Basics

Question 1

Type of project finance is what

Answer 1

limited recourse - because unless other rights are negotiated, the lenders will typically have recourse only to the amount of equity which is being injected

the borrower/sponsor is not held liable for the full amount of debt in the event of a default

Question 2

type of company in project finance

Answer 2

limited liability - sponsors desire this as they will want to have protection which this provides from banks looking through the project vehicle and having recourse against their balance sheet

Question 3

Different types of risk

Answer 3

> contractor risk - using FPTK contracts transfers a lot of this to the contractor surrounding cost overruns or delays

> supply risk - for feedstock which can be mitigated through long term contracts

> off take risk - can be thought of as volume to price risk - some projects might not have long term contracts for the off take of the product

> physical damage/environmental risk - insurance parties help with this

Question 4

Project vs corporate lending

Answer 4

most corporate lending has full recourse.. project does not

• corporate spreads the risk through the portfolio effect - having loans backed up by balance sheets etc

the lender also has access to historical data which may show a strong financial history - with a project, it isn’t built and isn’t generating cash flows yet

project finance is all about predicting and projecting > cash flow lenders

Question 5

CFADS

Answer 5

cash flow available for debt service is the surplus cashflow after payment of operating costs including taxes (before interest)

> lender will develop a base case cashflow projection in which they will sculpt the loan repayment schedule to ensure sufficient safety margins

Question 6

sensitivities on CFADS

Answer 6

on cases where:

• the loan amount structured on the base case analysis has been fully utilitised, but CFADS is weaker than expected e.g. sales revenues are reduced or operating costs are increased
• CFADS is as expected but the loan amount is increased - e.eg as a result of contruction cost increased or time delays

Question 7

Fly by wire in PF

Answer 7

as limited recourse financings are tailored to a predicted cashflow envelope, they require detailed project-specific control mechanisms which must be forward looking.

These mechanisms require revisions of projected cashflows so that underperformance against base case expectations are picked up early and remedial action can be taken

Question 8

What PF needs to include

Answer 8

• significantly greater reporting obligations
• more forward looking ratio tests
• tighter controls on cash distributions than corporately based loan instruments

Question 9

Project Financings are “Term Loans”

Answer 9

The project SPV wil utilise or “draw down” the loan facility during an “availability period” which broadly matches the construction period of the project.

during the contruction period the borrower will normally be cash-flow negative, meaning that the interest due to the banks will be added to the loan or “capitalised”

On completion of the projects construction the loan facility will cease to be available for drawing and any utilitisred debt capacity will be cancelled.

An agreed repayment schedule mechanism will then begin to apply and interest will be required to be paid rather than capitalised

Question 10

Two key features of term loans

Answer 10

loan facilities are:

1. drawn once and repaid once - amounts repaid are not capable of being redrawn as in a revolving loan facility
2. not repayable on demand - they are repaid in accordance with a pre-agreed schedule or mechanisms and can generally only be declared due for repayment at an earlier stage by the lenders on occurrence of an event of default

Question 11

The Sponsor’s risk-reward with the project

Answer 11

Exposed to both downside and upside potential.

Owners rank behind lenders for repayment of cash-flow.

In an insolvency the return of their capital will only happen if the banks have been fully repaid.

If the project outperforms expectations however, the owners receive this upside

With added gearing, the return on investment may rise in this case

Question 12

The Lenders risk-reward with the project

Answer 12

Exposed to downside risk but rarely upside potential

if it underperforms, lenders might lose a significant amount of loan capital - could even lose it all

the lenders interest return is typically fixed from the outset

if it outperforms then the lender will usually not enjoy higher returns

if the outperformance is high there is a significant chance the lender will be repaid early in which case a lender won’t have it on the books for as long as expected and the return will disappear

Question 13

Sponsor vs Lenders

Answer 13

Lenders, with the focus on returning their funds, will be focused on analysing and controlling risk, not maximising returns

Question 14

The cash back technique

Answer 14

Analysing how long is required for capital investment to be repaid - shorter the better

However this takes no account of the time value of money

> two projects with the same cash back will be rated equally even if one has a slower rate of investment or different distribution of cash received during the payback period

Question 15

DCF analysis

Answer 15

Discounting future inflows and outflows by a string of discount factors which increase overtime based on a chosen discount rate, the sum of all these discounted values will provide a Net Present Value

These NPVs can then be prepared and an assessment made

> a slower rate of equity injection for Capex will result in a higher NPV

Question 16

IRR

Answer 16

the rate of discount which returns an NPV of Zero

> how hard the cashflows can be discounted before they are effectively eliminated

an investor who knows an investments IRR does not need to ask what discount rate is being used

> If an IRR is greater than its WACC, it is logically worth considering

Question 17

Gearing

Answer 17

the debt-equity ratio

the interest payable on debt in most cases available as an offset to reduce corporate/profitds taxes

> a very considerable accelerator effect on IRR as gearing levels are increased

Question 18

Disadvantages of PF

Answer 18

Expensive when compared with debt raised against a balance sheet - project lenders are asked to share in the risks of a project, to contribute a substantial portion of the projects costs and to limit their recourse to the projects owners, it is logical they will require a higher return
Higher interest margins - recognise the greater risks which are being assumed by the lenders
higher arranagement fees - greater burden of analytical and structuring work which they will need to undertake, possibly over a period of many months.

Banks providing debt against a project will frequently also require detailed reports from third party “due diligence” consultants to assist in the work of risk analysis and finance structuring.
he costs involved in due diligence reporting can be substantial and they are required to be borne by the project SPV, whether or not the financing ultimately goes ahead.

Question 19

Follow ons from disadvantages

Answer 19

iven the above, the gestation period of project financings is generally much longer than that for corporate loans of comparable size.
need for exhaustive bank analysis, due diligence reporting, preparation of comprehensive information memoranda where syndication is planned, and the obtaining of credit approvals (potentially from a large number of banks) means that the time from first discussion to financial close is rarely less than three or four months. It can extend to a period of a year or two for very large projects with complex, multi-sourced financings.

Because of their greater risk acceptance and financial exposure, project lenders will also seek much greater rights of supervision and will expect much more extensive reporting than would be the case for corporate facilities where the lenders are protected by their access to a large and relatively liquid balance sheet.

Question 20

Arguments for lenders involvements

Answer 20

are providing a substantial amount of the cost of project construction;
* lend against a projected cashflow “envelope”, the predictability of which is by no means an exact science;
* commit funding to a project over periods of up to 20 years or even more, when their sources of funding are overwhelmingly of much shorter duration;
* generally will be expected by the sponsors/borrower to increase the debt level (as compared to equity) to the highest level which the project SPV can sustain;
* are not exposed to project upside potential, but do share downside risk;
* receive returns which, although high by banking standards, cannot possibly compensate them for losses of principal.

Question 21

The restrictive features typically included in project finance loan agreements typically include:

Answer 21

• prohibitions/severe limits on the raising of new debt by the project SPV;
• a requirement that the SPV shall not create new subsidiaries and/or engage in new projects without the lenders’ approval;
• limitations on contracts with other companies within the sponsor group;
• controls on distributions to shareholders by the SPV when actual or predicted cashflow falls below certain levels.

Question 22

list of “covenants” or “undertakings” within the project financing agreement

Answer 22

include a set of events of default designed to trigger lenders’ rights to accelerate repayment of the debt and if necessary to enforce their security. Especially where they receive significant levels of negotiated support from sponsors, lenders may also seek to bind sponsors by means of selected covenants and events of default

Question 23

lenders will also “ring-fence” the project SPV by means of far-reaching security agreements

Answer 23

designed to give the lenders a first ranking, fully perfected security interest in the assets and revenue-generating agreements of the company

Question 24

Wil create security interests over the following:

Answer 24

The share capital of the project SPV owned by the sponsor(s);
* Any license or concession agreements which regulate the activities of the SPV;
* Contracts for the construction and operation/maintenance of the project;
* Fuel and raw material supply agreements;
* The fixed physical assets of the project;
* Current assets such as stock, debtors and cash;
* Key revenue-generating contracts such as sales agreements;
* Policies of insurance (usually with the lenders named as loss-payee in the event of a claim being made).

Question 25

The objectives of these security agreements are to insure that:

Answer 25

their claims against the project SPV rank higher than almost all other creditors6, defeating the “pari passu” principle whereby all creditors will generally be treated equally in the event of insolvency;
* they have rights of inspection and supervision, so that they can monitor and protect the value of the project’s assets;
* disposal or mortgaging of project assets will be difficult without their agreement;
* they have rights of seizure and (especially importantly) sale with regard to the SPV or its assets if
this necessary to recover their debt.

Question 26

“Bips” and “spreads”- project loan interest pricing

Answer 26

Where the lenders are commercial banks, it will be very unusual for such loans to be provided at a fixed rate for their whole duration. This is because banks have very limited sources of fixed rate deposits.
Their long-term loans are largely funded from short-term sources, such as the inter-bank money markets. In these markets banks lend to and borrow from each other for periods of up to twelve months – with periods of a few days, a month, three months or six months being the most common.
It would be an enormous risk for a bank to borrow on the basis of a rate which is rising and falling constantly, but then to lend long-term on a fixed rate. What happens therefore is that the lenders provide short term packets of funding within a long-term envelope.
Each short-term packet is at a fixed rate, with the rate being revised when the maturity of that packet is reached.

Question 27

The Rate charged to the borrower is made up of two parts:

Answer 27

a benchmark (market) rate which the lenders are paying for their own funding; plus
b) a premium (referred to as the “margin” or “spread”) on top of the benchmark rate which reflects the riskiness of the transaction.

Question 28

the benchmark rate

Answer 28

will rise and fall in line with market rates over the life of the loan. Until recently the most common benchmark rate was the London Inter-Bank Offered Rate or “LIBOR”, which is gradually being replaced by a range of different, more regional, benchmark rates

Question 29

the margin

Answer 29

will be specified in the loan agreement and will not move as the benchmark rate moves. Project financing margins tend to be significantly higher than those charged to established corporate borrowers – especially corporate borrowers with strong financials. A strong corporate group such as BP will pay significantly less than 1% over the benchmark rate, especially if borrowing for less than one year. Project margins are more likely to be in the range 1.5-4.0%, reflecting the greater risk and longer maturity of project transactions

Question 30

why the margin is higher during construction

Answer 30

It is common also for the margin to be at its highest level during a project’s construction phase and then to fall when the project comes into operation.
This reflects the fact that the construction period is the time of greatest risk for a project lender. During that phase the project is, after all, consuming cash rather than generating it and interest is being capitalised (added to the loan) rather than being paid. The risk of cost overrun and delay are ever-present.
Thus, it would be quite normal, for example, for a renewable energy project with a construction phase margin of 2.25% to see its margin fall to say 1.75% when construction is completed and cash starts to flow.
Please note also that lenders will frequently express margins in “basis points” – hundredths of a percentage point (0.01%).
Basis points are often abbreviated to “bips” in conversation. So, when a lender talks about a “50 bip spread” s/he is referring to a 0.5% margin.

Question 31

reasons to project finance

Answer 31

1. The most obvious is that some companies have no choice. They simply do not have the financial creditworthiness to be able to raise the required funding against their balance sheets. An independent oil and gas or mining company for example, which might just have been established, may be contemplating a project which dwarfs the company at its current stage of development. A developer of a renewable energy project, such as a windfarm or biomass-burning power station, may not have the financial track record and corporate net worth to convince a bank to lend on a corporate basis. S

Slightly larger companies may have access to more significant resources but may still wish to ration available capital across a range of projects, asking lenders once again to provide the largest part of the required finance as debt

the desire to share specific risks with lenders.
We might consider the case of a major oil company considering the construction of a pipeline spanning a number of emerging-market countries with a history of some political instability. The oil company might be completely comfortable with the (possibly considerable) technical and construction challenges presented by the pipeline, but nervous that changes of regime or government policy in a transit country could result in negative consequences for the users of the pipeline and its investors. A transit country situated at a mid-point on a long and major pipeline does after all have some economic influence if it feels its interests are not being respected! If the pipeline is financed on a project finance basis, the sponsors can simultaneously:
* limit their exposure in financial terms (by investing a modest amount of equity rather than funding the whole project on a corporate basis);
* share the risk of adverse government actions with the lenders, who will suffer along with the investors if the project is damaged.

Perhaps the most common reason why major companies overcome their dislike of project finance is in circumstances of joint venture or unequal partnership.
A major national power company, in expanding outside its own home country, might for example find itself in partnership with much smaller renewable power developers who are quite incapable of funding their share of the cost of project developments on a corporate basis.

Question 32

what is a syndicated loan?

Answer 32

Offered by a group of lenders
Lenders pool their capital together to finance a single loan for one borrower

Question 33

why syndicate a loan?

Answer 33

In this regard, it is important to appreciate that banks have internal and external controls on the level of exposure they may accept to individual borrowers or borrower groups. The external controls are imposed by bank regulators – typically the central bank of the country where a bank is based and / or has operations. Banks will also set their own limits for reasons of prudence and conservatism. This means that a project requiring, say, €1 billion of debt finance will need a substantial group of banks to provide funding.

Question 34

Mandated Lead Arrangers

Answer 34

A syndicated loan will be structured by a single bank or a group of banks (known as the “mandated lead arranger(s)” or “MLAs” and will then be distributed (syndicated) to a much larger group of lenders.
The syndication may be seen as a pyramid , with the MLA(s) at the top and tiers of lenders beneath.
All the lenders in the group will receive the same risk margin over LIBOR (or whatever reference rate is being used to set interest costs for the deal), because they are all taking the same credit risk.
They will not, as we shall see, receive the same fees.
The MLA(s) will often provide the largest proportion of the transaction and will be expected to do so by the sponsors, with banks further down the pyramid holding smaller and smaller debt amounts.
The amount of their participation is often referred to as their “ticket”.
The MLAs will approach the bank market offering a range of potential ticket sizes, with the participation (or “front-end”) fee on offer being linked to the size of the ticket. The smaller the ticket, the smaller the fee.

Question 35

Titles

Answer 35

The title which the potential participants are offered will also depend on their ticket size. Titles are undoubtedly important because they carry a certain amount of prestige and banks have shown significant inventiveness in inventing new titles over time.
The MLAs will normally retain a much more significant proportion of the fees paid by the borrower than the other debt providers

Question 36

MLAs to attract other lenders

Answer 36

the MLAs might receive a global front-end fee of, say, 150 basis points (1.5%) on the full amount of the loan, the higher-level participants will receive significantly less than this (perhaps 100-120 basis points) and as the ticket sizes decrease so will the front-end fee paid.
It is really for the MLAs to determine what they need to pay to attract other lenders into the transaction and the amount which they are able to “skim” (keep for themselves) increases their return on their own participation and compensates them for the work they have done in structuring and arranging the financing7.

Question 37

Methods of building a syndicate: Underwriting:

Answer 37

A borrower who is keen to have absolute certainty of the availability of financing may decide to ask the transaction MLAs to “underwrite” the syndication.
This means that, in return for the payment of an underwriting fee - in addition to the arrangement fee - the MLAs will effectively guarantee to provide (lend) up to the full amount of the financing if they are unable to syndicate the deal in the wider bank market. In such cases it is common for the borrower to sign the loan agreement with the MLAs, with other banks being brought into the financing as syndication proceeds.

Question 38

Problems with failing to syndicate an underwritten transaction:

Answer 38

They will find themselves potentially having to fund (in the extreme case where they cannot syndicate any of the facility) up to the full amount of the loan facility and being exposed to the risks of the transaction for a much larger sum than the anticipated net lending position which has been approved by their individual credit committees.
The loan origination groups within the underwriting banks will certainly come under enormous pressure from their own internal authorities to reduce the excess exposure, if necessary, using up all of the fees they have earned on the transaction.

Question 39

best-efforts basis

Answer 39

Before the financial crisis a lot of loans would be oversubscribed so underwriting was rare
Most syndications were carried out on a “best-efforts” basis (otherwise known as a “book-build”). The MLAs would not underwrite but would simply commit their own institutions for their own approved net take amount and then proceed to assemble a group of banks until the required total debt amount had been achieved.
Logically of course the borrower was not permitted to commence drawing (even from the MLAs) until the syndication had been completed.

Question 40

club-style syndication

Answer 40

In a club-style syndication, which is something of a half-way-house between underwriting and best efforts, a larger than usual group of MLAs is assembled, with the MLAs providing the bulk – if not all – of the required debt amount.
Even where the MLAs do not provide the full amount, the sum of their approved net takes represents such a large proportion of the required debt amount that the amount to be raised from the general syndication market is greatly reduced – also reducing the syndication risk.

Question 41

Interests and fees - economics of syndicated transactions

Answer 41

Arrangement Fees
The arrangement fee agreed between the borrower and the MLAs will typically be paid directly to the MLAs and from this sum the MLAs will pay out participation fees (also referred to as front-end fees) to the participant banks in accordance with their individual ticket sizes

Underwiting Fee - paid to underwriters only

Interest margin - all lenders within the syndicate will receive the same interest margin over the reference interest rate

Question 42

conditions precedent

Answer 42

if the borrower meets all requirements in the loan agreement, the banks have no choice but to advance funds
Commitment fee - lenders will then have to reserve capital within their balance sheets to reflect this commitment whether or not funds have actually been drawn
“commitment fee”, which is sometimes called a “non utilisation fee”, on that part of the committed loan which has not yet been drawn.

Question 43

fees in the construction period

Answer 43

The available project debt will be drawn over time and peak at the end of the construction period.
At any time along the curve, interest (reference rate plus the agreed margin) will be charged on the amount which has actually been drawn while commitment commission will be charged on the amount which is committed but not yet drawn.
The commitment fee will be charged in arrears. Every quarter or half year a calculation will be made of the commitment fee payable on each day of the period just ended and an invoice will be sent to the borrower for the sum of these amounts.
Commitment fee rates / calculation bases vary from one part of the markets to another. In project financing the commitment fee tends to be 30-40% of the lending margin.
Thus if the interest payable on the drawn amounts were, say, the benchmark rate plus 2% then the commitment fee would be between 60 and 80 basis points (30-40% of the margin of 2%)10.
Obviously, the commitment fee will fall away once the loan facility has been fully drawn or – if it turns out that the whole facility will not be required, perhaps because of cost savings – any amount which is not required has been cancelled.

Question 44

other fees

Answer 44

The only other fees which need to be addressed are the agency fee and specialist fees such as those paid to technical / modelling banks in project financing transactions.
In project financing transactions one of the MLAs will be designated as modelling bank and will be responsible for building and maintaining the spreadsheet model used to size, structure and administer the financing. For this an annual fee will typically be paid – the profitability of which for the modelling bank will depend very much on the amount of unplanned (and therefore unpriced) modelling work which has to be done as the deal proceeds. Despite this risk the role of modelling bank is a pivotal one in project finance loans.

Question 45

agent bank

Answer 45

The MLA in a syndicated transaction – or one of the MLAs if there are more than one – will typically carry on once the syndication is completed to act as the administrator of the deal on behalf of the syndicate of lenders.
This “agent bank” will frequently also hold security instruments like mortgages on behalf of the whole lender group.
Any retention or control accounts - such as revenue accounts, debt service reserve accounts or escrow accounts – will be held by the agent, who will also be responsible for arranging drawdowns, interest payments, principal repayments and fee collections.
For undertaking all these (quite labour-intensive) activities, the agent will receive an annual fee, often calculated as an amount per bank in the syndicate with a defined minimum

Question 46

The “LMA” - Loan Market Association

Answer 46

Founded in 1996, the Loan Market Association, or LMA, is a trade association for the primary and secondary syndicated loan markets. It has more than 700 member organisations, including commercial and investment banks, institutional investors, law firms, service providers and rating agencies. The LMA states its key objective to be:

”…improving liquidity, efficiency and transparency in the primary and secondary syndicated loan markets in Europe, the Middle East and Africa (EMEA). By establishing sound, widely accepted market practice, the LMA seeks to promote the syndicated loan as one of the key debt products available to borrowers across the region.”

The LMA has drafted a wide range of standard documents which include loan agreements for corporate revolving and term loan facilities, mandate letters and intercreditor agreements. The aim is to provide agreed wording for the essential, non-contentious parts of such documents, so that lenders and borrowers may concentrate on the commercial aspects of a transaction.

During loan agreement negotiations the phrase “That’s LMA” will often be heard, meaning that the clause in question is standard LMA-sanctioned language and should not therefore need to be negotiated. The other term often used is “boilerplate”11, by which the speaker means that the clause being discussed is essential but at the same time non-contentious.

Question 47

what is PF

Answer 47

a financial structure where lenders have recourse primarily to the cashflow of the project or asset they are financial, rather than to the balance sheet of the sponsors

Question 48

The LIBOR scandal

Answer 48

on the run up to the 2008 crash, banks understated their borrowing costs (interbank) leading to a wildly understated LIBOR rate

alleged banks did this to maintain their creditworthiness and/or avoid increasing their borrowing costs in periods of turmoil

this made the banking system seem a lot healthier than it in fact was

Question 49

Sponsors objective in PF

Answer 49

• maximise debt
• delay equity injection (time value of money)
• accelerate returns (time value of money)
• AVOID cash traps (don’t want to lock up cash in SPV)
• minimise / manage recourse

Question 50

Lenders objective

Answer 50

• analyse and control risk
• ensure risk is bankable and consistent with IRR
• include cushions
• incorporate command and control