ebt
1 ! % ) , / . 2 3 ( !1
-ereciation J %1J %1J %1J !1J !1J !1J !1J
-ereciation 311 311 311 ,11 ,11 ,11 ,11
Accumulated dereciation 311 !*.11 %*,11 %*311 )*%11 )*.11 ,*111
+esidual book value )*%11 %*,11 !*.11 !*%11 311 ,11 E
Princial reayment !1J !1J !1J !1J !1J !1J !1J !1J !1J !1J
Princial reayment )%1 )%1 )%1 )%1 )%1 )%1 )%1 )%1 )%1 )%1
'enior outstanding )*%11 %*331 %*/.1 %*%,1 !*(%1 !*.11 !*%31 (.1 3,1 )%1 E
'ubordinated reayment E E E E E E E E E E
'ubordinated outstanding /11 E E E E E E E E E E
"nterest exenses senior %/..1 %)1., %1,.3 !2(.% !/).. !%3.1 !1%., 2..3 /!.% %/..
"nterest exenses subordinated 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1
+evenues !*!%/.1 !*!2/.1 !*%%/.1 3,1.1 3//.1 3./.1 33/.1 3(/.1 (%/.1 (%/.1
7erating costs !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1 !2/.1
-ereciation 311.1 311.1 311.1 ,11.1 ,11.1 ,11.1 ,11.1 E E E
Q 65"# !/1.1 %11.1 %/1.1 %./.1 %31.1 %(1.1 )!1.1 2%1.1 2/1.1 2/1.1
"nterest exenses %/..1 %)1., %1,.3 !2(.% !/).. !%3.1 !1%., 2..3 /!.% %/..
"nterest exenses subordinated 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1
Q 65# !3!.1 !1/., %(.3 !1.3 /!., 32.1 !)%.. /.3.% .%).3 .,(.,
#axes E E E ).. !2.1 %3.2 ,).3 !32./ %1/.( %!,.)
R #ax credit !3!.1 !1/., %(.3 E E E E E E E
E ).. %1./ ,(.% ().1 %31./ ,3.., 211.2
Loss carryforward E ).. !2.1 %3.2 ,).3 !32./ )/.2 E
Q 4et "ncome !3!.1 !1/., %(.3 !1.3 /!., 32.1 !)%.. /.3.% ,/).. ,)/.!
65"# !/1.1 %11.1 %/1.1 %./.1 %31.1 %(1.1 )!1.1 2%1.1 2/1.1 2/1.1
#axes E E E E E E E E !21.% %!,.)
R -ereciation 311.1 311.1 311.1 ,11.1 ,11.1 ,11.1 ,11.1 E E E
Q Free cash flow (/1.1 !*111.1 !*1/1.1 ../.1 .31.1 .(1.1 2!1.1 2%1.1 /2(.3 /)/.2
"nterest exenses %/..1 %)1., %1,.3 !2(.% !/).. !%3.1 !1%., 2..3 /!.% %/..
"nterest exenses subordinated 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1 2/.1
Princial reayment )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1 )%1.1
'ubordinated reayment E E E E E E E E E E
Q Cash flow to eCuity %((.1 )2,.. ,/1.% (1.3 !)!., !.2.1 %!%.. %,3.% !)).. !!/.!
be heavier. #able .D%! shows that losses in the first three years lead to negative
eCuity. Legislation in many countries does not allow this* and so the investment
must be liCuidated. When sonsors and arrangers define the caital structure and
combination of subordinated debt and eCuity* they must bear in mind the tradeDoff
between avoiding the dividend tra and the negative eCuity roblem.
..( Funding 7tions& 'enior -ebt
#his section reviews the issue of senior bank debt in dethK the alternative of recourse
to bond caital markets is covered in 'ection ..!!. First the review covers the various
!(/ Funding 7tions& 'enior -ebt
#A5L6 .D%% 'onsors? Payoff "f 'ubordinated -ebt "s <sed
1 ! % ) , / . 2 3 ( !1
5eginning year eCuity )11.1 !!(.1 !).. !..% !/.2 !).! 3.2 %.! %..) ,(.1
4et income=loss !3!.1 !1/., %(.3 !1.3 /!., 32.1 !)%.. /.3.% ,/).. ,)/.!
/J reserve rovision E E E 1./ %.. ,., ... %3., %%.2 %!.3
-ividends to shareholders E E E !1.) ,3.3 3%.2 !%..1 /)(.3 ,)!.1 ,!).)
6nd year eCuity !!(.1 !).. !..% !/.2 !).! 3.2 %.! %..) ,(.1 21.2
Payoff subordinated R dividends 2/.1 2/.1 2/.1 3/.) !%).3 !/2.2 %1!.1 .!,.3 /1..1 ,33.)
tranches of senior debt made available by the ool of banks* after which an analysis is
made of refinancing the debt already granted.
..(.! #he 5ase Facility
#o seak of senior debt in a general manner oversimlifies ro$ect finance deals*
given that banks make available various tranches to the 'P0. 6ach of these tranches
is intended to finance art of the ro$ect?s needs and is utiliFed and reaid in different
ways. #he ma$ority of the financing constitutes the base facility. #his is debt granted
to the 'P0 to finance construction and will be reaid from cash flows the ro$ect
generates in the oerating hase. Clauses covering utiliFation and reayment of the
base facility are very strict* and therefore the 'P0 is left with very little discretion.
<ses of the base facility concern 'P0 ayments to the constructor. Payments are
made after invoices resented covering rogress for the works have been checked and
aroved by the ool?s agent bank. "nterest due will then start to mature on the art
utiliFed* whereas the 'P0 will ay the commitment fee on the unutiliFed art. "nstead*
reayments are structured based on the cash flow trend forecast in the financial lan.
6ach reayment reduces the 'P0?s debt to the ool* and so the base facility is not a
revolving credit. #he two otions for reaymentEvariable caital installments and a
given ercentage are analyFed in 'ection ..(.2.
..(.% Working Caital Facility
#he second tranche of debt that banks make available to the borrower is intended to
finance any cash deficit arising as a result of the cash collection cycle* that is* the
difference between the average collection eriod for trade receivables lus average age
of inventories and the average ayment eriod for sulier accounts ayable. #he
amount of working caital will deend on the tye of ro$ect. "n PPPs* for instance* the
working caital facility covers the eriod necessary for the 'P0 to receive ayments
from the ublic administration. "n ro$ects in the ower sector* working caital may be
needed to finance the average collection eriod of receivables from the offtaker.
Clearly this tye of facility can be used at the 'P0?s discretion and is a revolving
credit* so every reayment made by the 'P0 means this credit line granted to the
borrower is again available. Furthermore* given the redictability of an 'P0?s
oerations comared to that of an alreadyDoerating comany* the trend for use of
!(. C 8 AP # 6 + . Financing the -eal
the working caital facility will see an initial drawdown of funds in the early stages of
oeration and then stabiliFation throughout the entire life cycle of the ro$ect. Full
reayment normally takes lace in the final stages of the ro$ect?s life cycle.
..(.) 'tandDby Facility
#his is a tranche of additional debt made available to the 'P0 to cover contingencies
arising during the ro$ect?s life cycle. #he tranche can only be used if secific events
occur. #here are two ossibilities&
. A standDby loan only utiliFable to cover additional costs to those estimated in
the budget
. A standDby loan utiliFable to cover additional costs comared to those budgeted
after the base facility has been comletely used @the more freCuent caseA
Clearly this is the riskiest art of the loan for lenders because it will be used only if
contingencies arise. For this reason a higher sread is reCuested for this facility than
the one alied for the base facility and the working caital facility.
..(., 0A# Facility
#he early years of the ro$ect will concern the construction stage* during which initial
develoment costs are incurred. "f the ro$ect takes lace in a country where 0A# is
in force and 0A# reimbursement times are long* then the 'P0 will be entitled to a tax
credit but will not be able to recover it from 0A# on sales @given that the ro$ect will
start to roduce revenue only after the construction stage and not beforeA. And so
cash will be needed to finance 0A# aid on construction and develoment costs.
A secific 0A# facility is granted by the ool to the 'P0 to cover 0A# reCuirements
during the construction hase. Clearly the 0A# facility will be reaid from 0A#
receits during the oerating hase. For instance* if during the first year of oeration
the ro$ect generates sales of !11 with a 0A# rate of %1J* then cash flow from sales
will be !%1* of which %1 will be used to reay the 0A# facility. 'o the higher the sales*
the sooner the 0A# facility will be reaid. #he sread reCuested for the 0A# facility
is lower than that alied for the revious tranches.
..(./ Loan +emuneration
#he tranches analyFed are granted at a cost eCual to the interbank market rate lus a
sread* which can be fixed for the entire tenor of the loan reayment eriod.
8owever* the most freCuent ractice is to establish a variable sread linked to time
or deending on the level of cover ratios for each year @esecially the loan life cover
ratioA. As regards the sreadNtime relationshi* the most used solution is to rovide
for an increasing sread& Low increases to the base rate are alied during the
construction hase @and therefore to caitaliFation of interestA. After the start of
the oerations hase @and for a eriod ranging from !./ to % yearsA* sreads begin to
increaseK starting from the fourth=fifth oerating year the sread is fixed at its
definitive level. As far as sreadNcover ratios are concerned* on the other hand* in
!(2 Funding 7tions& 'enior -ebt
certain ro$ects interest is established based on the level reached by cover coefficients&
#he higher the coefficients @and therefore the higher the ro$ect?s erformanceA* the
lower the sreads alied to the base rate* and vice versa.
..(.. Loan Currency
Loans can be disbursed in the currency of the 'P0?s home country or in one or more
foreign currencies. #he latter case is referred to as a multicurrency agreement* accordD
ing to which the ro$ect comany can choose the currency in which to draw down the
funding reCuired based on a comarison of convenience in terms of the interest rate
differential and the differential between sot and forward exchange rates. We should
bear in mind that* in terms of loan cost* recourse to currency swa contracts
@see Chater )A* in certain cases* will enable a borrower to obtain better cost
conditions by contracting debt in one currency and then transforming the original
currency to the home country currency by means of a currency swa.
Aart from certain contracts involving nonresident counterarties that invoice
their services in foreign currency @in which case a decision to finance itself in foreign
currency would be taken for uroses of matchingA* the sonsors? advisors will
always tend to set u loans in the 'P0?s accounting currency so as to avoid exchange
rate risk. #hese roblems should not be underestimated* given that it is difficult to set
u forward cover or use derivatives for a time frame exceeding !3 months* a very
short eriod as comared with the ro$ect?s life cycle.
..(.2 +eayment 7tions
#he main comonent of a syndicated loanEthe base facilityEincludes the methods
of utiliFation and reayment defined beforehand with lenders in the credit agreement.
+eayment methods for the base facility are critical given that the ratio of debt
caacity to debt reCuirement is a direct function of the eriod over which the loan is
amortiFed. #he longer this eriod is* the more likely that the first figure will be higher
than the second. 'imulation models can be used to test various alternative reayment
lans for the caital amount borrowed @see Chater /A. 6xamles of two lans are
given. 8owever* we should mention that it is rare to find fixed installment or eCual
rincial reayment lans as in the case of normal industrial loans inasmuch as these
lans always contain clauses that change loan reayment. #he reason for this is that
fixed reayment lans don?t fit in well with the volatility of oerating cash flows.
#he alternatives are&
!. A tailorDmade loan reayment lan
%. A dedicated ercentage loan reayment lan
"n the first case* the advisor estimates oerating cash flows and then establishes a
timetable for loan reayments in which the ercentage to be reaid year by year also
takes into account assumtions as regards future interest rate trends. 8owever* the
ercentages defined may not match oerating cash flow trends erfectly. #his situD
ation leads to debt service cover ratio @-'C+A values below the minimum threshold
accetable by lenders or that cannot satisfy the average level reCuired. "f such is the
!(3 C 8 AP # 6 + . Financing the -eal
case* then the ercentages are revised down to reallocate reayments to years when
ositive cash flow is higher.
"n the case of the dedicated ercentage otion @which* as we see shortly* assumes the
defining of a constant -'C+A* the caital reayment is in roortion to oerating cash
flow for the year because a constant ercentage is established at the outset. #he higher
the cash flow* the larger the reayment made to lenders. #he eCuation for this is
7CF Q 7erating cash flow for year t
-' Q -ebt service to be aid in year t
-P Q Percentage of oerating cash flow established for reayment
@dedicated ercentageA
#o illustrate the difference between these two alternatives* consider the following
examle* in which it is assumed that outstanding debt at the start of oerations is
!*111* for which the minimum debt service cover ratio is !.). "n the case of reayment
of a variable caital amount* the advisor set u the loan with !. halfDyearly deferred
installments* initially for an amount eCual to ..%/J of the total debt at the beginning
of the oerating hase. "n this case it is easy to see that reayment of the loan will
roceed in exactly the same manner as in the eCual rincial method. 5ased on this*
the model will generate the results shown in #able .D%).
Clearly* the assumtion for the reayment lan is sustainable based on the
ro$ect?s oerating cash flows @shown in the 7CF columnA& All -'C+s are higher
than the minimum ratio of !.) @even though they are very close in the early yearsA.
:iven this situation* the advisor revises the reayment lan by modifying the erD
centage of debt to be reaid in terms of caital. As we can see from the cash flow
trends* in later years the cover ratio is considerably higher than the minimum value
and so can suort higher debt service amounts. Assuming the advisor reduces the
first three installments by /1 basis oints and reallocates the !/1 oints to the last
three installments* then the situation will be as shown in #able .D%,. After the change
in the reayment lan it is clear that all -'C+s reach an accetable level in terms of
the reCuired minimum. #his can be a valid solution the advisor could roose to
banks invited to articiate.
Let us now consider reayment based on a dedicated ercentage. "n this case the
terms of the roblem are reversed. Whereas in the first case the rincial amount was
established and as a conseCuence the interest and debt service were determined* in this
case it is the latter value mentioned that is established first. Clearly this has two effects.
!. #he debt service cover ratio will be a function of the dedicated ercentage
decided. "f the ercentage is stable throughout the entire reayment eriod*
the -'C+ will remain constant. "n effect* given a certain level of -'C+* the
dedicated ercentage will immediately be eCual to the inverse of the -'C+.
%. #he tenor of the reayment lan will deend on the dedicated ercentage
decided by the advisor. #he greater the ercentage* the faster the loan will be
reaid* and vice versa.
#A5 L6 .D%) +eayment with 0ariable Caital "nstallments& #he Advisor?s First Assumtion
5ase +ate
+eayment J
+eayment "nterest
Loan 7CF -'C+
1 .J !%1 2.%1J !*111.11
! ..%/J !%1 2*,/J ..%/J .%./ )2.%/ ((.2/ ()2./1 .%./1 !)!..2 !.)%
% ..)/J !%1 2.//J ..%/J .%./ )/.)( (2.3( 32/.11 !%/.11 !)1.!( !.))
) ../1J !%1 2.21J ..%/J .%./ ))..( (..!( 3!%./1 !32./1 !),... !.,
, ...1J !%1 2.31J ..%/J .%./ )!..( (,.!( 2/1.11 %/1.11 !)).2/ !.,%
/ ...1J !)/ 2.(/J ..%/J .%./ %(.3! (%.)! .32./1 )!%./1 !)).3/ !.,/
. ..31J !)/ 3.!/J ..%/J .%./ %3.1% (1./% .%/.11 )2/.11 !)!.%/ !.,/
2 ..3/J !)/ 3.%1J ..%/J .%./ %/..) 33.!) /.%./1 ,)2./1 !%(./, !.,2
3 ..3/J !)/ 3.%1J ..%/J .%./ %).1. 3/./. /11.11 /11.11 !%/.23 !.,2
( ..2/J !/1 3.%/J ..%/J .%./ %1..) 3).!) ,)2./1 /.%./1 !%,..( !./
!1 ..2/J !/1 3.%/J ..%/J .%./ !3.1/ 31.// )2/.11 .%/.11 !%!..) !./!
!! ..2/J !/1 3.%/J ..%/J .%./ !/.,2 22.(2 )!%./1 .32./1 !%1.3/ !.//
!% .../J !/1 3.!/J ..%/J .%./ !%.2) 2/.%) %/1.11 2/1.11 !!...! !.//
!) ...1J !/1 3.!1J ..%/J .%./ !1.!) 2%..) !32./1 3!%./1 !!..%1 !..
!, ..//J !/1 3.1/J ..%/J .%./ 2.// 21.1/ !%/.11 32/.11 !!%.13 !..
!/ ..//J !/1 3.1/J ..%/J .%./ /.1) .2./) .%./1 ()2./1 !1..21 !./3
!. ..//J !/1 3.1/J ..%/J .%./ %./% ./.1% E !*111.11 !1%.2% !./3
#A5 L6 .D%, +eayment with 0ariable Caital "nstallments& #he Advisor?s 'imulation
5ase +ate
+eayment J
+eayment "nterest
Loan 7CF -'C+
1 .J !%1 2.%1J !*111.11
! ..%/J !%1 2.,/J /.2/J /2./ )2.%/ (,.2/ (,%./1 /2./1 !)!..2 !.)(
% ..)/J !%1 2.//J /.2/J /2./ )/./3 ().13 33/.11 !!/.11 !)1.!( !.)((
) ../1J !%1 2.21J ..11J .1 ),.12 (,.12 3%/.11 !2/.11 !),... !.,)!
, ...1J !%1 2.31J ..%/J .%./ )%.!3 (,..3 2.%./1 %)2./1 !)).2/ !.,!)
/ ...1J !)/ 2.(/J ..%/J .%./ )1.)! (%.3! 211.11 )11.11 !)).3/ !.,,%
. ..31J !)/ 3.!/J ..%/J .%./ %3./) (!.1) .)2./1 ).%./1 !)!.%/ !.,,%
2 ..3/J !)/ 3.%1J ..%/J .%./ %..!, 33.., /2/.11 ,%/.11 !%(./, !.,.%
3 ..3/J !)/ 3.%1J ..%/J .%./ %)./3 3..13 /!%./1 ,32./1 !%/.23 !.,.!
( ..2/J !/1 3.%/J ..%/J .%./ %!.!, 3).., ,/1.11 //1.11 !%,..( !.,(!
!1 ..2/J !/1 3.%/J ..%/J .%./ !3./. 3!.1. )32./1 .!%./1 !%!..) !./
!! ..2/J !/1 3.%/J ..%/J .%./ !/.(3 23.,3 )%/.11 .2/.11 !%1.3/ !./,
!% .../J !/1 3.!/J ..%/J .%./ !).%, 2/.2, %.%./1 2)2./1 !!...! !./,
!) ...1J !/1 3.!1J ..%/J .%./ !1..) 2).!) %11.11 311.11 !!..%1 !./3(
!, ..//J !/1 3.1/J ../1J ./ 3.1/ 2).1/ !)/.11 3./.11 !!%.13 !./),
!/ ..//J !/1 3.1/J ..2/J .2./ /.,) 2%.() .2./1 ()%./1 !1..21 !.,.)
!. ..//J !/1 3.1/J ..2/J .2./ %.2% 21.%% E !*111.11 !1%.2% !.,.)
%1! Funding 7tions& 'enior -ebt
'o* again considering the loan of !*111 of the revious examle and maintaining
the same interest rates* if the advisor ots for a dedicated ercentage of 21J of
the oerating cash flow* then reayments to lenders will be structured as shown in
#able .D%/.
7f course* acting in the interest of sonsors* the advisor will attemt to secure the
lowest ossible dedicated ercentage. 6ach reduction in the amount alied to service
the debt will* in fact* increase dividend flows earned in the early years of oeration*
which will benefit the sonsors? "++. 'o if* for instance* the dedicated ercentage is
reduced to .1J and we assume a flat yield curve from the seventh year onward and a
constant oerating cash flow from that same year* then the reayment eriod
will increase from !. to %! halfDyearly ayments and generate the flows shown in
#able .D%..
..(.3 +efinancing Loans Already :ranted to the 'P0
#he ool of lenders may change after the loan has been structured* given that some
banks may ot out of the deal and be relaced by others. "n these circumstances* can
terms and conditions for the funding be revised; Actually* it is rather common ractice
to refinance an alreadyDgranted loan or to increase it to reduce the sonsors? eCuity
commitment or to change the contractual terms and conditions of the debt. <sually
the ro$ect sonsors themselves launch discussions to renegotiate the debt. 8owever*
it is not unusual for a bank @erhas the arranger of the original financing ackageA to
roose refinancing in order to obtain a new assignment and in doing so earn the
relevant comensation @the soDcalled work feeA. #he refinancing is structured with the
aim of imroving the 4P0 and the internal rate of return for the deal?s sonsors. "n
fact their ob$ectives are&
. #o free u cash blocked to service reserve accounts @esecially the debt reserveA
. #o reduce sreads aid above base interbank interest rates
. #o extend the tenor of the debt
. #o introduce a new form of funding alongside the bank loan* based on a bond
issue* which will mean diversifying the grou of lenders
. #o reduce the severity of certain covenants
+efinancing can be broken down into two categories&
. 'oft refinancing @often known as a waiverA
. 8ard refinancing* or refinancing in the true sense
..(.3.! 'oft +efinancing @WaiverA
#he waiver is the easiest and fastest way to refinance a deal. "n reality it would be
more correct to seak of renegotiating conditions* inasmuch as this aroach
doesn?t involve changing the financial leverage decided for the ro$ect and the
tenor of the loan. "n effect* the waiver is an amendment. "ncreasing financial
leverage @soDcalled regearingA or extending the tenor would* in fact* increase the
ro$ect?s risk rofile. #his would necessarily mean discussing articiation again
with each of the banks in the ool* considerably lengthening the time reCuired to
come to a new agreement.
#A5 L6 .D%/ +eayment 5ased on a -edicated Percentage
5ase +ate
+eayment J
+eayment "nterest
Loan 7CF -'C+
1 .J !%1 2.%1J !*111.11
! ..%/J !%1 2.,/J 21.11J /,.(% )2.%/ (%.!2 (,/.13 /,.(% !)!..2 !.,%3/2!
% ..)/J !%1 2.//J 21.11J //.,. )/..3 (!.!, 33(..% !!1.)3 !)1.!( !.,%3/2!
) ../1J !%1 2.21J 21.11J .1.1! ),.%/ (,.%. 3%(..! !21.)( !),... !.,%3/2!
, ...1J !%1 2.31J 21.11J .!.%2 )%.)/ ()..% 2.3.), %)!... !)).2/ !.,%3/2!
/ ...1J !)/ 2.(/J 21.11J .).!. )1./, ().21 21/.!( %(,.3! !)).3/ !.,%3/2!
. ..31J !)/ 3.!/J 21.11J .).!, %3.2, (!.32 .,%.1/ )/2.(/ !)!.%/ !.,%3/2!
2 ..3/J !)/ 3.%1J 21.11J .,.). %..)% (1..3 /22..( ,%%.)! !%(./, !.,%3/2!
3 ..3/J !)/ 3.%1J 21.11J .,.). %)..( 33.1, /!).)) ,3...2 !%/.23 !.,%3/2!
( ..2/J !/1 3.%/J 21.11J ./.!! %!.!2 32.%3 ,,2.%) //%.22 !%,..( !.,%3/2!
!1 ..2/J !/1 3.%/J 21.11J ....( !3.,/ 3/.!, )31./, .!(.,. !%!..) !.,%3/2!
!! ..2/J !/1 3.%/J 21.11J .3.(1 !/.21 3,..1 )!!.., .33.). !%1.3/ !.,%3/2!
!% .../J !/1 3.!/J 21.11J .3.() !%.21 3!..) %,%.2! 2/2.%( !!...! !.,%3/2!
!) ...1J !/1 3.!1J 21.11J 2!./! (.3) 3!.), !2!.%1 3%3.31 !!..%1 !.,%3/2!
!, ..//J !/1 3.1/J 21.11J 2!./. ..3( 23.,/ ((.., (11.). !!%.13 !.,%3/2!
!/ ..//J !/1 3.1/J 21.11J 21..3 ,.1! 2,..( %3.(. (2!.1, !1..21 !.,%3/2!
!. ..//J !/1 3.1/J 21.11J %3.(. !.!2 2!.(! E !*111.11 !1%.2% !.,%3/2!
#A5 L6 .D%. Lowering the -edicated Percentage
5ase +ate
+eayment J
+eayment "nterest
Loan 7CF -'C+
1 .J !%1 2.%1J !*111.11 E
! ..%/J !%1 2.,/J .1.11J ,!.2/ )2.%/ 2(.11 (/3.%/ ,!.2/ !)!..2 !......2
% ..)/J !%1 2.//J .1.11J ,!.(, )..!2 23.!% (!..)! 3)..( !)1.!( !......2
) ../1J !%1 2.21J .1.11J ,/./% )/.%3 31.31 321.2( !%(.%! !),... !......2
, ...1J !%1 2.31J .1.11J ,..%( )).(. 31.%/ 3%,./1 !2/./1 !)).2/ !......2
/ ...1J !)/ 2.(/J .1.11J ,2./, )%.22 31.)! 22..(. %%).1, !)).3/ !......2
. ..31J !)/ 3.!/J .1.11J ,2.1( )!... 23.2/ 2%(.32 %21.!) !)!.%/ !......2
2 ..3/J !)/ 3.%1J .1.11J ,2.31 %(.(% 22.2) .3%.12 )!2.() !%(./, !......2
3 ..3/J !)/ 3.%1J .1.11J ,2./1 %2.(. 2/.,2 .),./2 )./.,) !%/.23 !......2
( ..2/J !/1 3.%/J .1.11J ,3.., %..!3 2,.3! /3/.() ,!,.12 !%,..( !......2
!1 ..2/J !/1 3.%/J .1.11J ,3.3! %,.!2 2%.(3 /)2.!) ,.%.32 !%!..) !......2
!! ..2/J !/1 3.%/J .1.11J /1.)/ %%.!. 2%./! ,3..22 /!).%) !%1.3/ !......2
!% .../J !/1 3.!/J .1.11J /1.!) !(.3, .(.(2 ,)..., /.).). !!...! !......2
!) ...1J !/1 3.!1J .1.11J /%.1, !2..3 .(.2% )3,..! .!/.)( !!..%1 !......2
!, ..//J !/1 3.1/J .1.11J /!.2. !/.,3 .2.%/ ))%.3, ..2.!. !!%.13 !......2
!/ ..//J !/1 3.1/J .1.11J /1..% !).,1 .,.1% %3%.%% 2!2.23 !1..21 !......2
!. ..//J !/1 3.1/J .1.11J /1.%3 !!.). .!..) %)!.(, 2.3.1. !1%.2% !......2
!2 ..//J !/1 3.1/J .1.11J /%.)1 (.), .!..) !2(.., 3%1.). !1%.2% !......2
!3 ..//J !/1 3.1/J .1.11J /,.,1 2.%) .!..) !%/.%, 32,.2. !1%.2% !......2
!( ..//J !/1 3.1/J .1.11J /../( /.1, .!..) .3../ ()!.)/ !1%.2% !......2
%1 ..//J !/1 3.1/J .1.11J /3.32 %.2. .!..) (.22 ((1.%) !1%.2% !......2
%! ..//J !/1 3.1/J .1.11J (.22 1.)( .!..) E !*111.11 !1%.2% !......2
%1, C 8 AP # 6 + . Financing the -eal
#he waiver can hel sonsors achieve three of the ob$ectives mentioned
!. #o free u cash from the debt service reserve account
%. #o reduce sreads aid on the loan
). #o reduce restrictions imosed by covenants
As regards the first oint* it is Cuite normal ractice to allow sonsors to use cash
in reserve accounts* which is relaced by a bank guarantee @bond or letter of creditAK
the second and third ob$ectives* instead* are achieved in negotiations with all the
other banks in the ool* carried out by the arranger of the refinancing. 7nce the ool
has given aroval* the arranger?s legal advisor then amends the financing agreeD
ment* introducing the new conditions negotiated with the 'P0. "n terms of cost* a soft
financing renegotiation reCuires ayment of a work fee @or waiver feeA to the arranger
amounting to around !1=%1 basis oints. "n addition to this are costs for revising the
legal documentation and fees for legal* technical* and insurance consultancy. Market
standards indicate that soft refinancing can be set u in a eriod of !./ to % months.
..(.3.% 8ard +efinancing
#rue refinancing concerns the agreements between the sonsors and ool of lenders*
and leads to a change in the level of leverage for the deal or the tenor of the loan* two
conditions that can increase considerably the risk factor for the ool of lenders. 8ard
refinancing doesn?t resent any roblems from the standoint of logic. Again* in this
case it is a Cuestion of modifying some of the basic ro$ect financing conditions*
exactly as in the case of the waiver costs or covenants change. 8ere* however* the
roblems are of a legal nature and a tax nature. +efinancing is worthwhile if can
minimiFe the following two effects that deend on tax regulations and laws in the
country concerned.
. #ax costs& "n some countries* new longDterm financing is sub$ect to the ayment
of tax on the debt amount and guarantee amounts for the debt itself.
. Clawback action& "n some countries* refinancing is considered a new debt and
therefore cancels out time allowed to creditors to avoid falling foul of a
clawback action in the event of default of the ro$ect.
#akeover& #akeover is the first method of hard refinancing. "t involves acCuisition
of the loan by a new ool of lenders* who relace the old ool as regards relations
with the 'P0. #he takeover can involve either maintaining the same loan amount and
tenor or changing both @the more freCuent caseA. "n several countries* regulations
usually reCuire that the takeover be aroved unanimously by all creditors* which is
the ma$or obstacle to overcome with the takeover techniCue.
#akeover combined with regearing of the deal deserves secial mention. "n this
case* the deal is structured in two tranches. #he first concerns relacement of the old
creditors by the new onesK the second* in contrast* is to grant funding u to the new*
higher level of debt @lower level of eCuityA agreed with the 'P0?s sonsors* who can
immediately draw this additional amount of cash. #his second tranche is guaranteed
but with a lower level of seniority than the refinanced tranche. #his solution can be a
way of avoiding tax on the new financing and guarantees. #he greater rocedural
comlexity of the takeover techniCue as comared to the simle waiver is also
reflected in the cost* which includes not only the work fee and costs for legal advice
%1/ Funding 7tions& 'enior -ebt
but also the underwriting fee on that art of new debt that is reCuired to increase
leverage. #he significant change in loan risk* furthermore* means that renegotiation
of terms with banks in the ool and with new lenders reCuires more time. "n ractice*
it takes from ) to / months to comlete the deal.
4ew Financing @or 4ew LendingA& Many loan agreements give the debtor the otion
to reay the ool in advance* although this usually reCuires giving notice. "t is
therefore ossible to set u a deal in which the following occurs.
!. A ool of new lenders advances a sum to the 'P0 that is sufficient to reay
creditors in the old ool comletely.
%. #he new lenders grant a new loan tranche to increase the leverage level*
guaranteeing this increased funding with a lower level of seniority than for
the first loan. #he reasons for creating a second tranche are exactly the same as
those mentioned for the takeover solution.
). #he 'P0?s sonsors immediately draw down the additional cash.
When the deal is structured in the form of new financing @or new lendingA* the
debtor borrows a sum to ay off another debt and can also decide to relace the old
creditor with a new one* even without the consent of the former. A diagram showing
the structure of such a deal is shown in Figure .D/. Costs and time reCuired to
structure refinancing using this method are very similar to those mentioned for the
takeover solution.
5ond "ssue at the 6nd of the Construction Phase& #he three methods analyFed
reviously don?t lead to a change in debt structure because the funding continues
to be rovided to the 'P0 by a ool of banks* whether the old or the new grou. At
the end of the construction hase* this method of refinancing calls for a ro$ect bond
issue and credit enhancement guarantee scheme @for instance* recourse to monoline
insurers using the wraed bond techniCueK see 'ection ..!!.%A. #his can increase the
S!ecial?"%r!ose Ve3icle
to ol
Ol "ool
ne6 !ool
Ne6 "ool
F " : < + 6 .D/ +efinancing <sing the 4ew Financing 7tion
rating level for the issue in order to achieve a rivate lacement with a reselected
grou of institutional investors. #he funds raised by the bond issue can be used to
reay the banks that funded the ro$ect during the construction hase. "ssue of
ro$ect bonds usually means that better conditions can be achieved in terms of
tenor& An issue can have a tenor of u to %1 years. Furthermore* these bonds are
Cuite aealing to rofessional investors in times when rates are droing or when
they are low on securities from issuers with a high standing.
#he advantage of refinancing using bonds can be illustrated by the following
examle. Let?s assume a ro$ect has a cost of )11 and is financed 2/J by a senior loan
@tenor ) years and swaed cost /JA and the remaining %/J by eCuity. "nterest
during the construction hase is caitaliFed u to the end of year %. +efinancing of
the senior loan is lanned at the end of year % @end of the construction eriodA by
means of a bond with a ,Dyear maturity and interest rate of ,.2/J.
#able .D%2 gives
an analysis based on a syndicated loan
#he ro$ect has cover ratios ranging from a minimum of !.13 to a maximum of
!.!(* a ro$ect "++ of 3..)J. and "++ for sonsors of !).(J. #he extension of the
tenor and lower interest rate on bond refinancing clearly imroves the sonsors?
osition. 'ee #able .D%3.
#he costs of organiFing a bond issue are similar to those for a takeover and
new lendingK but in addition there is a rating fee to ay to the rating agencies @see
#A5L6 .D%2 +efinancing the -ealE'tandard 'yndicated Loan
Construction Period 7erating Period
1 ! % ) , / .
Pro$ect 65"#-A 1 1 1 !11 !11 !11 !11
Pro$ect "nvestment !11 !11 !11 1 1 1 1
Q <nleveraged free cash flow !11 !11 !11 !11 !11 !11 !11
"nterest costs ] /J 1 1 1 !%.1) 3.1% ,.1! 1.11
-ebt withdrawals 2/ 2/ 2/ 1.11 1.11 1.11 1.11
Caital reayment @old loanA 1 1 1 31.!( 31.!( 31.!( 1.11
6Cuity contribution %/ %/ %/ 1.11 1.11 1.11 1.11
Free cash flow to eCuity 1 1 1 2.23 !!.2( !/.31 !11.11
Flows to sonsors %/ %/ %/ 2.23 !!.2( !/.31 !11.11
-'C+ !.13 !.!) !.!( n.m.
Pro$ect "++ 3..)J
'onsors "++ !).(J
7ld loan reayment schedule
7utstanding @year endA 2/ !/2..( %,1./2 !.1.)3 31.!( 1.11 1.11
CaitaliFed interests 2..( 2.33 1.11
Princial reayment 1 1 1 31.!( 31.!( 31.!( 1.11
"nterest costs !%.1) 3.1% ,.1! 1.11
(. #he longer tenor and lower interest rate for the bond comared to the senior loan are by no means a
matter of good fortune. "f a ro$ect overcomes the construction hase* then many of the risks that could have
affected it have already been overcome. A bookrunner @an arranger of bond issuesA can therefore roose more
aggressive conditions to otential investors.
#A5L6 .D%3 +efinancing <sing a 5ond "ssue
Construction Period 7erating Period
1 ! % ) , / .
Pro$ect 65"#-A 1 1 1 !11 !11 !11 !11
Pro$ect "nvestment !11 !11 !11 1 1 1 1
Q <nleveraged free cash flow !11 !11 !11 !11 !11 !11 !11
"nterest costs on loan 1 1 1 1 1 1 1
-ebt withdrawals 2/ 2/ 2/ 1 1 1 1
Caital reayment @old loanA 1 1 %,1./2 1 1 1 1
5ond issue 1 1 %,1./2 1.11 1.11 1.11 1.11
5ond reayment 1 1 1 .1.!, .1.!, .1.!, .1.!,
5ond interests 1 1 1 !!.,) 3./2 /.2! %.3.
6Cuity contribution %/ %/ %/ 1 1 1 1
Free cash flow to eCuity 1 1 1 %3.,) )!.%( ),.!, )2.11
Flows to sonsors %/ %/ %/ %3.,) )!.%( ),.!, )2.11
-'C+ !.,1 !.,. !./% !./(
Pro$ect "++ 3..)J
'onsors "++ !..(J
7ld loan reayment schedule @RA bond issue
7utstanding @year endA 2/ !/2..( %,1./2 !31.,) !%1.%( .1.!, 1.11
CaitaliFed interests 2..( 2.33 1.11 1.11 1.11 1.11 1.11
7ld debt reayment 1 1 %,1./2 1.11 1.11 1.11 1.11
5ond issue 1 1 %,1./2 1.11 1.11 1.11 1.11
5ond rincial reayment 1 1 1 .1.!, .1.!, .1.!, .1.!,
5ond interest costs 1 1 1 !!.,) 3./2 /.2! %.3.
'ection ..!!./.!A and the listing fee if the issue is to be listed on a stock exchange @in
6uroe* this is normally done on the Luxembourg stock exchangeA. #he time reCuired
to organiFe a bond issue ranges from ) to / months. 8owever* it is advisable for
sonsors to define the refinancing strategy to be adoted right from the start @bank
loan or 6urobondA so that the arranger is able to evaluate the best timing for the
issue. #he main difficulty in this tye of transaction in some countries is incomatiD
bility of limits for issuing bonds with the high debtDtoDeCuity ratio of a ro$ect finance
deal. A ossible solution is recourse to an issuing vehicle incororated in a foreign
Mixed 'olutionsE4ew Lending and 5ond "ssue& #he single solutions analyFed can
also be combined. For instance* the combination of a new financing and a bond issue
can involve two hases&
!. An initial hase* in which the arranger=underwriter lends the 'P0 the necessary
funds to reay the old loan and* if necessary* the additional funds for regearing
@in effect the arranger becomes the !11J lender for a redefined eriodA
%. A second hase* in which the arranger roceeds with the bond issue and laces
the residual art of the new contractual conditions with a ool of banks that
can include both old and new member banks
Clearly this is only an otion for very large intermediaries who can cover !11J of
the 'P0?s existing debt without infringing regulatory limits as regards large borrowD
ings and risk concentration. Furthermore* the higher degree of risk assumed by the
arranger @who could fail to lace the bond issue or refinance the deal with a new oolA
means that structuring takes longer* making costs higher for sonsors. 5ut given that
the mandate for the two deals is assigned to the same arranger* the fees will be lower
than if the mandate had been given to two different intermediaries.
..!1 Pro$ect Leasing
An alternative to a syndicated loan @but less widesreadA is the use of leasing* which
in some cases offers interesting oortunities in countries with favorable tax
regimes. Leasing has been used in the <9 in several PF" ro$ects involving the
construction of different kinds of real estate investments @schools* social housing*
risons* and hosD italsA.
"n a ro$ect leasing contract* the leasing comany @lessorA rovides the asset to the
'P0 @lesseeA after urchasing it from the sulier @contractorA. "n turn the 'P0
commits to ay the lessor installments @either fixed or floatingA for a given eriod
of time according to a reestablished timetable. #here is also a rovision for redemD
tion when the contract exires.
While the contract does not differ from a regular leasing contract* some comliD
cations must be ket in mind when comaring ro$ect leasing to a normal finance
leasing contract&
. #he tye of asset obtained in leasing by the ro$ect comany
. +elations with lenders as regards the debt @essentially with the ool of banks that
materially disburses funding to comlete the structure to be assigned in leasingA
#he asset assigned in leasing can be a lant or sometimes a very comlex
structure that is assigned to the 'P0 on a turnkey basis after construction and
initial testing. 'o the 'P0 transfers the roblems of organiFing and monitoring the
construction hase to the leasing comany. 5ecause the lessor=leasing comany is
the owner of the asset right from the start of the construction hase* it obviously
must assume the risks of this hase and negotiate all the guarantees that enable it to
cover all risks adeCuately.
..!1.! 0aluing the Convenience of a Pro$ect Leasing
A financial evaluation to establish whether using ro$ect leasing techniCues is oorD
tune isn?t different from the case of financing by means of a syndicated loan but
shows certain significant differences.
An imortant difference now is that the lessor*
in addition to banks and sonsors* must obtain an accetable rate of return given the
degree of risk assumed for the deal. #he "++ for the lessor is obtained by comaring
construction costs and financial exenses that arise from borrowing to fund structure
imlementation and incoming cash flows from leasing installments aid by the 'P0
!1. #o investigate in deth asects concerning construction of financial simulations for leasing contracts in
ro$ect finance* see 5ull @!((/A* . !)!.
%1( Pro$ect Leasing
@lesseeA and received by the lessor during the oerations hase. When seaking of
leasing during the construction hase* the industrial and financial organiFation
remains with the leasing comany* which contracts out the construction work conD
Furthermore* the lessor* like the banks* must also evaluate if the leasing installD
ments effectively match ositive cash flows generated by the ro$ect by calculating
cover ratios similar to those already seen in the case of a loan.
Cover ratios concerning the lessor are easy to calculate. #he debt service cover
ratio will eCual the result of dividing oerating cash flow of the 'P0 by the leasing
installment* whereas the loan life cover ratio will be the resent value of the sum of
oerating cash flows of the 'P0 throughout the life of the leasing contract and the
outstanding at the time of valuation.
Figure .D. summariFes the variables which influence the convenience of a ro$ect
leasing. 8ere it is assumed that the lessor and the constructor are two different
arties. #he alternative is when constructor and lessor are the same arty @as in the
case of oerating leasingA.
Figure .D. shows the life cycle of the ro$ect and indicates that during the
construction hase the leasing comany @lessorA ays the contractor with funds
borrowed from banks and used based on a reagreed milestones schedule. #he
investment of the leasing comany is then reaid during the oeration hase by the
'P0Dlessee with the cash flows generated by the ro$ect. "t becomes clear that this
financing alternative is feasible when&
!. 'P0 sonsors get a satisfactory eCuity "++ calculated as discussed in Chater /.
%. #he leasing comany gets an accetable level of "++. "n this case* the lessor
"++ can be calculated as
Banks len to
t3e leasin- com!an&
Leasin- com!an& leases t3e facilit&
to t3e S"V after constr%ction
$onition to be f%lfille9
+: Satisfactor& le;els of
IRR for banks
$onitions to be f%lfille9
+: Satisfactor& le;els of e'%it& IRR
/: Satisfactor& le;els of DS$R an LL$R for
t3e leasin- com!an&
1: Satisfactor& le;els of IRR for
t3e leasin- com!an&
F " : < + 6 .D. 0ariables <nderlying the 6valuation of +ecourse to Pro$ect Leasing
@! R "++
Q Construction cost lus interest exenses incurred by the leasing
comany until year $ @C7-* commercial oerating dateA L"
Q Leasing installment cashed in at time t
n Q 4umber of leasing installments agreed with the 'P0Dlessee&
). #he leasing comany gets accetable levels of -'C+ and LLC+* calculated as
@tA Q
@tA Q
@! i A
R -+
Q 7erating cash flow generated by the 'P0 in year t
Q Leasing installment in year t
-+ Q -ebt reserve available at time t
i Q -iscounting rate of interest @corresonding to the leasing "++A
Q 7utstanding amount of leasing to be reaid by the 'P0
at time t
..!1.% #he #ax 6ffect
7ther differences between ro$ect leasing and syndicated loans concern the measure
of certain key ro$ect investment variables that change radically when moving from a
loan to a ro$ect leasing aroach&
. #he otentially different interest rate for the 'P0?s debt from the rate obtained
from a leasing comany
. #he imact of the tax variable
As regards the interest rate* while the 'P0 lacks credit standing in its own right
and cannot count on total recourse to sonsors* the lessor is often an established
comany already oerating in the market that has a business history and can be
evaluated by lenders based on its ast erformance. "f the leasing comany has a
good credit rating* the interest rate charged to the 'P0 on debts with the lessor may
%!! Pro$ect 5onds
#A5L6 .D%( Calculation of +ecoverable and 4onrecoverable Losses
1 ! % @ $ A ) , / @mA +ecoverable Losses 4onrecoverable Losses
Assumtion !
Assumtion %
!1 !1 !1 R/ R/ R/ !/ !/
Loss=Profit !1 !1 !1 R/ R!1 R%1 )1 1
sometimes be lower than the cost of direct bank funding to the 'P0* which basically
deends on risk analysis and risk allocation.
#he tax variable lays a critical role in the use of leasing. "f the 'P0 owns the
structure* then in its first few years of life it may fall foul of the dividend tra
discussed in 'ection ..3 due to dereciation effects. "n several countries tax regulaD
tions don?t allow losses to be carried forward or only allow this for a limited number
of years. "n such cases it can become convenient to resort to a leasing contract
solution. For instance* if m is the maximum eriod for carrying forward losses and
$ is the year in which 'P0 oerations move from a net loss to a net rofit situation*
then the 'P0 can comletely benefit from a tax shield on losses if
m $ G

65# Q 6arnings before taxes for year k
L Q losses in the balance sheet referred to year k
#he eCuation indicates the amount of losses recoverable and* therefore* by difD
ference* the amount of losses that cannot be used to reduce tax liability. Assuming
that the 'P0 benefits from a loss carryforward for direct tax uroses over a eriod
m eCual to a maximum of / years and a eriod 1N% @$ therefore eCuals %A for negative
income* given two different assumtions for earnings before taxes* the situation from
a tax standoint would be as shown in #able .D%(.
"n the case of financing using ro$ect leasing* the roblem of nonrecoverable
losses is almost always overcome. "n fact* if the leasing comany makes a rofit
@which is likely because the comany is already oerativeA and has other deals already
in lace* it will be able to benefit from tax savings immediately* given that the 65#
and therefore taxes will be reduced. As a conseCuence* the tax saving that is not lost
can in art be transferred to the 'P0 in the form of lower leasing installments while
still ensuring that the lessor achieves a satisfactory "++ level.
..!! Pro$ect 5onds
A ro$ect bond issue is an alternative that an 'P0 can use to obtain funding. As in the
case of bank loans* the rincial and interest on ro$ect bonds are also reaid to
investors from the ro$ect?s cash flows. 5ecause many bank syndicates finance ro$ect
loans granted to 'P0s on the interbank market or by issuing bonds themselves* it
would seem Cuite reasonable for 'P0s to aroach the bond market directly. From
an 'P0?s standoint* issuing bonds is similar to contracting debts with banks. #he
borrower* in fact* obtains resources in the form of a longDterm debt. #he main
difference between a ro$ect loan and a ro$ect bond is that a bond issue can count
on a much wider base of arties otentially interested in financing the deal @soDcalled
bond urchasers or bondholdersA. As is seen in 'ection ..!!.!* this grou will include
not only banks but also institutional investors such as ension funds and insurance
comanies or mutual funds secialiFed in infrastructure investments.
Aart from the foregoing difference* ro$ect loans and ro$ect bonds are similar.
First* Cuite freCuently the 'P0?s bonds are urchased by a ool of banks @a soDcalled
bought dealK see 'ection ..!!./.,A. 'econd* bonds are securities that can be traded on
financial markets between an investor and another buyer* although in reality ro$ect
bonds can show lower liCuidity than usual cororate bonds. 7ften they are sold to
grous of institutional investors by rivate lacement @'ection ..!!.%A and are held in
ortfolio right u to maturity. #he international market for ro$ect bonds is much
smaller than the ro$ect loan market* which still constitutes the normal form of
ro$ect financing @see #able .D)1A.
8owever* the growth rate for the bond market has been Cuite significant in
recent years. Furthermore* issues are concentrated in wellDdefined geograhical
areasK in fact* the <nited 'tates* western 6uroe* and Asia account for almost all
issues during the years considered. -ata available as regards Cuality of issues
@measured by ratings for issuersA also show that the market certainly refers use
#A5L6 .D)1 Pro$ect 5ond "ssues by Country* %11%N%11/ @<'I millionsA
%11% %11) %11, %11/
Americas 2*1,) !2*/%! !,*(%. !.*..)
<nited 'tates )*,%% !1*,)% 3*2(, !%*/3%
Canada (/.
5raFil %/1 !*(11 3/%
Chile ,1/ !*%!) !*%31
Mexico %*(.. )*111 )*(!% )*111
Western 6uroe !*3/) (*12. 2*1)/ ,*..(
<.9. !*))1 /*2.( .*/11 ,*..(
Central 6uroe and C"'
Middle 6ast and 4orth Africa
'ubD'aharan Africa %/%
Asia %*113 %*,!3 %*!3) ,*/%3
Malaysia !*(1, !*(!2 !*/!( %*%23
'outh 9orea
Australasia %*33, %*3(2 )*1,) 3,!
#otal !)*233 )%*!., %2*!32 %.*21!
'ource& Adated from Pro$ect Finance "nternational* issues %/2 @Hanuary %%* %11)A* %3!
@Hanuary %!* %11,A* )1/ @Hanuary %.* %11/A* )%( @Hanuary %/* %11.A.
#A5L6 .D)! Pro$ect 5ond "ssues by +ating Class* !((.N%11,
'BP +ating !((.
AAA %J !J %J 2J (J (J !1J !1J !1J
AAR* AA* or AA , , % , % % % ! )
AR or A 2 / , . . 2 2 !% ,
A ( . 3 2 2 . . , /
555R , / , ) , , ) !1 /
555 2 !, !! !% !% !% !1 . !2
555 /1 ,% )% %3 %) %/ %3 !, %)
55R % , / . !% !1 2 , )
55 2 . !! !, ( !1 !1 ) .
55 / ( !! / / . , % .
5R 1 ! % ! ! ! % ( .
5 ! ! % % % % % !. )
5 1 ! % ! 1 ! ! ! ,
CCC and below % ! , , 3 / 3 3 /
#otal !11J !11J !11J !11J !11J !11J !11J !11J !11J
#otal rated volume @<'I billionsA I!(.. I%2.. I)2./ I/1., I.%./ I3!.) I!1..) I!%1.. I!,..1
4umber of bonds /2 23 !!) !/% !.! !(. %)1 %%! %33
J "nvestment grade 3)J 22J .)J .2J .,J ./J ..J .,J ..J
J +ated 5R or lower /J /J (J /J .J /J /J !/J !3J
'ource& Adated from 'tandard B Poor?s Pro$ect B "nfrastructure Finance& Criteria and Commentary (=(3* (=((* !1=11* !1=1!*
!1=1%* !1=1)* and !!=1,K :lobal Pro$ect Finance* 2=(.* !1=1/.
of ro$ect bonds for safe ro$ects. -ata in #able .D)!* rocessed based on 'tandard
and Poor?s data* indicate a ercentage of investmentDgrade issues of at least .1J for
the eriod !((.N%11,.
#here are various reasons for the growth of the ro$ect bond market.
. :rowth in demand for infrastructure develoment and ugrading reCuires
heavy investments* whereas governments have been increasingly less willing or
unable to intervene directly in order to finance them.
. 6xertise and interest from institutional investors is increasing for alternative
investments meeting their reCuirements for mediumD* longDterm assets with
secific combinations of risk and return.
. "nternational rating agencies are taking on a more central role in evaluating
ro$ect finance deals* which reresents an imortant and lowDcost source of
information for investors in securities.
. 6xerience in the <.'. market @articularly in the ower sectorA has been
ositive for ro$ect sonsors and relevant lenders.
From the standoint of sectors in which bond issues are used most often* #able .D)%
shows that ower and oil and gas account for almost all issues in the %111N%11/ eriod.
Also note the increase in use of ro$ect bonds for PF" ventures in the last year of the
eriod under review.
#A5 L6 .D)% Pro$ect 5ond "ssues by 'ector* %111N%11/ @<'I millionsA
'ector %111 %11! %11% %11) %11, %11/
Power !!*(%1 !2*%2) ,*)!/ !%*),. !!*)2. 2*%.!
"nfrastructure )*)(, %*,)1 .*,2! !!*()! !!*13% )*.%!
7il gas )*%3/ )*3!) %*.)% 2*1%) /*!/( (*.22
#elecom %*1). !*,32 1 3., 1 1
Petrochemical 1 1 1 1 2), ,11
"ndustrial !2. 1 %/1 1 !%3 1
Mining 1 1 1 1 !.3 2!3
Leisure 1 1 !%1 1 1 1
'ocial infrastructure=PF" 1 1 1 1 1 /*1%,
#otal %1*3!! %/*11) !)*233 )%*!., %3*.,2 %.*21!
'ource& Adated from Pro$ect Finance "nternational* issues %1( @Hanuary %,* %11!A* %)) @Hanuary %)* %11%A* %/2 @Hanuary %%*
%11)A* %3! @Hanuary %!* %11,A* )1/ @Hanuary %.* %11/A* )%( @Hanuary %/* %11.A.
..!!.! "nvestors in Pro$ect 5onds
5onds issued by 'P0s are urchased by institutional investors with a longDterm
asset allocation rofileEmainly ension funds and insurance comanies. Pro$ect
bonds are* in fact* alternative investments to government or cororate bonds with
secific riskNreturn combinations. As regards life insurance comanies* only the
largest ones have the necessary ability to analyFe credit and other risks associated
with a ro$ect finance deal. 'mall ones almost always rely on assessments of rating
agencies as regards the Cuality of bonds issued by 'P0s @see 'ection ..!!./.!A. :iven
the nature of the life insurance business* these comanies can count on a relatively
redictable annual cash flow and must invest for very long eriods* given the nature
of their liabilities toward olicyholders. #his reCuirement finds a match with the
needs of 'P0s that issue ro$ect bonds. #his match is also found as regards the siFe
of investments* which for the ma$ority of life insurance comanies is around I/
million* whereas only the largest insurers invest higher amounts. "t should be
mentioned that the main factor influencing a life insurance comany?s investment
decision is credit risk* an asect that is often regulated by law. For instance* in the
<nited 'tates the 4ational Association of "nsurance Commissioners @4A"CA has
secific rating systems to evaluate these investments* which means American insurD
ance comanies tend to select bonds with a rating higher than the 'tandard and
Poor?s 555N investment grade or Moody?s 5aa) grade @corresonding to 4A"CD%A
@see 'ection ..!!./.!A.
#he second category of investors interested in ro$ect bonds is ension funds.
"n the <nited 'tates there are both ublic ension funds for government and ublic
administration emloyees and rivate cororate funds* although only the latter are
imortant otential urchasers of ro$ect bonds. #his* because they are sub$ect to
fewer constraints as regards credit risk for their investments* which must have a
'tandard and Poor?s rating of at least A. #hese investors are mainly attracted by the
return offered and liCuidity of the securities and* in articular given their mission*
ro$ect bond issues with rotection against inflation risk @see 'ection ..!!.,.,A.
Among other categories of investor interested in investing in ro$ect bonds are the
. "nvestment funds secialiFed in financing infrastructure ro$ects in certain sectors
or geograhical areas& 7ften many of these funds are the arms of multilateral
develoment banks @see 'ection ..,AK
. "nvestment banks* commercial banks* damage insurance comanies* and foundaD
tions& "n this regard* an interesting survey was conducted by +andolh @%11!A of
the ro$ect finance market in the liCuefied natural gas @L4:A sector that
analyFed their involvement in ro$ect bond investment.
..!!.% 0arious Categories of Pro$ect 5onds
As mentioned* ro$ect bonds are issued by the 'P0 to a series of investors to whom it
commits to ay eriodic couons and to reay the caital sum at maturity or
according to a redefined amortiFation schedule. #he general definition can* howD
ever* be adated to cover a wide range of financial instruments that can be issued for
uroses of ro$ect finance deals. And in fact ro$ect bonds can be classified based on
various characteristics&
!. 4ationality of the issuer in terms of issue currency for securities and lacement
%. #arget investors
). 6xistence of caital and interest ayment guarantees or otherwise
,. 'ubordination clauses
/. "nterest calculation method
.. Caital reayment method
..!!.%.! 4ationality of the "ssuer in #erms of "ssue Currency for 'ecurities
and Placement Market
An 'P0 could issue bonds in its domestic currency and then lace the securities with
institutional or retail investors in its own country. "n such a case* this funding
instrument is referred to as domestic bonds and is aroriate for smallDscale ro$ects
concentrated in a wellDdefined geograhical area. "n the case of a largeDscale ro$ect*
however* a single geograhical market may not be able to suly sufficient funding to
finance the deal. "n such circumstances* the solution is to lace the bonds in a broader
market with greater liCuidity than the domestic one. Furthermore* the 'P0 could
decide to issue the bonds in other than its domestic currency to take advantage of a
reference of investors to emloy their funds in a given currency @the most oular
currencies are the <.'. dollar* the ound sterling* the Haanese yen* and the euroA.
Currency swas against the domestic currency @see Chater )A are then used to avoid
exchange rate risk. "f bonds are issued by an 'P0 in other than its domestic market
and in the currency of the lacement market* they are referred to as foreign bonds.
"f the 'P0 issues bonds in a currency other than that of the lacement market they
are referred to as 6urobonds. 6xamles of foreign bonds are soDcalled Lankee bonds
@issued in <.'. dollars on the American market* registered with the 'ecurities
and 6xchange Commission @'6CA by nonresident issuersAK samurai @or shogunA
bonds* namely* issues in yen of the Haanese market* registered with the Haanese
Ministry of FinanceK bulldog bondsEissues in ounds sterling by issuers not resident
in the <9K kangaroo bonds* Australian dollar securities issued in Australia by a
nonresident 'P0.
..!!.%.% #arget "nvestors
An 'P0 and the intermediary handling the bond issue @the soDcalled bond bookrunnerK
see 'ection ..!!./A must decide which investors they want to be buyers of their bonds.
#he two alternatives available are a tender offer to retail investors and a rivate
lacement restricted to institutional investors. "n the case of a tender offer to the retail
market* the 'P0 must comly with regulations that the relevant authority in the
country concerned has issued to rotect investors @in the <nited 'tates this function
is fulfilled by the '6CA. #he fact of being regulated by a national authority means the
issuer must ublish a rosectus satisfying reCuirements concerning transarency and
eriodic disclosure* and in certain cases there may be a reCuirement to obtain ratings.
All of these reCuirements can add u to a disadvantage for issuers in terms of costs
@much higherA and timing @much longerA than for an offer made only to institutional
investors. "ssues offered to retail investors can* on the other hand* reach a much
broader investor base and might achieve a saving on cost of funding* esecially when
market conditions are articularly favorable @soDcalled hot issue marketsA and because
of greater liCuidity for securities as a result of their listing on a secondary market. #he
costNbenefit ratio for an issue aimed at the retail market is normally less than !. #his is
why the ma$ority of bonds issued as art of ro$ect finance deals are laced with
institutional investors using the rivate lacement mechanism. "n the case of rivate
lacement* an 'P0 instructs its bond bookrunner to identify a wellDdefined grou of
rofessional investors interested in urchasing the bonds and holding them in ortfolio
until maturity. "nsurance comanies* banks* and mutual funds secialiFed in infraD
structure finance are* in fact* on the lookout for mediumD to longDterm investment
oortunities with a good return=risk ratio and are less interested in the instrument?s
liCuidity because in reality the bonds will never be traded and will be held until
maturity. #he advantages of rivate lacement are many&
. Lack of strict regulatory constraints alying in the case of tender offers to the
retail market
. 'eed of structuring the deal and therefore the ossibility to exloit better the
timeDtoDmarket factor
. Possibility to structure the characteristics of the bond to suit the reCuirements of
. Cost of fundingElacing bonds with a limited grou of investors is less risky
for the bookrunner* which means underwriting fees are lower than for issues
aimed at the retail ublic.
A very clear examle of rivate lacement is reresented by the +ule !,,A PlaceD
ment market in the <nited 'tates. < until Aril !((1* stocks and bonds urchased in
a rivate lacement on the American market couldn?t be sold for at least % years.
-uring this eriod an investor was therefore unable to liCuidate the investment* and
this led to a reCuest for a higher return for investors as a remium for the security?s lack
of liCuidity. "n Aril !((1 the '6C introduced +ule !,,A and eliminated this time
restriction for trading these securities. 'tocks and bonds* even those issued by nonD
residents* which are not registered with the '6C @because they were urchased by
rivate lacementA* can be traded between soDcalled X"5sECualified institutional
buyers. #hese are institutions with security ortfolios exceeding a value of I!11
million. #he introduction of +ule !,,A reresented an imortant innovation for the
ro$ect bond market* facilitating security issues by both domestic and nonresident
'P0s on the American market* which is the world?s largest and most liCuid. #his
recludes the costly registration rocedure for issues with the '6C and reCuirements
for eriodic disclosure. Pro$ect bonds issued ursuant to +ule !,,A are usually issued
with the hel of a ool of underwriter banks or urchasing banks @in a bought dealK see
'ection ..!!./.,A that subseCuently sell the bonds to a target of X"5s. 'o this excludes
smallDscale issuesK in fact* the market range is between I!11 million and I%11 million.
..!!.%.) Caital and "nterest Payment :uarantees
Payment of rincial and interest on an 'P0?s bonds can be guaranteed by the
ro$ect assets. "n this case they are referred to as secured @or collateraliFedA bonds.
When there are no such guarantees* then the bonds are defined as unsecured. 'uch
bonds are more difficult to lace with investors* even if they are rofessionals. For
instance* some of the latter are bound by articles in their memorandum of incororD
ation that rohibit investment in securities with ratings below 'BP?s 555N or
Moody?s 5aa) @soDcalled seculative gradeK see 'ection ..!!./.!A. #o avoid this
roblem* a secial form of guarantee can be set u for the bond issue with an
insurance comany @soDcalled monoline insurerK see 'ection ,.)..A that unconditionD
ally and irrevocably >>loans?? its own rating to the 'P0Ecreating what are known as
wraed bondsEin exchange for ayment of an insurance remium. #his means that
if the 'P0 should default on rincial and interest ayments to investors* then the
monoline insurer stes in and ays but then has the right to demand reayment of the
sums concerned by the 'P0 @see Figure .D2A.
Particiation of a monoline insurer often means the bond obtains an investmentD
grade rating from the rating agencies. :iven that only leading insurers oerate in this
line of business* ratings obtained are usually high* even as high as the maximum AAA=
Aaa* although wraing by a monoline insurer is costly and remiums aid diminish
cash flows available to sonsors. As a result* evaluation of recourse to a monoline
insurer reCuires careful comarison of benefits and costs. #he benefits are as follows.
. "t reduces the cost of funding for ro$ect bonds issues.
. Covenants as regards debt reserve reCuested by investors in the bonds are likely
to be less stringent.
. ConseCuently* the sonsors "++ imroves* all other conditions being eCual.
"ro7ect Bon Ins%rance
Ins%rance "remi%m
Monoline Ins%rer
Bon Iss%e "rocees
Debt Ser;ice
F " : < + 6 .D2 "ssue of 5onds with +ecourse to Monoline "nsurers
#he main disadvantage of recourse to monoline insurers is the higher cost rereD
sented by insurance remiums aid. Pro$ect erformance as seen from the sonsors?
standoint imroves only if benefits exceed costs.
#he most active monoline insurers in the international financial market are
American* for instance* F:"C @Financial :uarantee "nsurance CororationA* F'A
@Financial 'ecurity AssuranceA* AM5AC* M5"A* and GL. +ecourse to monoline
insurers is very oular in the <9* where it has been used in numerous PF" ro$ects*
and in the <nited 'tates* where in the !(21s it was used for municial bond issues @see
'ection ..!!.)A.
..!!.%., 'ubordination Clauses
Pro$ect bonds can include subordination clauses roviding for rights over other
categories of creditor @rights for senior lenders* usually banks that have formed the
syndicate to finance the loan to the 'P0A. "n this case* these are known as $unior
bonds and the subordination clause calls for reayment of the rincial on one of two
. 7nly after full reayment of the senior loan @the most freCuent caseA
. 7nly on the condition that debt service of the senior loan and interest on the
$unior bonds have been fully satisfied
"n the latter case* if the remaining cash doesn?t have to be allocated to debt reserve
or 7BM reserve account* then the $unior bonds can be reaid with the residual funds
Hunior bonds are hardly ever laced with institutional investors because of the
higher level of risk involved when comared to senior bonds. As seen in 'ection ..3*
$unior bonds are usually urchased by the sonsors themselves. 'uch instruments
reresent a hybrid form of caitaliFation used to revent blocking of funds available
to sonsors in the event of lower annual net rofits @dividend traA.
..!!.%./ "nterest Calculation Method
Pro$ect bonds can be issued with a fixed couon @fixedDrate bondsA or* as is the case
with syndicated loans* with a variable interest rate @floatingDrate bonds using the base
rate lus a sreadA. #his solution can facilitate sale of these securities to investors*
esecially when bonds have a very long tenor. CP" @consumer rice indexA bonds are
similar to floatingDrate bonds. "n the case of these securities the yield @or more often
reayment of rincialA is linked to a consumer rice index. #his tye of instrument
has been used in the <9* where CP" bonds have financed hositals* risons* and gas
and water ielines.
..!!.%.. Caital +eayment Method
#he most widesread form for bonds is total reayment of the rincial at
maturity @bullet ayment or balloon aymentA. #his method is entirely logical in
the case of cororate bonds destined to be refinanced at maturity* given the
ongoing nature of business oerations. 8owever* it is not the best in the case of
ro$ect finance* given that the deal has a closed life cycle. For this reason* bonds
rovide for the gradual reayment of the rincial that is directly linked to the timeline
for the secific ro$ect?s cash flows. #he final maturity of ro$ect bonds is usually
fixed. #his is also another difference from
cororate bonds* which in certain cases include ut otions in favor of
investors themselves that make bonds easier to sell to investors. Call otion clauses
allowing the 'P0 to reay the bonds before maturity are not very common either.
..!!.) Municial 5onds
Municial bonds are a secial category of bond issued by ublic bodies in order to
finance ro$ects linked to the mission of local authorities. While these are not art of
the ro$ect bond category discussed in revious sections* they are worth mentioning
because they are structured in the same way as ro$ect bonds. #he term municial
bonds refers to bonds issued by ublic bodies such as states* governments* rovinces*
municialities* or other bodies in order to finance oerating exenses or secific
ro$ects. #hese bonds can be sold either by ublic lacement to retail investors or by
rivate lacement targeting institutional investors.
Many oerators consider this method of financing the forerunner not only of
bond ro$ect financing but of ro$ect finance itself as the term is intended today.
"n fact* the <.'. municial bond market has existed and grown over more than one
century @the first issue was made by the City of 4ew Lork in !3!%A and has become
the world?s largest market.
#heir widesread oularity is due to the fact that interest is taxDfree @which
reduces returns reCuested by the marketA* and normally the issues are for a relatively
low value @around I!1 millionA and therefore also utiliFable for smallDscale ro$ects.
7ther countries have also started to use these instruments* for instance* 6ast 6uroD
ean countries @Poland* CFech +eublic* 5ulgaria* 8ungary* 6stonia* etc.A and those
in 'outh America @5raFil* Argentina* Colombia* etc.A* which often issue them on the
#hese instruments can be classified into the following categories&
. :eneral obligation bonds
. Pro$ect revenue bonds
. -edicated revenue bonds
:eneral obligation bonds are securities for which debt service is guaranteed by >>full
faith and credit*?? namely* by the issuer?s creditworthiness* which deends on its
ower to imose taxes on the ublic.
Pro$ect revenue bonds are very similar to ro$ect bonds. "n fact* debt service for the
loan is guaranteed by the cash flows generated by a secific ro$ect. #he essential
difference from a ro$ect bond is that the issuer is a ublic body instead of an 'P0.
#hese bonds are named according to the sector for which funding is being raised and
so there can be airort revenue bonds* highway revenue bonds* hosital revenue
bonds* ublic ower revenue bonds* resource recovery revenue bonds* sort revenue
bonds* water and sewer revenue bonds* and industrial revenue bonds. Funds from
issues are transferred by the ublic body to a rivate comany for urchase of lant
and structures* and revenues from the latter will be used to guarantee reayment of
the bonds. A variation can be the case where the ublic body urchases the necessary
structures and then leases them to the comany. A tyical contractual framework is
shown in Figure .D3A.
Lastly* dedicated revenue bonds are a secial category of bond in which debt
service is guaranteed by a secific cash flow generated by revenues collected by the
"lant sale
or leasin-
"%blic Bo&
"lant !rice4
leasin- !a&ment
Debt ser;ice
Bon In;estors
F " : < + 6 .D3 Contractual Framework for a Pro$ect Financed by Pro$ect 5onds
ublic body concerned. 8owever* these flows are not normally linked to the secific
ro$ect in Cuestion. For instance* there can be bonds issued based on cash flows from
tax receits @such as taxes from roduction of alcoholic beverages* natural gas*
gasoline* etc.A to which the ublic body is entitled or funds transferred to it by the
central government.
..!!., When 'hould Pro$ect 5onds 5e <sed;
Pro$ect bonds reresent a form of funding for an 'P0 as an alternative to the more
freCuent form of a syndicated loan. 8owever* this is a valid alternative only in certain
wellDdefined situations and markets. "t should be remembered that whereas syndiD
cated loans are contracts an arranger structures according to sonsors? needs in a
tailorDmade manner* ro$ect bond issues are based on securities that are much less
easy to ersonaliFe. "n effect* a ro$ect bond bookrunner knows it will be more
difficult to find investors willing to hold ro$ect bonds in their ortfolio if they
have a large number of secial characteristics* unless these investors have been
identified in advance as targets for a rivate lacement. "f* instead* the issue is to
be listed on secondary markets* it must have standard characteristics that won?t form
a erfect match with the secific needs of a ro$ect finance deal. A further asect to
consider is that bond investors @unlike banksA are less inclined to run risks associated
with the construction hase* referring to assume risks only in the oerating hase.
Also* country risk can be a handica for a bond issue when the 'P0 is located in
a country where this tye of risk is articularly high. #his is why* whenever ossible*
bond issues are more aroriate for refinancing deals that have already overcome
the construction hase @see 'ection ..(.3A because in this case the bonds are more
similar to an assetDbacked securitiFation than a ro$ect finance deal.
Certain factors will now be reviewed to distinguish between ro$ect bonds and
ro$ect loans and that can influence sonsors and their advisors? decision as regards
one of the two alternatives available.
..!!.,.! "nvestor #arget
7nly a few countries have a wellDdeveloed domestic caital market in which the
financing needs of an 'P0 can be satisfied by investors Cualified to evaluate the risks
and forecast return. "f the cororate bond market @in which ro$ect bonds are a
subcategoryA is not very well develoed and lacks availability of funds* then this will
reresent an obstacle for a ro$ect?s ability to draw on caital markets directly. "n the
case of syndicated loans* arrangers can structure the ool either on a domestic basis
@inviting only domestic banksA or on an international basis* therefore overcoming the
constraints of the cororate bond market in the country where the ro$ect is located.
As already mentioned* a real turning oint for overcoming similar obstacles was the
introduction of +ule!,,A in the <.'. caital market* which essentially encourages
bond issues by nonresident ro$ect comanies.
..!!.,.% #enor of Financing
Probably the greatest advantage of ro$ect bonds as oosed to syndicated loans is
that a bookrunner can structure an issue with a longer tenor than in the loan otion.
'ometimes ro$ect bonds can bridge the tenor ga with the bank loan market because
the ro$ect bond investor market manages to assume longerDterm risks than are
accetable to banks. #enors of %1N%/ years can easily be reached* esecially in mature
markets* although even maturities of )/ years and longer have been tested with
#his is ossible mostly thanks to the tyes of investors interested in ro$ect
bonds. Life insurance comanies and ension funds certainly like longDterm=very longD
term assets to back u their liabilities so as to otimiFe their ALM @asset and liability
managementA strategies. :enerally seaking* banks find it Cuite easy to roose loans
u to !/ years. 8owever* internal restrictions based on the tye of relative liabilities
and external restrictions imosed by the regulatory environment mean that this limit
cannot easily be exceeded. #he effect of maturity also lays an even more imortant
role after the imlementation of 5asel "" @see Chater 3A* inasmuch as longer maturities
mean that banks must absorb more caital* all other conditions being eCual.
..!!.,.) Preservation of the 'onsors? Financial Flexibility
A bond issue can mean that sonsors don?t have to use their own credit lines for this
reserve* which would otherwise delete the unusual ortion of credit facilities with
banks. #he fact of being able to access a different investor base makes ro$ect bonds
more indeendent than bank lending* which is certainly an advantage.
..!!.,., "nflationDLinked 5onds
As seen in Chater )* one of the risks inherent to ro$ects is the unredictable
trend in inflation* esecially when costs and revenues are not tied to the same rice
!!. 5ased on a samle of !2. syndicated loans and ro$ect bonds* 6sty reorts that %,J of the bond loans
issued for ro$ect finance deals have a tenor of more than %1 years* comared with 3J for ro$ect bank loans.
#he average duration for bank loans was (., years @median 3.1A against !).. years for ro$ect bonds @median
!).)A. 'ee 6sty @%11/A.
index. While floatingDrate syndicated loans are granted at a variable interest rate
@linked as regards the base rate comonent to the inflation trend reflected in the
nominal interest rateA* ro$ect bonds can exlicitly incororate the inflation effect if
structured in the form of inflationDlinked bonds. #hese are bonds for which
ayment of interest and=or caital is tied to a consumer rice index @CP"A* all the
better if this index is the one to which the 'P0?s costs and revenues are linked.
"nflationDlinked bonds are articularly oular with institutional investors with
longDtermDmaturity financial ortfolios* as is the case with life insurance comanies
and ension funds.
..!!.,./ 'tructure for <tiliFation and +eayment of Funding
#he inflexibility of ro$ect bonds comared with syndicated loans becomes evident
when considering utiliFation of funds and subseCuent method of reayment. As seen
in 'ection ..(.2* with ro$ect loans* sonsors and banks structure the loan so that
ro$ect trends for unleveraged free cash flows and debt service @in the oerations
haseA and covering outgoings for startDu and construction costs by withdrawals
from credit facilities are made as comatible as ossible. Pro$ect bonds* on the other
hand* mean that funds from the issue are received immediately and so the 'P0 has to
reinvest the roceeds until the funds are reCuired. "f* as often haens* the return on
liCuidity is less than the "++ on ro$ect bonds @soDcalled negative arbitrageA* the
ro$ect bond issue is inefficient comared to a ro$ect loan.
..!!.,.. Credit Policies and Market 'entiment
5ank credit deartments tend to define credit olicies and guidelines based on longD
term growth ob$ectives. +ecourse to ro$ect loans is therefore almost always a
ossibility. "n contrast* bond markets are much more sensitive to shortDterm macroD
economic and comany trends @soDcalled caital market shortDtermismA. "n such
cases* a currency crisis or bond default by a rivate or sovereign state issuer can
cause a generaliFed loss of confidence and* as a result* the imossibility to finance
ro$ects with bond issues. Cases like the Asian crisis in the !((1s and the more recent
crisis in Argentina show that the bottom can dro out of the bond market when
investors lose confidence and anic.
..!!.,.2 Fixing the Financing #erms and Conditions
7nce an arranger has a mandate to syndicate a ro$ect loan* conditions for the sread
and fees can robably be indicated to sonsors right from the early stages of
syndication* even though this would not become a formal commitment from the
banks until confirmed at the time of the financial close. #his clearly means more
accurate financial forecasts can be reared from the start. As is seen in the following
section* the contractual terms and conditions for ro$ect bond issues are fixed at a
much later stage. 6xcet in cases of bought deals* the effective interest of investors
and their willingness to accet a given yield on bonds can only be discovered later as a
result of road shows. 'onsors are therefore unsure of the final rice throughout the
eriod of rearing to launch the bonds on the market.
..!!.,.3 Confidentiality
Contractual terms for a bank loan are strictly confidential. #he series of contracts
signed by the 'P0 and included in the information memorandum cannot be disclosed
and can only be used by arties involved in the deal* so fewer lenders in the ool
ensures greater confidentiality. #he case of bond issues is different. "f the issue is
aimed at retail investors* then the law in many countries reCuires ublication of a
rosectus and disclosure of certain contractual terms. #his may not be accetable to
one or more sonsors* for business reasons. For instance* a general contractor might
not want to disclose information concerning guarantees given for building a lant.
"n the case of rivate lacement* this roblem is less critical. As we saw reviously*
the introduction of +ule!,,A means that registration with the '6C and other related
formalities are no longer reCuired* which has heled reduce roblems associated with
disclosure of confidential information.
..!!.,.( Covenants and Monitoring Management of the Pro$ect
7ne of the essential features of ro$ect loans is the inclusion of a series of extremely
detailed covenants and commitments binding the 'P0 in the credit agreement. #hese
commitments make monitoring easier and avoid moral haFard on the art of the
'P0?s management. "n this way lenders have an incentive to monitor their investD
ment* and this is facilitated because commitments are clearly defined.
Pro$ect bonds don?t usually have such recise* strict covenants as ro$ect loans*
for two reasons. First* the investor ublic in ro$ect bonds is numerically larger than
the banks articiating in a ool. #his generates roblems of free riding* given that
no individual bondholder is interested in monitoring the 'P0 or* rather* sustaining
the costs of this and sharing the benefits with other investors. 'econdly* the inclusion
of extremely recise contractual conditions makes the bond very much tailorDmade
and therefore difficult to relace with other forms of investment. All other factors
being eCual* this means the security has a lower liCuidity in the market.
..!!.,.!1 +enegotiation of Contractual Conditions and +efinancing
'onsors tend to refer financing methods that enable them to change the original
contractual terms and conditions negotiated for the deal. #his is the case both when
the 'P0?s erformance exceeds the forecast and when it is less favorable and breaking
covenants means the debt must be refinanced to avoid default of the ro$ect. "f the
ro$ect generates a higher cash flow than forecast* the sonsors could use this excess
liCuidity to reay the debt in advance. "n the case of bank syndicates* early reayment
is an otion that normally calls for ayment of a enalty* although not an excessive
one @around 1./N!J of the outstanding debt at the time of reaymentA.
"nclusion of
a call otion for early reayment in a ro$ect bond is also ossible* but investors
usually want a higher rate of return in such cases. "n effect* if sonsors reay a bond
in advance* an investor could run a reinvestment risk @also known as reayment
riskA* that is* the risk of not finding an alternative investment on the market with a
similar interest rate to that of the bond reaid in advance. #he reayment risk must
therefore be comensated by a higher return @a higher couon or lower lacement
riceA than that of a normal bond without a reayment otion.
7ne of the ma$or weaknesses of ro$ect bond issues is renegotiation of financing
when ro$ect erformance falls short of the forecast or when certain covenants have
been broken. "n fact* a ro$ect that runs into trouble reCuires significant changes in
contractual terms in order to ensure survivalK however* it is very difficult to establish
a direct dialogue with bondholders. #his is esecially true when there are a large
!%. 'ee Lescombe @%11%A.
number of bondholders* each of which holds $ust a small number of the bonds issued.
"ntuitively* it is easy to see that the cost and time reCuired to renegotiate a loan
increases the higher the number of creditors involved.
"n such cases interest to
organiFe refinancing actively is very low and the temtation for free riding is higher.
Furthermore* assive investors normally have a shortDterm mentality. 'o* after
downgrades in ratings* they tend to sell the security concerned Cuickly to recover
the investment* which in turn accelerates default of the ro$ect. "n this regard* it
should be noted that the trustee of a bond issue @see 'ection ..!!./.%A reresents the
bondholders? interests but cannot take decisions on their behalf* whereas having
decisionDmaking owers would facilitate and seed u the renegotiation rocess
with the 'P0?s creditors. All that the trustee can do is to call a bondholders? meeting.
7n the other hand* it is much easier to negotiate with a small number of banks in a
ool than with a larger number of bondholders.
6secially in cases of ublic ro$ect
bond issues* the rocess of amending all the bond documents is extremely long and
comlex and* therefore* inaroriate in a crisis situation reCuiring a solution as fast
as ossible. #he difficulty of managing restructuring in the case of ro$ect bonds also
exlains why bonds are only referred when refinancing syndicated loans in erformD
ing ro$ects that have already overcome the critical construction hase. @#here is less
likelihood such ro$ects will run into difficulties.A
..!!./ Procedure for "ssuing Pro$ect 5onds
As we saw in 'ection ..!!.%* the form used most freCuently when issuing ro$ect bonds
is rivate lacement with a grou of clearly identified investors. "ssuing ro$ect bonds
by rivate lacement is a somewhat similar rocedure to organiFing a syndicated loan
by one or more mandated lead arrangers @see 'ections ..!.% and ..%A. #he arties
involved in the deal and cash flows deriving from it are summariFed in Figure .D(.
Comared with a syndicated loan* however* Figure .D( indicates certain arties that
are only found in the case of bond issues& rating agencies* the bond trustee* and the
aying agent. #he roles layed by these arties are covered next* before describing the
issuing rocedure itself.
..!!./.! +ating Agencies
6ven though investors in ro$ect bonds have deartments that can analyFe an 'P0?s
ability to ay interest and caital over time* they tend to base their investment
decision on both the ro$ect bond bookrunner?s certification of the Cuality of the
issuer and* above all* on the assessment of creditworthiness issued by rating agencies.
#his rating refers to an issuer?s intention and ability to reay its debts unctually
both in the short term and the medium to long term. As far as ro$ect finance is
concerned* meaningful ratings are those referring to mediumD=longDterm creditD
worthiness. #able .D)) shows the scales used by the world?s three ma$or rating
agencies @'tandard and Poor?s* Moody?s and Fitch "5CAA. 8ere* we can clearly see
that distinction is made between the soDcalled investment grade @bonds having a
!). 'ee :ilson* Hohn* and Lang @!((1A. #roubled debt restructuring& an emirical study of rivate reorganD
iFation of firms in default. Hournal of Financial 6conomics* and AsCuith* :ertner* and 'charfstein @!((,A.
Anatomy of financial distress& an examination of $unk bond issuers.Xuarterly $ournal of 6conomics.
!,. 6sty and Megginson @%11)A. Furthermore* it is easier to restructure fast if the ool of banks comrises a
limited number of lenders.
Decision to re'%est ratin-
Initial contacts 6it3 a-enc&
(ile ratin- a!!lication
Set %! meetin-
"re!are ata
S%bmit ata
Meetin- 6it3 a-enc&




"ro7ect Bon
Bookr%nner an
Ratin- A-enc&
Bon "rocees
Ratin- Assi-nment
"a&in- A-ent
Bon "rocees
Interest an "rinci!al Re!a&ments
Interest an "rinci!al Re!a&ments
Bon In;estors
Bon Tr%stee
F " : < + 6 .D( Parties and Cash Flows "nvolved in a Pro$ect 5ond "ssue
limited risk of insolvencyA and seculative grade @bonds with an increasing risk of
insolvency u to actual defaultA.
+ating agencies lay a key role with regard to bond issues* including ro$ect
bonds. 7ften even the charters of some institutional investors* such as ension funds*
forbid the urchase of these securities if they lack this credit assessment. 7ne of a
ro$ect bond bookrunner?s main tasks @also chronologically seakingA is to resent
the ro$ect to one or more rating agencies. Comleting the rocedure for assigning a
rating is extremely time consumingK this is why the ro$ect bond bookrunner contacts
agencies almost immediately after receiving the mandate for a rivate lacement. 'ee
Figure .D!1.
#he rating rocedure follows a very recise timetable that includes all hases
leading u to ublication of the rating by the agency. A simlified overview of the
rocedure is illustrated in Figure .D!!.
#he reliminary discussion doesn?t reresent a commitment for the sonsors. #his
is an exloratory meeting with the agency during which information is given conD
cerning the criteria for assigning a rating and reCuirements to obtain a final rating.
"f the sonsors accet the conditions* then a mandate is given to the agency conD
cerned. #he first stage in the rocedure is to reare a credit assessment* namely* a
reliminary indicator of creditworthiness exressed by means of a rating grade or in
Ratin- -i;en
F " : < + 6 .D!1 'tandard #imetable for Assigning a +ating
'ource& Moody?s
#A5 L6 .D)) +ating :rades <sed by the Ma$or "nternational +ating Agencies
'tandard and Poor?s U Moody?sUU Fitch
"nvest. Cat. -escrition "nvest. Cat. -escrition "nvest. Cat. -escrition
"nvest. grade
AAA 6xtremely high ability to ay interest
and reay caital
"nvest. grade 4otes with the lowest investment
risk& ayment of both interest
and caital is safe thanks to
very high and extremely
stable margins. Changes in
economic conditions will
not affect the safety of
the notes.
"nvest. grade Maximum creditworthiness
AA 0ery high ability to honor ayment of
interest and caitalEonly marginally
different from issues in the highest
Aa 8igh Cuality notes. #hey
have a lower rating than
the revious grade inasmuch
as they have lower or less
stable margins or* over the
long term they are exosed
to greater dangers.
AA 0ery high creditworthiness
A 8igh ability to ay interest and caital*
but a certain sensitivity to unfavorable
changes in circumstances or
economic conditions
A MediumDhigh Cuality notes.
6lements guaranteeing the
caital and interest are
adeCuate but factors exist
that raise doubts as to
whether these elements
will also ersist in the future.
A 8igh creditworthiness
555 'ufficiently high caability to ay
interest and caital* however*
unfavorable economic conditions or a
change in circumstances could have
a greater effect on the ability to honor
the debt normally
5aa Medium Cuality notes.
Payment of interest and
caital aear to be
adeCuately guaranteed
at resent but the same
cannot be said for the
future. #hese notes have
both seculative and
investment features.
555 :ood creditworthiness
'eculative grade
55 Less vulnerability to risk
of insolvency in the shortDterm
than other seculative issues*
however* considerable uncertainty
and exosure to adverse economic*
financial and sectoral conditions
5a 4otes featuring seculative
elementsK they cannot be said
to be well guaranteed over
the long term. #he guarantee for
interest and caital is
limited and may no longer
exist in the event of future
unfavorable economic
55 'eculative
5 More vulnerable to adverse economic*
financial and sectoral conditions*
however* currently able to honor its
financial commitments
5 4otes that cannot be
termed as being desirable
investments. :uarantees
for interest and caital or
timely erformance of
other contractual conditions
are low over the long term.
5 0ery vulnerable
CCC Currently vulnerable and deendent
on favorable economic* financial and
sectoral conditions in order to
honor its financial commitments
Caa Low Cuality notes. May
be in default or there can
be elements of danger as
regards ayment of caital
and interest.
CCC* CC* C 6xtremely vulnerable
CC Currently extremely vulnerable Ca 8ighly seculative notes. ---* --* - "n default
C Proceedings for bankrutcy or similar
have been filed* although ayments
and financial commitments are
being maintained
- "nsolvency @defaultA
#hey are often in default or
risk other significant losses.
C 4otes with extremely low
rosects of ayment.
U +atings from AA to CCC inclusive can be modified by adding a R or notch to better define the osition within the rating grade.
UU +atings from Aa to Caa inclusive can be modified by adding the numbers !* %* or ) in order to better define the osition within an individual rating grade @! eCuals the highest
Cuality* )* the lowestA.
%%3 C 8 AP # 6 + . Financing the -eal
Assi-nment of ratin-
*!ossibilit& for a!!eal,
"%blication of
"ossibilit& to interr%!t
t3e !roce%re
Re'%est for
Start anal&>in-
F " : < + 6 .D!! Procedure for Assigning a +ating
'ource& 'tandard and Poor?s
descritive terms. #his evaluates the issuer or financial structure?s strengths and
weaknesses. #his evaluation isn?t sub$ect to monitoring and is usually confidential.
#he credit assessment is based on an analysis of contracts stiulated by the 'P0* by
reviewing the term sheet* financial model* and sensitivities* and also makes use of
draft reorts reared by indeendent advisors. #his assessment leads to the estabD
lishment of a reliminary rating based on information received to date and assumD
tions develoed by the agency?s analysts concerning oints still outstanding. #he
reliminary rating is issued to facilitate ublication of the resale reort* that is* the
document circulated among investors so that they can evaluate how an assessment
concerning a given ro$ect finance deal was arrived at. #hen once all the documents
and oinions have been signed off by the 'P0* indeendent advisors* and contractual
counterarts* the agency ublishes the final rating. #he reliminary rating* in fact* is
only modified to become the final rating when the debt has been issued and all
information has been received and analyFed. <sually the final rating coincides with
the reliminary ratingK if* however* there have been substantial changes in terms of
forecasts and assumtions incororated in the reliminary rating* then the two
assessments may differ.
..!!./.% 5ond Paying Agent and #rustee
Funds deriving from lacement of the issue with investors are only transferred to the
'P0 indirectly. First they are channeled to the bondDaying agent* usually a bank*
which then transfers them to the 'P0. "t is also this arty?s task to receive sums due
from the 'P0 to cover ayments on the debt and to credit them to the bondholders.
And so it could be said that this role eCuates to that of an agent bank in the case of a
bank loan @see 'ection ..%A. #he task of the trustee is basically to reresent bondD
holders and their interests @checking* for instance* that the 'P0 issuer comlies with
covenants and all other commitments included in the trust indentureA* to hold the
securities on their behalf* and to call meetings to vote on secific decisions @for
instance* renegotiation in the case of restructuringA. 'ometimes these two arties
@bondDaying agent and trusteeA can be the same institution.
..!!./.) Choice of the Pro$ect 5ond 5ookrunner
"nvestors in ro$ect bonds don?t tackle the due diligence rocedure that is fundamenD
tal for evaluating the ro$ect @or at least not in dethA. "nstead they rely on the review
erformed by the investment bank selected by the ro$ect comany @ro$ect bond
bookrunner or lead managerA and above all on assessments made by rating agencies.
<sually sonsors assign an investment bank or large commercial bank the role
erformed by the financial advisor in more traditional ro$ect finance frameworks
based on bank loans. #he role of this advisor is* in effect* to study various asects of
the ro$ect* reare the bond issue* and establish contacts with ossible final invesD
tors. #he choice of this advisor can be fundamental for the success of the entire deal.
4ormally the selection rocess entails the rogressive screening of candidate banks
based on the sonsors? riorities. Cost and ability to establish correct ricing are
clearly the basic oints. 8owever* in certain cases imortance is also given to the
range of services the bank can offer* its degree of sohistication in terms of suort*
the existence of a solid relationshi with the issuer* or ability to distribute bonds to
final investors.
#he choice of a bookrunner marks the beginning of the rocess to outline and
lan a bond issue. "n the initial stages the sonsors and bookrunner first define
underlying assumtions in order to sound out the otential investor market. FollowD
ing this* as we describe later* the offer is rogressively defined in detail. #he bookD
running services market is highly cometitive* and only banks with secific exertise
figure as leaders in international league tables. #able .D), indicates ma$or investment
and commercial banks involved in the bond lacement business in %11/.
..!!./., 'etting < the 'yndicate& Managers and 'elling :rou
As in the case of syndicated loans* the bookrunner sets u the syndicate with which to
share the underwriting risk for the entire issue* ossibly with assistance from one or
more comanagers. #oday* in fact* it is normal market ractice to organiFe bought
deals* that is* bond issues bought by the syndicate and then sold to interested
investors. 5ought deals cost more for the issuer in terms of higher feesK however*
they revent the risk of undersubscrition by the market* which is a risk in the case of
lacements based on a bestDefforts clause. #he banks in the ool that also underwrite
the issue are known as the managers.
#A5L6 .D), Ma$or Lead Managers of Pro$ect 5ond "ssues* %11/
Manager Country Imillion 4o. of "ssues
Credit 'uisse 'witFerland %*/!2., 3
MiFuho Financial Haan %*%1(./ (
Citigrou <.'.A. !*/((., !!
West L5A: :ermany !*,23., !)
': @'ocieMteM :eMneMraleA France !*!/!., 2
+5' @+o$al 5ank of 'cotlandA :reat 5ritain !*1)(., .
5anco 5ilbao 0iFcaya Argentaria 'ain (!(.(1 !%
:oldman 'achs <nited 'tates 33(.) ,
Calyon <nited 'tates 31).( !1
Mitsubishi <FH Financial Haan 233./ !!
'ource& Adated from Pro$ect Finance "nternational* issue )%( @Hanuary %/* %11.A.
"n issues that are not structured as bought deals* the syndicate is extended to
include banks forming the selling grou* that is* banks whose task is to sell the bonds
to their customers. #his grou will be resonsible for lacement with final investors.
As oosed to bookrunners and managers* the selling grou doesn?t give any underD
writing guarantees and therefore isn?t exosed to risks if they don?t manage to sell
bonds assigned to them. #o inform otential members* the bookrunner reares a
reliminary bond rosectus that includes the same data as in the information
memorandum for a syndicated loan. #his facilitates evaluation of the ro$ect by
financial institutions that are candidates to become managers. Already in this hase
the intermediaries involved start to contact investors and inform their customers who
could otentially be interested in urchasing the bonds.
"n certain cases meetings are also organiFed to resent the issue.!
#hese meetD
ingsEknown as road showsEinvolve structured resentations in ma$or international
financial centers during which lead managers and sonsors illustrate the ro$ect to
interested investors so that they can evaluate the deal. @#his valuation* obviously* is
also very much based on the rating assigned in the resale reort.A
..!!././ #he 'ubscrition Agreement
Hust as in the case of negotiating credit agreements for syndicated loans* negotiations
between the issuer and the bookrunner concern services the bank will rovide to the
issuer and rules for risk sharing and underwriting among members of the syndicate
set u by the bookrunner. #his structure determines the comensation due to the lead
manager from the 'P0. #his comensation will be the difference between the rice at
which the lead manager buys the securities from the issuer and the rice at which they
are resold @soDcalled gross sreadA. #he gross sread covers the following fees.
. Management fee& #his is the amount aid to the lead manager for setting u the
syndicate. "t therefore deends on the comlexity of the issue transaction* its
siFe* and the effort reCuired to structure it. Part of this fee is returned by the lead
manager to any comanagers involved.
. <nderwriting fee& #his is the fee recogniFed for the underwriting service. "f* in
fact* the issue is entirely underwritten by the syndicate* then the latter bears the
risk that it is not comletely resold or sold at the lanned conditions. "n any
event* the issuer will always be certain of obtaining the necessary resources. #he
underwriting fee is divided between the bookrunner and the managers and of
course isn?t aid for bond issues on a bestDefforts basis @without guaranteed
. #akeDdown @or sellingA fee& #his is the sales commission aid to comensate the
syndicate for the sales effort. 6xcet in the case of bought deals* the banks
comrising the selling grou receive art of the gross sread returned by the
lead manager.
. 6xense reimbursements& #hese include all exense items incurred by the syndiD
cate* for instance* rearation of road shows. "t therefore deends on the range
of services contracted.
!/. #o a large degree* the road show is suerfluous in the case of issues aimed at secific categories of
investor @rivate lacementsA. "t is only necessary in the case of large issues to be laced in several markets. "n
such cases the bookrunner accomanies the sonsors for a series of meetings @road showsA with the financial
community to evaluate the otential investors? aetite for the ro$ect bond issue.
All terms and conditions concerning relations between issuer and lead manager*
including the characteristics of the securities themselves* are established in the subD
scrition agreement. 6fforts of members of the underwriting syndicate @managers
and other bank underwritersA in terms of individual Cuotas underwritten are detailed
in the underwriting agreement. "n contrast* the selling grou agreement covers
relations between the underwriting syndicate and the grou of banks that have the
task of selling the securities to final investors.
..!!./.. #he Final 5ond Prosectus
"n the final stages of rearing the issue* all the various details must be established
and included in the final bond rosectus* also known as the bond offering circular in
the 6urobonds market. "n secific terms* the offering circular includes the following
. Price @under=at=above arA& #he choice from among these otions will determine
directly the issue roceeds and the level of the couon. :iven the same "++* a
sale under ar will in fact lead to a lower couon than that reCuired for a sale at
or above ar. #he decision will have to take into account the trends for forecast
cash flows during the construction and oerating hases.
. 0ariable or fixed couon& #he inclination to choose a variable couon @like
L"57+ or 6uribor lus sreadA is $ustified by the longDterm nature of these
issues and conseCuent interest rate risk run by bondholders* who therefore
reCuire that this be limited.
. Maturity& #he characteristics of the ro$ect are reflected in the final maturity of
the bonds* which is usually Cuite long.
. Lield @or internal rate of returnA& #his is erhas the key oint because it must
exress the return reCuired by investors. #he yield is fixed on the basis of a
market benchmark to which a sread is added based on the forecast rate for
bond default. For an investment in ro$ect bonds* the investor reCuires a yield
eCuivalent to that for an investment with the same tenor but free of risk @so a
riskDfree benchmark yield is used* like that on government bondsA. A sread is
then added to this* reflecting the risk inherent in the secific ro$ect @which is
derived directly from the rating assigned to the issueA. Lastly* ad$ustments are
made to take into account the degree of liCuidity forecast for the security or
erformance of similar ro$ects.
. Covenants& As in the case of syndicated loans* ro$ect bonds can include
ositive* negative* and financial covenants. "t should also be mentioned that
covenants are used much more in cases of rivate lacements. #hey are used
much less for bonds to be listed on retail markets or to be listed on the
secondary market* given that these clauses limit the security?s liCuidity* making
it very secific and not easy to relace by other investments.
This page intentionally left blank
C 8 A P # 6 +
Legal Asects of Pro$ect Finance
#his chater is devoted to the legal asects of ro$ect Wnance. #he urose here is to
identify legal issues raised by ro$ect Wnance transactions and the solutions that are
normally develoed and adoted by oerators.
#he ro$ect Wnance techniCue makes it ossible to raise the Wnancial resources
needed to develo an economic initiative rimarily through a bank loan that is reaid
from the cash Gows generated by the ro$ect itself. @"n this sense reayment is secured
by these Gows.A -escribing the legal asects of ro$ect Wnance means outlining how
Wnancial and economic=industrial lanning for the develoment of the ro$ect is
reGected in a system of legal=contractual relationshis that are binding for the
articiants. "f this system is not ossible or is not reliable* the ro$ect Wnance deal
itself is not ossible.
#he observations that follow in this chater will overla somewhat with issues
that have already been addressed in revious chaters. #his is unavoidable. A ro$ect
Wnance deal is* in fact* a comlex system in which every element is interconnected.
8owever* it is robably fair to say that the legal issues inherent to ro$ect Wnance
essentially revolve around two basic concets or grous of concets&
!. #he ro$ect comany and its economic=legal function
%. #he network of contracts @Wrst and foremost* the credit agreementA that
regulate the relationshi between the di0erent layers in the ro$ect
Addressing legal issues also means contending with @or at least delineatingA an
initial structural comlication. #he legal framework of ro$ect Wnance originated in
common law systems. Within the framework of codiWed legal systems @i.e.* the civil
U #his chater is by Massimo 4ovo.
%), C 8 AP # 6 + 2 Legal Asects of Pro$ect Finance
law systemsA* the legal construction of ro$ect Wnance becomes a search for the
available legal instruments that are Wt for the urose of ro$ect Wnance. #his
means taking notions born in contexts other than ro$ect Wnance and adating
them to the seciWc needs of this techniCue. "n many circumstances this is $ust not
ossible* and* as a conseCuence* market ractice has come to accet Wnancing
ro$ects on the basis of >>legal structures?? much less suited to the urose than
what would be ossible in a common law context. #his is a sign of the vitality of
this Wnancing techniCue* for it rises above and beyond the ossible structural rigidity
of the legal environment to which it has to be adated.
Fundamentally* ro$ect Wnance is a Wnancing techniCue or a Wnancing structure as
oosed to a legal concet in the strict sense. #his is true in the $urisdictions that
conceive of such institutions and regulate @or codifyA them as a concetual fact rior
to actual utiliFation and in noncodiWed $urisdictions as well* where concetualiFation
of legal notions comes @if at allA after actual imlementation.
A legal analysis of ro$ect Wnance* therefore* basically consists of studying a
seciWc examle of a tyical ro$ect Wnance deal @the kind of ro$ect that might
only be found in textbooksA and how it takes shae around&
. #he ro$ect comany
. #he contracts relating to the ro$ect and their interconnections
#he remainder of this chater is organiFed as follows& 'ection 2.! focuses on the
secial characteristic of the ro$ect comany* the reasons for its incororation
and the relative cororate documentation. 'ection 2.% is dedicated to the contract
structure of the deal. More seciWcally 'ection 2.%.! analyFes the due diligence reort
and the term sheet. 'ection 2.%.% is centered on the classiWcation of ro$ect docuD
ments* further examined in 'ections 2.%.) @credit agreementA* 'ection 2.%., @security
documentsA* 'ection 2.%./ @eCuity contribution agreement* intercreditor agreement*
and hedging agreementsA* and 'ection 2.%.. @ro$ect agreementsA. 'ection 2.) conD
cludes the chater with some indications about the reWnancing of existing ro$ect
Wnance deals.
2.! #he Pro$ect Comany
"n ro$ect Wnance* an initiative is develoed >>in?? or >>through?? a ro$ect comany*
which is actually the borrower of the Wnancing. #his is common knowledge for
anyone familiar with the deWnition of this Wnancing techniCue.
#o be clear* ro$ect comany usually refers to a legal entity* i.e.* the comany that
is formally resonsible for a seciWc ro$ect Wnance deal. For reasons exlained in the
following ages* this comany must be a newly organiFed entity. "t is >>born?? along
with the ro$ect and does nothing but develo* build* and oerate the ro$ect. From
this ersective* the ro$ect comany is deWned as a newco and a secialDurose
vehicle @'P0A. #his latter exression is not exclusive to ro$ect Wnance and in fact is
normally used in all structured Wnance deals that reCuire a comany for a single
urose @for reasons that are in art the same as those regarding ro$ect WnanceA.
#here is no articular reason why the ro$ect has to be develoed in an 'P0*
either in terms of the economic or the industrial nature of the ro$ect or the
bankability of the investment in abstract terms. A ossible excetion is a ro$ect
with several sonsors* which would give rise to the oortunity and=or the need to
%)/ #he Pro$ect Comany
create a $oint venture comany in which sonsors articiate as shareholders.
Choosing a cororate structure in which to develo an investment ro$ect could
entail alying the >>usual?? standards of cororate and tax otimiFation* which is
normally how it is done.
2.!.! +easons for "ncororating the Pro$ect
in a Pro$ect Comany
#o begin with* we brieGy address the legal imlications of what it means to develo a
ro$ect >>in?? or >>through?? a ro$ect comany. Fortunately* the reason is simle. #he
ro$ect comany acts as the formal entity that runs and is the owner of the ro$ect&
Civil law systems normally use the notion of >>entrereneur?? to describe this osition
with resect to the ro$ect. #he ro$ect comany owns* develos* and oerates the
ro$ect @or at least these activities are legally attributable to itA.
#herefore* the ro$ect comany is entitled to use the site @as owner or lesseeA* the
industrial lant and its several assets* and all legal relationshis with third arties
needed to build and oerate the ro$ect.
#here are generally two categories of reasons why a ro$ect has to be develoed in
a secialDurose comany so that it can be Wnanced on a withoutDrecourse basis&
defensive reasons and ositive reasons.
2.!.!.! -efensive +easons
A given ro$ect could be develoed by the sonsor in a reexisting legal structure*
resumably a comany in the grou in Cuestion most comatible with the ro$ect @in
terms of available resourcesA.
8owever* this strategy runs into a nearly insurmountable obstacle& the rincile of
general liability of any erson. #his rincile is recogniFed in all advanced legal
systems* without excetion @though the nature* extension* and alicability of exceD
tions may vary deending on the legal systemA. 5ased on this rincile* eole are
liable for their debt obligations with all its resent and future assets. 4o limitations or
excetions are allowed* beyond those cases seciWcally established by the law. @#he
main such excetion is the ossibility to create security rights in favor of a seciWc
#he reercussions of this rincile on ro$ect Wnance are clear. "f revious or
ongoing activities have nothing to do with the ro$ect* then there is a risk that
liabilities deriving from or connected to such activities could contaminate the assets
of the borrower comany @see 'ection !./.!A. 7n the one hand* without recourse
lenders would be exosed to risks unrelated to the ro$ect* which would create an
imbalance in the Wnancial structure of the ro$ect. 7n the other hand* nonro$ect
lenders would beneWt from the liCuidity in$ection and ro$ectDrelated investments
added to the assets of their borrower. 4ote that mixing together ro$ect and nonD
ro$ect receivables and liabilities has no conseCuences that are necessarily adverse for
lenders. "t would simly be incomatible with ro$ect Wnance. 7utside the legally
rotected circle of the legal entity that is the ro$ect comany* Wnancing sills over
into cororate Wnancing* where* by deWnition* borrowers make all their assets*
without excetion* available to lenders as security @unless seciWc additional security
is reCuestedA. We simly Wnd ourselves in a di0erent legal and Wnancial area. "n this
sense* the term ring fencing is used* which means rotecting the ro$ect comany from
%). C 8 AP # 6 + 2 Legal Asects of Pro$ect Finance
external factors that could distort the correlation between the Wnancial model and the
ro$ect comany?s legal relationshis.
2.!.!.% Positive +easons
<nderlying any legal analysis of ro$ect Wnance are the ositive reasons why the
ro$ect comany and the ro$ect Wnance transaction have to coincide. Hust as the
ro$ect has to be defended from liabilities that redate the Wnancing and that would
alter the Wnancial base case* without recourse lenders have to be able to establish the
allocation area of the cash Gow generated by the investment ro$ect a riori. #his way
they can imlement the most suitable legal mechanisms to ensure that these funds are
allocated and alied in accordance with the Wnancial model.
#he customary solution is to give the ro$ect comany a single urose. #his
ensures that the cash Gow generated by the ro$ect can be totally controlled @at least
in theoryA and that it will be channeled in the order of riority set down in the
Wnancial model.
#his is why the ro$ect comany is called an 'P0. "t coincides with the