Agency Cost & Risk

Question 1

What is a Project?

Answer 1

• High operating margins.
• Low to medium return on capital.
• Limited Life.
• Significant free cash flows.
• Few diversification opportunities. Asset specificity.

Question 2

What are some of the Symmetric Risks? (4)

Answer 2

Demand, price.
Input/supply.
Currency, interest rate, inflation.
Reserve (stock) or throughput (flow).

Question 3

What are some of the Binary Risks

Answer 3

Technology failure.
Direct expropriation.
Counterparty failure
Force majeure
Regulatory risk

Question 4

What are some of the Asymmetric Downside Risks

Answer 4

Environmental.

Creeping expropriation.

Question 5

What does a project need?

Answer 5

Customized capital structure/asset specific governance systems to minimize cash flow volatility and maximize firm value.

Question 6

How does Project finance compare to Structured Debt?

Answer 6

Similar: Collaterized with a specific asset
Dissimilar: Recourse to corporate assets

Question 7

How does Project finance compare to Subsidiary Debt?

Answer 7

Similar:
Dissimilar: Possible recourse to corporate balance sheet

Question 8

How does Project finance compare to Asset backed securities?

Answer 8

Similar: Collaterized and non-recourse
Dissimilar: Hold financial, not single purpose industrial asset

Question 9

How does Project finance compare to LBO/MBO?

Answer 9

Similar: High debt levels
Dissimilar: No corporate sponsor

Question 10

How does Project finance compare to Venture backed companies?

Answer 10

Similar: Concentrated equity ownership
Dissimilar: Lower debt levels; managers are equity holders

Question 11

What are some of the disadvantages of Project Finance

Answer 11

• Often takes longer to structure than equivalent size corporate finance.
• Higher transaction costs due to creation of an independent entity. Can be up to 60bp
• Project debt is substantially more expensive (50-400 basis points) due to its non-recourse nature.
• Extensive contracting restricts managerial decision making.
• Project finance requires greater disclosure of proprietary information and strategic deals.

Question 12

Does “off balance sheet” mean that you don’t have to disclose the project on your balance sheet?

Answer 12

Even if you do not have to report the debt on a consolidated basis, there are often lots of obligations that do need to be disclosed. For example, if you agree to buy the output of a project, that should be disclosed as a contingent liability in the footnotes to your annual report. There are differences between tax and accounting conventions.

Question 13

What is a solution to Completion Risk?

Answer 13

Contractual guarantees from manufacturer, selecting vendors of repute.

Question 14

What is a solution to Technology Risk?

Answer 14

Expert evaluation and retention accounts.

Question 15

What is a solution to Environmental Risk?

Answer 15

Insurance

Question 16

What is a solution to Price Risk?

Answer 16

Hedging (Swaps / Futures / Forwards / Options)

Question 17

What is a solution to Resource Risk?

Answer 17

Keeping adequate cushion in assessment.

Question 18

What is a solution to Operating Risk?

Answer 18

Making provisions, insurance.

Question 19

What is a solution to Interest Rate Risk?

Answer 19

Hedging (Swaps)

Question 20

What is a solution to Political / Sovereign Risk?

Answer 20

1- Externalizing the project company by forming it abroad or using external law or jurisdiction
2- External accounts for proceeds
3- Political risk insurance (Expensive)
4- Export Credit Guarantees
5- Contractual sharing of political risk between lenders and external project sponsors
6- Government or regulatory undertaking to cover policies on taxes, royalties, prices, monopolies, etc
7- External guarantees or quasi guarantees

Question 21

What is a solution to Insolvency Risk?

Answer 21

Credit Strength of Sponsor, Competence of management, good corporate governance

Question 22

What is a solution to Currency Risk?

Answer 22

Hedging (Swaps / Futures / Forwards / Options)

Question 23

What is Agency Cost?

Answer 23

Agency costs are a type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal.
These costs arise because of core problems, such as conflicts of interest, between shareholders and management.

Question 24

What is a possible solution to the agency cost of High levels of free cash flow? Possible managerial mismanagement through wasteful expenditures and sub-optimal investments.

Answer 24

• Traditional monitoring mechanisms such as takeover markets, staged financing, product markets absent.
• Reduce free cash flow through high debt service.
• Contracting reduces discretion.
• “Cash Flow Waterfall”: Pre existing mechanism for allocation of cash flows. Covers capex, maintenance expenditures, debt service, reserve accounts, shareholder distribution.
• Concentrated equity ownership provides critical monitoring.
• Bank loans provide credit monitoring.
• Separate ownership: single cash flow stream, easier monitoring.
• Senior bank debt disgorges cash in early years. They also act as “trip wires” for managers.

Question 25

What is a possible solution to the agency cost of Opportunistic behavior by trading partners: hold up. Ex-ante reduction in expected returns.

Answer 25

• Vertical integration is effective in precluding opportunistic behavior but not at sharing risk (discussed later). Also, opportunities for vertical integration may be absent.
• Long term contracts such as supply and off take contracts: these are more effective mechanisms than spot market transactions and long term relationships.
• Joint ownership with related parties to share asset control and cash flow rights. This way counterparty incentives are aligned.
• Due to high debt level, appropriation of firm value by a partner results in costly default and transfer of ownership.

Question 26

What is a possible solution to the agency cost of Opportunistic behavior by host governments: expropriation. Either direct through asset seizure or creeping through increased tax/royalty. Ex-ante increase in risk and required return.

Answer 26

• Since company is stand alone, acts of expropriation against it are highly visible to the world which detracts future investors.
• High leverage forces disgorging of excess cash leaving less on the table to be expropriated.
• High leverage also reduces accounting profits thereby reducing local opposition to the company.
• Multilateral lenders’ involvement detracts governments from expropriating since these agencies are development lenders and lenders of last resort. However these agencies only lend to stand alone projects

Question 27

What is a possible solution to the agency cost of Debt/Equity holder conflict in distribution of cash flows, re-investment and restructuring during distress.

Answer 27

• “Cash flow waterfall” reduces managerial discretion and thus potential conflicts in distribution and re-investment.
• Given the nature of projects, investment opportunities are few and thus investment distortions/conflicts are negligible.
• Strong debt covenants allow both equity/debt holders to better monitor management.
• To facilitate restructuring, concentrated debt ownership is preferred, i.e. bank loans vs. bonds. Also less classes of debtors are preferred for speedy resolution. Usually subordinated debt is provided by sponsors: quasi equity