The Principles of Project Finance

Rod Morrison

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9781138245686
• eBook ISBN: 9781317019114
• Topic: Business
• Subtopic: Business General
• Index: Business

The Principles of Project Finance reviews the technique of project finance. It explores, step-by-step, the key ingredients of the concept. The book is aimed at a business savvy audience, but one which is not necessarily up to speed on the concept, and has a global reach by covering both OECD countries and the emerging markets. Project finance is positioned at a key point between the global capital markets and the energy and infrastructure industries. To explain and illustrate the ideas behind project finance, the book is made of chapters written by a range of leading players in the market from around the world and is split into four sections: ¢ The first reviews various themes and issues key to the project finance market - views from bankers, lawyers and advisers plus chapters on bank, bond and multilateral finance and a look at environmental, insurance and construction market issues. ¢ The second section looks at how project finance is used in various sectors of the energy and infrastructure market - renewable energy, oil and gas, mining, PPPs and roads and transportation. ¢The third then takes an in-depth look at various projects finance markets from around the world - Australia, Vietnam, Indonesia, India, Turkey, Russia, Africa, France, USA and Brazil. ¢ Finally, the fourth section presents a series of Top 10 deal cases studies from the pages of Thomson Reuters Project Finance International (PFI), the leading source of global project finance information.

SECTION 1 Themes

CHAPTER 1 Project Finance – A Banker’s Reflections

STEPHEN CRANE
Green Investment Team

Like most bankers in 2007/9 I thought that whilst the industry as a whole deserved the battering it received, I felt that the project finance sector could hold its head up with some justification as to its place in the industry and indeed society. There was many a dinner party where I was brave enough to explain I was a banker, not any old banker but a project financier.

I have worked in three of the most successful banks in the field of project finance over the last 24 years: NatWest, Deutsche and BTMU. From its natural resource origins, I have seen the great product growth spurt stemming from the UK privatisation of electricity in the early 1990s, the development of private finance initiative (PFI)/public private partnership (PPP) and the export of the contract based product into Europe and then globally. Yet there were times during this period, in the late 1980s and 1990s in particular, when the appropriateness of project finance as a banking product was questioned.

Sponsors have blown hot and cold over its effectiveness and deployment and banks themselves questioned the merits of project finance. I recall a previous boss commenting that strong views existed as its survivability as a product and it was regarded as ‘too long, too complicated and too cheap’. In saying, too long he meant the tenor was too long as credit officers and financial controllers with balance sheet responsibility held a view that banks with an inherent short term funding base should not lend beyond their own funding cycle. It was also by its nature complicated and complex as the projects themselves needed great understanding. The combination of the exceptional need to lend over what was regarded as the long term with a documentation basis that, whilst undeniably thorough, was to some due-diligenced to death and hideously complex and thus demanded premium pricing. Of course, it rarely received the pricing so desired and thus the product was criticised as not commanding an appropriate premium over corporate pricing.

Reflecting on the original observation, my colleague could have also meant when he said long just how long in terms of time it took to close the deal. In my career, I have been more than conscious of this as a lead transactor and as a manager and I will draw on experiences as to how this additional criticism can be addressed.

In the course of this chapter, I will come back to these central comments (dare I say accusations) as the banker in whichever organization he/she has worked would have had to deal with similar themes in order to persuade their bank strategically and economically to develop a project finance business and compete for scarce capital.

The chapter will focus on the viewpoint of the banker although I cannot rule out the occasional foray across the table to my advisory experience to make a point or two when needed. It will focus predominantly on closing the original deal but with ‘a weather eye open’ to the demands and merits of project monitoring.

I will be seeking to draw out as to what makes a good project financing.

Let’s start by saying that to make a good project financing, it needs to be first and foremost a good project. A good project also needs to work for all stakeholders and not just for the banks. There has been many a project that banks have congratulated themselves on a good deal’s work only to find that they have made mortal enemies of the entire cast of sponsors and sometimes the contractual parties, although it would be rare to alienate the full suite of parties! A good project also needs to close in a reasonable time frame, pay sensibly according to the risk and should have limited risk of default. I do not think there is a deal that has closed where during the negotiation a banker (normally those with more experience) has remarked that all they seek is simple repayment of the money lent in the first instance at some reasonable return! The need to close is critical but not at all costs, for obvious reasons. When I started out in the late 1980s, it could genuinely be said that no project finance deal had lost money. The forest products industry, novel technology projects in the environmental sector and seemingly anything with the word ‘Euro’ in the project name put paid to that. And this was before the sovereign debt crisis!

Good project finance bankers rarely move outside of the industry so are proud of their career track record. Knowing when to close out a deal is a skill but the better skill is knowing when the position is becoming marginal and too risky.

I’d like to start by looking at the role of the sponsor. Sponsors have many motivations in using project finance and come in many guises and one of the fascinations of the industry is that one frequently encounters unique situations, the solving of which makes the job more interesting than say the corporate market. However, in my view one can distil the type of sponsor into three basic forms: those that wish to use project finance but have the option to deploy corporate funding sources should they wish, those who are persuaded by partners to use the product but would prefer not to and those that have no choice but to use the product to stay in the deal they may well have originated.

There are good, bad and indifferent sponsors in all categories.

The classical good sponsor and one that credit committees wish to see present are those in the first category, namely someone that has elected to use the product out of choice and in all probability has a wide ranging involvement in the project apart from being a financial sponsor. This sponsor is a natural supporter of project finance and understands and appreciates its idiosyncrasies and indeed may even be responsible for some. Their motivation is likely to be based around having a good track record of using project finance before and an intelligent understanding as to the merits of the product. These merits are likely to be one of the following, which is by no means comprehensive:

• The ability to achieve more leverage for the project than would otherwise be possible on a corporate basis;

• To diversify funding sources (banks will often lend more and not necessarily consolidate lending if undertaken on a project basis);

• To achieve a longer tenor than would otherwise be available corporately, and

• The value that comes from the disciplines of the due diligence process conducted by banks and their advisers.

To this list could be added, but rarely spoken about by banks especially in front of the credit committee, the desire to genuinely share risk of the project or the country in which the project is being undertaken.

I have always been pleasantly surprised by sponsors who have admitted that they value the due diligence effort as in nothing else from a motivational perspective, it seems (at least when the comment is made) that the effort is appreciated. I’m sure the oft-maligned lawyers feel the same. Sponsors in this category also appreciate that the monitoring rigour of a project financing is a virtue and not an inconvenience as they welcome the reporting needs as a means of adding discipline to their own internal controls.

This then (at least from a text book or credit perspective as they tick all the boxes) is the ideal sponsor, but such benevolence to the credit side of the bank comes at a cost: terms that might not be quite right and a price that might be too cheap. It will probably mean though that this type of sponsor is using the product for the right reason and is likely to be mindful of repeat business so they should in theory strike a fair position in the negotiation game. These deals are the staple of the market, have a high credit quality (usually) and when critical moments occur during a construction delay or a dispute they will work with banks to resolve the issue. It’s not difficult to understand why credit functions like transactions, sponsored by this type of party.

Examples of good sponsors would be experienced Middle Eastern governmental-owned agencies that have a track record of using project finance for their infrastructure and energy needs. They will have a track record of successfully closing transactions and at times of stress will have provided considerable support in getting the deal closed. Such sponsors will understand the motivations of the banks but are not necessarily out to wring the best possible deal from the banks. It should be no surprise then such sponsored deals are fiercely competed for. Even if the economic return can be questioned, when the entire relationship is factored in, these are high-class deals.

The second category of sponsor has the same ability to proceed with project finance, but are either testing the water and trying out the project as some sort of corporate experiment, or are in the deal because the demands of the JV project structure are such that project finance is the only way to proceed. This is altogether more testing ground as pricing and terms can be just as challenging as the credit standing can be very good but the motivations are different. The reluctant sponsor will often lack the understanding of the core ingredients and will bemoan the due diligence, often hankering after the relative simplicities of corporate finance. Negotiation can be difficult as the last thing the PF banker wants is to alienate his corporate banking colleagues but sometimes this is unavoidable. I have lost count of the times this happened to me in my formative years! Some parties who may start off in the process as say a fuel supplier but become a sponsor, can be quite difficult and ‘fail to grasp’ the needs of the project – a good example being a seemingly complete lack of understanding (deliberate or otherwise) for direct agreements.¹

This can all lead to a greater deal execution timeframe but in some strange way the sense of satisfaction on closing night can be more rewarding if the obstacles that have been overcome have met with a degree of acknowledgement that the banker has done a good job. In some cases, it is possible to convert a few non-believers en-route to the closing and sponsors can then be reclassified under the first category.

A difficulty with the experimental sponsor is the risk that they might change their mind throughout the process and simply proceed with a corporate solution, through either changed circumstances or changed strategy. Such situations can be quite rare but in more recent years I have witnessed a greater tendency for this to happen.

A clear example of where this can happen is in the political arena where the Sponsor is a governmental entity. There was the occasion of the cancellation of a major European road project due to failure of the deal to close before the election date. In this instance the new government cancelled the financing. Another example was a power project in Estonia which failed to proceed due to changing political circumstances. More frustrating for bankers is the project that goes ahead but without the much-hoped-for project financing. An example might be the hypothetical utility that elects to access the bond market as a result of the central treasury team (in this instance detached from the project team) assessing that an expensive project financing cannot be justified on simple mathematical comparisons. This may happen notwithstanding nine months’ work from a banking syndicate. There is no easy answer to mitigate against these events except to be vigilant as to whom to work with, set a deadline to close so that reassessment is not feasible and work like hell to get corporate ‘buy in’ from more senior levels from such a Sponsor. Of course ‘drop-dead fees’ are what the text book would demand but, in practice, these are rarely available. The loss of several millions in fees/swap income and margin near to the end of the reporting year can be quite chilling on the team target.

The last type of sponsor is my personal favourite as they need the product to ensure the project proceeds. They can work with other category sponsors but to meet the test they need to have sufficient weight that they carry their partners with them. The obvious issue is that the Bank’s credit function may not share the same view. The internal challenge of getting the deal approved is often more hazardous than the external negotiations.

This assertion is not the stuff of text books but as the job of the PF banker is also to be fairly paid and to close out the deal (preferably in a reasonable timeframe) then a sponsor who needs to use PF is preferred. The ideal sponsor will fight hard in negotiation but the deal can and should end up being sensibly balanced in the bank’s favour but not to the point of unfairness. It should be priced a little higher reflecting the circumstances and all matters being equal the deal should close in a more efficient matter. This presupposes that the Sponsor is experienced of course, but even if they are working on their first deal, the cost and inefficiency of a learning experience on the first deal can be used with considerable effect on repeat business. If the banker has done his job properly then his chances of securing such repeat business are quite high. I’ve never liked one-off deals with no chance of repeat business. Project finance deals last a long time and the relationship should be continued not only on the project monitoring process but into future transactions. Of course, deals with all sponsors can be rewarding but sponsors who are similarly motivated and need the deal to close in the same manner as the banker but without the ethos that one can find with larger sponsors with options to threaten to ‘not do the deal’ are in my opinion better to deal with.

I’d now like to spend a little time on some key banker concerns before concluding with what makes the ideal project finance deal.

Motivation for the Project

One of the attractions for a banker of project finance is the tangibility of the product and the genuine sense that we are financing something real, clearly visible and hopefully good for society and wider economic growth. This is one of the reasons why so many bankers in the sector endure as they simply like the sector and what they are doing and the sense of satisfaction of being involved in building something long lasting. I know I have felt like this.

The key issue is that there must be a need for the project and not just the brainchild of some government or sponsor. Financing a project that is debatable economically that relies on subsidies can be fraught with risk. There are many exceptions: the renewables regime, social infrastructure etc, where there is widespread political and social acceptance of the need for a project. But the so-called white elephant risk can be real. Examples would be roads that nobody really wanted, encouraged by governments for some manifesto reason and financed by bankers who badly miscalculated or failed to understand the intricacies of traffic risk.

In other cases, the commercial nature of a project may be debatable even if the base need for its promotion is understood. This is a grey area, but a good example would be the alternative energy sector as it was called before the renewable energy sector became mainstream. There were many examples where the idealism and enthusiasm of sponsors w...

Table of contents

• Cover Page
• Half Title Page
• Title Page
• Copyright Page
• Contents
• List of Figures
• List of Tables
• About the Contributors
• Introduction
• Section 1 Themes
• Section 2 Sectors
• Section 3 Countries
• Section 4 Case Studies
• Index