Project Finance Underwriting & Analysis - Credit and Finance Risk Analysis

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Project Finance Underwriting & Analysis

Project Finance is the financing of the new construction or redevelopment of small and large-scale infrastructure and industrial projects. These types of projects are constructed in both industrialized and developing countries. There is usually an equity investment by the sponsors (public or private entities) of the project and the debt is provided by a single bank, syndicate of banks or an investment group. There may also be some sort of government support in the form of tax concessions, development bank or export credit agency participation and / or debt guarantee.

In most cases, the debt provided by lenders is on a non-recourse (to the sponsors) or limited recourse basis and repayment of the debt (including scheduled amortization of the loan) usually depends entirely upon the cash flow generated by the project when completed (the non-recourse clause may not be in effect until the project is mechanically constructed, started and passes a series of predefined tests).

Project financing requires substantial investment upfront and then the servicing of the debt is from the long-term cash flow thus these types of loans tend to have a longer maturity than straight-forward corporate lending.

If the project is located within a nation with either an officially sanctioned muslim faith or has a population with a predominantly muslim faith then the transaction must be structured in accordance with Islamic Law (Shari'a). Please also see the Guide to Islamic Banking & Finance

From the viewpoint of the sponsor, not only does the project have to be able to satisfy the debt obligation but the annual profits generated by the project must be sufficient to pay back the capital investment of the sponsor within a reasonable time and add to the earnings of the company.

The industrial sectors where project financing is prevalent include:

Energy (power generation such as gas-fired, coal-fired, hydro, solar, wind or geothermal)

Petroleum (upstream and downstream; pipeline construction)

Natural gas (extraction and pipeline construction)

Mining (coal, precious metals, metals, minerals)

Chemical

Telecommunications

Maritime (port construction or redevelopment)

Real estate

Airports

Transportation (road, bridge and tunnel; train / rail line for both public transport and industrial freight; rail stations)

Water and sanitation / waste managment

Public health facilities

The advantage to the sponsor is that a project finance structure usually allows them to keep the project off of the company's balance sheet. This insulates the company from the failure of the project but there are also instances where the company's balance sheet isn't strong enough to justify financing the project through corporate finance. However, corporation sponsors must still perform a standard cost benefit analysis (capital investment vs. expected rate of return) of the project in order for it to become a candidate for proposal: the project will have to generate an annual net operating income equal to a specific percentage of the loan value before project finance is feasible. Secondly, the sponsor must decide how to finance the project: the bond market tends to provide longer term maturities than bank financing.

Risks involved in Project Finance

There are several risks involved with the total project and some occur during the construction phase of the project and some occur after the completition of the project during the operation phase. Thus, the project risks tend to diminsh as the project reaches various points of completion.

Construction Completion Risk: This is the basic risk that for some reason the project is never completed.; If the lender(s) have already released funds for the land acquisition and initial start-up of construction but the borrower / project developer does not commence construction then the lender may have to foreclose on raw or only partially improved land that does not have sufficient value to cover the initial release of funding.; If a certain amount of funding is released and the project developer becomes insolvent or there is some type of problem that halts the project then the lender may have to foreclose on assets / infrastructure that is incomplete and not of sufficient value to recover all or a partial amount of funding from the borrower.; The assets may be very highly specialised and possibly located in a remote area. Because the assets are project specific they may have not have any value (other than scrap) outside of the project itself.; The lenders may have to hire a new company to come in and complete the project and provide additional funding to that new developer, and may have to renegotiate off-take contracts due to perceived problems connected to the project.; Completion risk considers all risks and factors: problems with suppliers during construction, natural conditions and weather, political and force majeure, environmental regulation, labor and technical / construction issues.

Technical Risk: This risk occurs during the construction (and design) phase of the project.; Is the project design or concept itself, or the fuel source or the output of the project of a new type or design that has not been tried before?; Has the project been designed correctly and took advantage of, or anticipated, any changes in technology so that the facility operates at its highest capacity?; If changes in technology are not contemplated then the facility may function at lower capacity or be unable to provide a product or service that is in demand.; The facility may operate in a manner that violates local environmental regulations.; Will it be difficult to move construction supplies, machinery and labor to the site or is it located in an extreme environment? Is there any special training required for the hired labor to construct or operate the facility?

Environmental Risk: This risk occurs during both the construction and operation phases of the project.; There is a possibility that a spill of some material during construction could contaminate the immediate ecosystem in which the project is located.; There is the possibility that a spill of some material during operation (for instance, fuel delivery) could contaminate the immediate ecosystem in which the project is located.; There is the possibility that the operation of the facility may be in violation of environmental regulations (for instance CO₂ emissions).

Economic / Market Risk: This risk occurs during the operational phase of the project.; The actual amount realized from the project cash flow can be affected and impacted by inflation, interest rates, exchange rates, labor costs and prices for the inputs and output of the project. For instance, there is the possibility that the cost of inputs (fuel) have substantially increased since the inception of the project. Similarly, there may too few passengers for a rail line or toll road, or inadequate reserves for a mine.; Do the currencies of the sales contracts match with the currencies of supply contracts?; Is there a history of labor disputes that may result in work stoppages or excessive wage increases?

Political / Sovereign Risk: This risk occurs during both the construction and operation phases of the project, particularly in developing countries / emerging markets.; Expropriation by the host nation; Currency convertibility and transferability; Political violence / terrorism; Unanticipated changes in regulations or the failure by the government to implement tariff adjustments (critical to power projects) because of political considerations; Government licenses and approvals required to construct or operate the project are not issued; Project operation is subject to state-owned suppliers or customers; Taxation and royalty payments are unilaterally increased

Project Finance Sequence

The project finance sequence usually begins with a Feasibility Study that covers all of the aspects of the project:

Assess existing conditions (baseline conditions).

Develop alternatives to the project as planned.

Develop an environmental overview and impact.

Map and survey of the topography of the project location (major natural features, land use, watersheds, existing access).

Identify government agencies that will be involved and must provide authorization / certification.

Assess the cost and details of the construction phase of the project

Assess the cash flow generated by the operation of the project.

Accurately measure the cost of inputs to construct and operate the project.

Accurately measure the demand / price for the product(s) or service of the project.

The study must also cover many details, everything from whether the soil can support a large structure, is it located in a hurricane, flood or earthquake zone, is there sufficient skilled labor among local residents or will outsiders be able to afford to live there; the report has to consider all issues that will make the project a success.

In completing the project a set of problems will be solved but what new problems are created and how will they be solved?

Recommend improvements where necessary.

Feasibility Studies tend to have a standard layout:: Executive Summary; Background; Report Purpose and Scope of the Study - including the authority and competency of the entity conducting the study; Public and Agency Involvement; Project Purpose and Need; Alternatives Considered - strengths and weaknesses; Overview - Definitions / Acronyms, Study Area, Existing conditions, Ecosystem Characteristics, Design and engineering, Problems identified, Evaluation, Cost estimate(s), Financial feasability, Environmental review and consequences, Opinion of Probable Cost; Funding and Implementation Plan - short-, medium- and long-term funding requirements and sources, construction and maintenance; public/private partnerships; Project Management Plan - schedule, permits and certifications, cost changes, schedule oversight, schedule / cost change authority, project closeout procedures; Scope of Work for Preliminary Design, Engineering and Environmental Permitting; Support Documentation, Legal Opinions, Appendices

Feasibility studies are expensive thus there may be a pre-feasibility study.

An independent experts' report regarding the design and construction materials allocated for the project should also be submitted. If the project contemplates an unusual architectural design or pioneers a new technology then it increases the possibility for problems.

On site interviews with regional and local officials, business owners and community groups in the area surrounding the project should be conducted to solicit local support and they may also aid the project team to identify the needs and problems and whether the primary purpose of the project is realistic and of value.

The sponsors create a separate, independent (of the sponsors) legal entity whose sole purpose is to own and operate the assets of the project: Special Purpose Corporation / SPC. This allows the sponsor(s) to keep the project off their balance sheet. Similarly, if the debt is on a non-recourse basis then even if the project were to fail, this would not jeopardize the financial integrity of the sponsors’ core businesses. There may actually be 2 separate SPCs: one for the ownership of the assets and one to manage the assets. In the event that there is a problem at the project once it is operating, for instance environmental regulation, then the Sponsor(s) can not be sued by any plaintiff as there are 2 SPCs that actually own and operate the facility.

The construction phase begins with the preparation of the land (roads, water, sanitation and power). With regard to commencing the construction of the project ideally the contract would specify the delivery of a fixed-price, turnkey operation from a reputable and financially sound contractor(s). Again, ideally, the completion of construction should be secured by performance bonds or guaranteed by third parties.

Project Finance Credit Analysis

The credit analysis is rather time consuming as one must analyze the:

Project feasibility study

Sponsor(s)

Joint-ownership structure of the project.

Host nation (or nations if the project crosses national boundaries).

Project supervisor

Contracts regarding construction, supply, off-take, maintenance and concession agreements

Contractors and Subcontractors and any performance surety bond(s).

Supplier (for instance, gas or coal delivery to a power plant).

Potential customers for the project's services once completed or the Off-taker, which is entity that commits to purchase the project output under a long-term purchase (or off-take) agreement.

The feasibilty study must be looked at very carefully not just for accuracy but because some parties already tend to be predisposed to a specific location, design or outcome and may influence, directly or indirectly, the recommendations of the study.

The lenders must decide how much of the project to actually finance, which will be the debt-to-total capitalization ratio of the corporate entity that owns the project. The leverage could be as high as 70%. However, a project's borrowing capacity should be based on the cash flow projections of the infrastructure once in operation. Lenders have to borrow the funds to lend to the project, a portion of which may be short-term, thus the timing and certainty of project cash flows is important for the lenders to manage their own balance sheet liabilities.

Due to the non-recourse clause it means that the lender(s) have exposure to a project-specific / asset-specific credit risk. The risk can be controlled either by:

purchasing a credit derivative in the capital markets

entering into a public-private partnership (PPP) with the host government

obtaining an credit agency guarantee (which may result in lengthening the maturity of the loan)

securitizing the loan

Once the project is operating the lender(s) may also have to enter into a currecy derivative product to cover any fluctuations in the value of the local currency cash flow.

Does the feasability study accurately represent the cost of construction and accurately project the cash flow from operations? What has changed since the date of the feasability study and are the assumptions utilized in the study still viable?

Have the the prices of inputs or outputs been estimated correctly? What sort of expansion / contraction of prices and demand can the project survive and still be viable?

What is the level of experience of the sponsors and what is the level of experience of the operator of the facilities. Although there may be no recourse to the sponsors, the credit worthiness and financial strength and stability must be evident and clearly demonstrated to indicate that they have the means to see the project through.

Do the lenders have a competent, third-party auditor who can monitor the project on-site, advise them that specific construction phases have been completed, and that reporting obligations are being met by the sponsor so that the next scheduled drawdown funding phase can be authorized and released? Will the thrid-party auditor also issue a certificate and assume some liability for an inaccurate assessment?

Have any budget / cost increases or construction delays increased the original amount of the loan or resulted in a delay in the scheduled loan repayment? Will supplier and/or off-take contracts have to be renegotiated due to a delay in the completion of the project?

Is there proper control over the management of the project so that they will not use the free cash flows generated by the project operation for opportunistic or inefficient investments?

Is there a local supply of skilled labor to operate and maintain the facilities? Will labor be members of a union that can offer collective bargaining and will there be defined benefit pension / postretirement benefit plan requirements?

Does the project have a credit concentration in its off-take agreement (single customer or just 2 or 3 large customers) or is it mitigated by a long-term, enforceable contract?

Will / does the project have the right to sell excess capacity during periods when it is not needed to meet contractual wholesale / retail requirements?

Will the project also be issuing Revenue Bonds (including mini-revenue bonds) that are secured by a pledge of, and a lien on, a proportionate amount of the revenues of the electric system, after deducting operating expenses? Are the bonds redeemable at the option of the bondholder and will there be sufficient funds to cover redemption?

What type of insurance, or self-insurance, is available for the operating entity's casualty and property exposures?

Are the cash streams in a foreign currency, supplies denominated in a foreign currency or commodity inputs accurately hedged by specifc derivative products / contracts?

Project Financial Statements

The balance sheet example below combines accounts from various types of projects. In the United States:

“Regulated” operations apply Statement of Financial Accounting Standards No. 71, “Accounting for the Effects of Certain Types of Regulation” (SFAS No. 71), while “non-regulated” operations follow GAAP for enterprises in general. Classification of regulated and non-regulated operations is determined in accordance with applicable GAAP accounting guidelines.

Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (SFAS No. 143), requires the recognition and measurement of liabilities for legal obligations associated with the retirement of tangible long-lived assets. Under the standard, these liabilities are recognized at fair value as incurred and capitalized as part of the cost of the related tangible long-lived assets. Accretion of the liabilities, due to the passage of time, is an operating expense and the capitalized cost is depreciated over the useful life of the long-lived asset.

FASB Interpretation No. 47 (FIN 47), clarifies the meaning of conditional asset retirement obligations under SFAS No. 143, and provides further clarification of when sufficient information is available to provide a reasonable retirement obligation estimate.

If the entity manages commodity supply risks with physical and financial derivative contracts then these transactions are accounted for under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (SFAS No. 133). Under SFAS No. 133, derivatives are recorded in the balance sheet as either an asset or liability measured at their fair value. The standard also requires changes in the fair value of the derivative be recognized each period in current earnings or other comprehensive income depending on the purpose for using the derivative and/or its qualification, designation and effectiveness as a hedging transaction. If the contract(s) qualify as a derivative but do not meet the SFAS No. 133 normal purchases and sales scope exception then they must be further examined to determine if they qualify for cash flow hedge accounting. If a contract does not meet the hedging criteria in SFAS No. 133, then the entity must recognize the changes in the fair value of the derivative instrument in net revenues each period (mark-to-market). Hedge accounting is discontinued when: (1) it is determined that the derivative is no longer effective in offsetting changes in cash flows of a hedged item; (2) the derivative expires or is sold, terminated or exercised; (3) it is no longer probable that the forecasted transaction will occur; or (4) management determines that designating the derivative as a hedging instrument is no longer appropriate.

Assets

Current Assets: Cash and cash equivalents; Restricted cash; Rate Stabilization Fund; Temporary investments; Receivables, net of allowance for doubtful accounts; Fuel stocks; Project costs in progress; Materials and supplies

Long-term Assets: Project plant / facilities in service (plant / facilities is stated at the historical cost of construction, less any impairment losses); Less – Accumulated depreciation on plant / facilities in service (straight-line basis over the estimated useful lives of the various classes of project assets); Plant held for future use; Construction work in progress; Non-operating property and other investments; Deferred charges and Other Assets

Liabilities

Current Liabilities: Customers’ deposits; Accounts payable; Commercial paper; Accrued interest; Accrued taxes and tax equivalents; Current portion of long-term debt; Other current liabilities

Long-term Liabilities: Long-term Debt - Revenue bond(s), bank loans, inter-company loans; Deferred credits and other non-current liabilities

Stockholder's Equity

Common stock
Retained earnings

Income Statement

During the construction phase the Income Statement consists almost entirely of construction related expenses.

Insurance Coverage

Currency inconvertibility coverage compensates investors if new currency restrictions, or other government action or inaction, prevent the conversion or transfer of investment returns from insured investments. Currency restrictions may take the form of new, more restrictive foreign exchange regulations or a failure by exchange control authorities to act on an application for hard currency. Usually does not protect against the devaluation of a country’s currency.

Expropriation coverage protects against the nationalization, confiscation or expropriation of an investment, including “creeping” expropriation, abrogation, impairment, and repudiation or breach of concession agreements, production sharing agreements, service contracts, risk contracts, and other agreements between the investor or the foreign enterprise and the foreign government due to unlawful government acts (or a series of acts) that deprive the investor of its fundamental rights in a project. The coverage excludes losses due to lawful regulation or taxation by host governments and actions provoked by the investor or foreign enterprise.

Political violence coverage compensates for property and income losses caused by violence undertaken for political purposes. Declared or undeclared war, hostile actions by national or international forces, civil war, revolution, insurrection, and civil strife, including politically motivated terrorism and sabotage, are all examples of political violence. Actions undertaken primarily to achieve labor or student objectives are usually not covered.

Contractor coverage compensates for the wrongful calling of bid, performance or advance payment guaranties, customs bonds, and other guaranties.

Information Resources

Development Banks / Funds

African Development Bank www.afdb.org/

Asian Development Bank www.adb.org/

Caribbean Development Bank www.caribank.org/

European Bank for Reconstruction and Development (EBRD) www.ebrd.com/

European Investment Bank (EIB) www.eib.org/

Finnish Fund for Industrial Cooperation www.finnfund.fi/

Inter-American Development Bank www.iadb.org/

International Finance Corporation (World Bank) www.ifc.org/

International Monetary Fund www.imf.org/

Islamic Development Bank www.isdb.org/

Japan Bank for International Cooperation www.jbic.go.jp/

Kreditanstalt fur Wiederaufbau (KfW) www.kfw.de/

Nordic Investment Bank (NIB) www.nib.int/

Overseas Private Investment Corporation www.opic.gov/

Swedfund International www.swedfund.se/

United Nations Development Program www.undp.org/

World Bank Group www.worldbank.org/

Export Credit Agencies

Argentina Compañía Argentina de Seguros de Crédito a la Exportación S.A (CASE) www.casce.com.ar/

Australia Export Finance & Insurance Corporation (EFIC) www.efic.gov.au/

Austria Oesterreichische Kontrollbank Aktiengesellschaft (OEKB) www.oekb.co.at/

Belgium Office National du Ducroire/ Nationale Delcrederedienst (ONDD) www.ducroire.be/

Brazil Banco Nacional de Desenvolvimento Econômico e Social (BNDES) www.bndes.gov.br/

Brazil Seguradora Brasileira de Crédito à Exportação SA (SBCE) www.sbce.com.br/

Canada Export Development Canada (EDC) www.edc.ca/

Chile Compañía de Seguros de Crédito - Continental S.A www.continental.cl/

China Export & Credit Insurance Corporation (SINOSURE) www.sinosure.com.cn/

Colombia Segurexpo de Colombia S.A www.segurexpo.com/

Czech Republic Export Guarantee and Insurance Corporation (EGAP) www.egap.cz/

Denmark Eksport Kredit Fonden (EFF) www.ekf.dk/

Ecuador Compañía de Seguros y Reaseguros S.A. (CONFIANZA) www.confianza.com.ec/

Finland Finnvera Plc www.finnvera.fi/

France Compagnie Française d'Assurance (COFACE) www.coface.com/

Germany HERMES www.agaportal.de/pages/aga/

Greece Export Credit Insurance Organization (ECIO) www.oaep.gr/

Hong Kong Export Credit Insurance Corporation (HKEIC) www.hkecic.com/

Hungary Magyar Exporthitel Biztosito (MEHIB) www.mehib.hu/

India Export Credit Guarantee Corporation (EGCC) www.ecgcindia.com/

Indonesia Asuransi Ekspor Indonesia (ASEI) www.asei.co.id/

Islamic Corporation for Insurance of Investments and Export Credits (ICIEC) www.iciec.com/

Israel Export Insurance Corp Ltd. (ASHRA) www.ashra.gov.il/

Italy Istituto per i Servizi Assicurativi del Credito all'Esportazione (ISACE) www.isace.it/

Jamaica National Export-Import Bank (EXIM) www.eximbankja.com/

Japan Nippon Export and Investment Insurance (NEXI) www.nexi.go.jp/

Korea Export Insurance Corporation (KEIC) www.keic.or.kr/

Malaysia Export-Import Bank (MEXIM) www.exim.com.my/

Mexico Banco Nacional de Comercio Exterior (BANCOMEXT) www.bancomext.gob.mx/

Multilateral Investment Guarantee Agency (MIGA / World Bank) www.miga.org/

Netherlands www.ncmgroup.com/

Norway Garanti-Instituttet for Eksportkreditt (GIEK) www.giek.no/

Peru Compañía de Seguros de Crédito y Garantías S.A. SECREX www.ciacnet.net/secrex/home_id230.jsp?pageid=231

Poland Korporacja Ubezpieczen Kredytów Eksportowych (KUKE) www.kuke.com.pl/

Portugal Companhia de Seguro de Créditos, S.A. (COSEC) www.cosec.pt/

Russia www.rosexim.com/

Singapore ECICS www.ecics.com.sg/

Slovak Republic Eximbanka SR www.eximbanka.sk/

Slovenia (Slovenska) izvozna druzba (SID) www.sid.si/

Spain Compania Espanola de Seguros de Credito a la Exportacion (CESCE) www.cesce.es/

Sweden Exportkreditnämnden (EKN) www.ekn.se/

Switzerland Export Risk Insurance (SERV) www.serv-ch.com/

Taiwan Taipei Export-Import Bank of China (TEBC) www.taiwanexport.com.tw/

Thailand Export-Import Bank of Thailand (EXIMBANK) www.exim.go.th/eng/index.asp

Trinidad & Tobago EximBank www.eximbanktt.com/

Turkey Export Credit Bank of Turkey (EXIMBANK) www.eximbank.gov.tr/

United Kingdom Export Credits Guarantee Department (ECGD) www.ecgd.gov.uk/

United States Export-Import Bank (EXIM Bank) www.exim.gov/

United States Overseas Private Investment Corporation (OPIC) www.opic.gov/

Uruguay Banco de Seguros del Estado (BSE) www.bse.com.uy/

Venezuela La Mundial C.A.V de Seguros de Crédito S.A. www.vesecred.com/

PPP Agencies

Australia, State Government of Victoria www.partnerships.vic.gov.au/

Canada Council for Public-Private Partnerships http://www.pppcouncil.ca/

Ireland Government Public Private Partnership www.ppp.gov.ie/

Italy Unità tecnica Finanza di Progetto (UTFP) www.utfp.it/

Japan PFI Association http://www.pfikyokai.or.jp/english_v/new_v/03.html

Public-Private Infrastructure Advisory Facility (PPIAF) www.ppiaf.org/

South Africa Public Private Partnership www.ppp.gov.za/

United Kingdom Partnerships UK (PUK) www.partnershipsuk.org.uk

Private Export Credit / Political Risk Insurance

AIG Global Trade & Political Risk aigglobal.aig.com/

Atradius global.atradius.com/

Berne Union (International Union of Credit & Investment Insurers) www.berneunion.org.uk/

Chubb Group www.chubb.com/

Compania Espanola de Seguros de Crédito y Caucion S.A. www.creditoycaucion.com/

Credit Guarantee Insurance Corporation of Africa Limited www.creditguarantee.co.za/

FCIA Management Company, Inc. (FCIA) www.fcia.com/

International Credit Insurance & Surety Association (ICISA) www.icisa.org/

Pan-American Surety Association (PASA) www.apfpasa.ch/

Sovereign Risk Insurance Ltd. www.sovereignbermuda.com/

Zurich American Insurance Company www.zurichna.com/specialties/pr/Politica.nsf/pages/home?opendocument

Credit Management

Association des Credit Managers www.afdcc.com/

Business Information Industry Association (BIIA) www.biia.com/

Euler Hermes www.eulerhermes.com/

Federation of European Credit Management Associations (FECMA) www.fecma.eu/

Federation of European National Collection Associations (FENCA) www.fenca.com/

Intrum Justita www.intrum.com/

National Association of Credit Management (NACM) www.nacm.org/

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Credit & Finance Risk Analysis