Updated 26 April 2007 FINA 522 Project Finance

Updated: 26 April 2007 FINA 522: Project Finance and Risk Management Lecture Three 0

Security Arrangements and Financing Sources 1

Security Arrangements Objectives – Ensure project completion (physical, mechanical and financial). – Upon completion, ensure that project generates sufficient cash to cover operating expenses and meet debt service requirements. – Ensure that the project can service debt in the event of disruption in operations (including force majeure situations). 2

Elements of a Security Package a) b) c) d) e) f) g) h) Mortgage on project assets Turnkey contracts Sale & purchase contractual agreements Sponsors’ commitment/support/pledges Financial covenants Guarantees Insurance Escrow funds 3

A) Mortgage on Project Assets • If financial institution has mortgage on assets of project it can take over assets if loans are not repaid. • First Mortgage lien on project’s fixed assets (land, buildings and machinery) means that the financial institution has first claim on fixed assets. • Works well for industrial projects and power projects but not so for other infrastructure projects (such as highway projects). • Not possible in case of concessions or BOTs— Sponsor guarantees will be necessary 4

Mortgage on Project Assets (cont’d) • Weak Mortgage Legal Framework is often a problem. For example, – No mortgage law in project country – No mortgage of land allowed to foreigners – If fixed assets are mortgaged, no other assurance can be used by lender. 5

B) Off Take and Supply Contracts • • • Off take contracts obligate buyers of the project’s output to provide credit support to the project and to share in its risks. Raw material supply agreements obligate providers of the project’s inputs to provide credit support to the project and to share in its risks. For example, suppliers of telephone switching and transmission equipment for all phone project. Contracts specify certain remedies when deliveries are not received or made. Off take and supply agreements are often requested by lenders to provide credit support for a project. Often supplemented by sponsors’ assurances and commitments. 6

B) Off Take Contracts • Take and Pay (Take-if-Offered) Contract A contract obligating the buyer of the project’s output to take delivery and pay for the output only if the project is able to deliver them. No payment is required unless the project is able to make deliveries. • Take or Pay Contract A contract obligating the buyer of the project’s output to pay for the output, regardless of whether the purchaser takes delivery. Cash payments are usually credited against charges for future delivers. 7

B) Off Take Contracts (cont’d) • Hell-or-High-Water Contract Similar to take-or-pay except there are no “outs”. Buyer has to pay in all events even if output is not produced and even in cases of force majeure. • Throughput Agreement An agreement according to which the shipper agrees to ship a specified amount of product through the pipeline within a certain time period. Throughput generates sufficient cash to cover operating costs and service debt. 8

B) Off Take Contracts (cont’d) • Cost of Service Contract This contract requires each sponsor to pay his proportionate share of project costs and receive its share of project output. • Tolling Agreement The agreement requires each sponsor to pay its share of tolling charges for processing a raw material. Typically raw material is owned by project sponsors. 9

C) Raw Material Supply Agreements • Supply or Pay Contract obligates the raw material supplier to furnish the required amounts of the raw material specified in the contract or else make payments to the project entity that are sufficient to cover the project’s debt service. 10

C) Step-Up Provisions • An obligation by other buyers to increase their respective shares of purchases in case one of the buyers goes into default; or by a other suppliers of raw material to increase their respective shares of supply if one supplier goes into default, hence enhancing the strength of the agreements. • Each of the buyers/suppliers coinsures the obligations of the other buyers/suppliers. • A step-up provision is often included in the purchase and supply contracts if there are multiple buyers of the project’s output/suppliers of raw material. 11

E) Sponsors’ Commitment/ Support/ Pledges • Project Funds Agreement by sponsors to provide additional funds as needed-- typically until project completion. 12

E) Sponsors’ Support (cont’d) • Share Retention Agreement An agreement by the shareholders not to sell their shares, or alternatively to hold a specified amount of shares. 13

E) Sponsors’ Support (cont’d) • Capital Subscription Agreement An obligation by creditworthy parties to buy the securities of the project entity for cash to the extent required to cover any cash short-falls by the project. Typically, common stock or subordinated debt (junior securities) 14

E) Sponsors’ Support (cont’d) • Clawback Agreement • An agreement by project sponsors to contribute cash to the project in return for project-issued securities (typically, common stock or subordinated debt) to the extent that they: (1) Received cash dividends from the project company or (2) Realized project-related tax benefits due to investments in the project. • In case of cash dividends, contribution is equal to dividends. • In case of tax benefits, contribution obligation is limited to the cash value of the project-related tax benefits. 15

E) Sponsors’ Support (cont’d) • Assignment to the lenders of the project’s right to receive payments under its different contracts. • Assignment to the lender of insurance payments. • Pledges of project shares to the lender. 16

F) Financial Covenants • Main objective is to restrain the scope of activities of the project entity. Examples are: – Limiting the ability to pay dividends. – Limiting the ability to expand without prior permission. 17

G) Guarantees • Sponsor Guarantees. • Third Party Guarantees. – Government guarantees. – Export Credit Agency Guarantees. – Multilateral lending institution guarantees. • Full Vs Partial Guarantees 18

H) Insurance • Taken out to protect against certain risks—mostly force majeure risks. Insurance will cover the cost of damage caused by natural disasters ensuring that the project remains a viable operating entity. • May be also used to insure against business interruption. • Lenders will insist upon insurance when the ability of the obligated parties to repay project debt on an accelerated basis is questionable. 19

I) Escrow Funds • A fund established upon the requirement of the lenders to hold cash that can be used towards debt servicing. • Typically contains between 12 and 18 months of debt service. • Cash can be withdrawn from the escrow fund if the project’s cash flow from operations does not cover the project’s debt service requirements. 20

Financing Sources • Financing sources can be classified in many ways. For example: – – by financing horizon (short, medium, long term) by debt and equity by source (domestic versus foreign) by importance • Classification below is by importance for project financing 21

Important Sources of Project Finance • • • Commercial Banks Capital Markets Equity Bilateral & Export Credit Agencies Multilateral Development Institutions Leasing 22

1. Commercial Loans • A major source of project financing • Commonly used for short to medium term financing • May be senior or subordinated 23

Different Types of Commercial Loans – Syndicated Loans • For large projects • To limit banks’ exposure to a single project/borrower – Term Loans • Draw down during construction period • Loan maturity typically does not exceed 10 years but may be longer for infrastructure projects 24

Different Types of Commercial Loans (cont’d) – Revolving Credit (Construction) Loans • Sponsors draw down as needed up a limit – Working Capital Loans • short term to meet working capital requirements – Bridge Loans • To cover gaps between expenditure and a scheduled draw down • Interm or temporary financing 25

Advantages of Commercial Bank Financing – – Availability of funds Capable of sophisticated project and risk analysis Fewer limitations Non-recourse or limited recourse financing possible 26

Drawbacks of Commercial Bank Financing – – – Typically medium-term lending (5 -10 years) with short-grace period which may not fit in with project needs Floating rate - uncertainty about project costs Higher cost 27

. 2 Capital Markets • National market for bonds/notes • International market (Euromarket) for bonds/notes – Underwritten by an international syndicate – Offered simultaneously in different countries – Issued outside the jurisdiction of a single country – 5 -10 year maturities; sometimes longer 28

. 2 Capital Markets (cont’d) • International market for bonds/notes-cont’d – – – • Denominated in major currencies: Eurodollar, Euroyen could be a lower cost of funding offers a diversified group of lenders Commercial Paper (U. S. , Euro) – – – Low cost of short term financing Not widely available in developing countries May require primary bank credit facility as credit support. 29

. 2 Capital Markets (cont’d) • Private Placements (insurance companies, pension funds, etc. ) – – Typically do not require regulatory approval Typically do not require public disclosure Arranged with a limited number of institutional investors Major source of long-term fixed rate financing 30

. 2 Capital Markets (cont’d) • Advantages – offers a wide range of financing possibilities • Disadvantages – generally requires a track record (not a real possibility for green field projects) 31

. 3 Equity • • Preferred and common stock May or may not be listed GDRs and ADRs Foreign and domestic Host governments Offshore joint venture partners/investors Domestic equity privatization 32

. 4 Export Credit (ECA) and Bilateral Agencies (BLA) • Established to promote trade with other countries • Export credits/guarantees are provided by foreign aid or export import banks • Most OECD countries offer export credits and/or guarantees, political risk insurance • Examples of such institutions include: – – Kreditanstalt fur Wiederaufbau (KFW) of Germany Export Import Bank of Japan Eximbank of the US OPIC of the US 33

Advantages of Export Credits • • Long maturities of loans 5 -10 years Fixed interest rates Below market rates Quasi government nature of loan 34

Disadvantages of Export Credits • Equipment may be not the best for project • There could be better services offered from other sources • Other complementary services and parts may be more expensive than substitutes. 35

. 5 Multilateral Funding Agencies • Institution organized by a group of counties to promote development • The World Bank Group – IBRD, IDA, IFC, MIGA • Regional Development Banks – EBRD, ADB, AFDB, IADB, CDB 36

International Bank for Reconstruction and Development (IBRD) • Project-based loans to development country governments • Partial Guarantee Program – Developed to help government entities raise capital on international markets priority for infrastructure – Government guarantee being replaced by guarantee fund. – First used by HUB 37

International Finance Corporation (IFC): Loans • Lends to, and invests in, private sector and government projects • Can not accept government guarantees • Mobilizes resources, and lends, on commercial terms • Lending less than 25% of total project costs; project costs greater than US$ 10 million • Loan terms run 7 -12 years but can be tailored to specific project 38

IFC - Equity • Takes straight equity positions • Equity position of up 35% of share capital • Established infrastructure department in 1992 to finance private infrastructure projects 39

Multilateral Investment Guarantee Agency (MIGA) • Insures against non-commercial risks • Insures against political risk • Expropriation – damages caused by war – currency inconvertibility – currency non-transferability • Insures equity and debt 40

European Bank for Reconstruction and Development (EBRD) • Established in 1991 and located in London • Geographical focus is on Eastern Europe • 40% of funding for private infrastructure • Financing options include loans, equity, guarantees and underwriting • Loan maturities range from 10 to 15 years 41

Advantages of Multilateral Funding • Better positioned to assume political risk • Participation endorses project for other lenders • Longer maturities • Fixed interest rates • Co-financing arrangements possible 42

Disadvantages of Multilateral Funding • Lengthy approval process • Funds may be in currencies difficult to hedge against. 43

. 6 Leasing • Two main kinds – Direct leasing: a lessor buys the asset and leases it to the lessee – Leveraged (indirect) leasing: a lessor uses his own funds to cover 15% to 30% of the cost of the asset and secures non recourse funds from institutional investors for the balance. The leveraged lease lenders have a lien on the asset. 44

. 6 Leasing (cont’d) • Leveraged Leasing (cont’d) – The lessor enjoys tax breaks due to the leverage – Consequently, the lessor can afford to lease at lower rates than under a direct lease – cumbersome and complex documentation 45