F7: Project Finance Flashcards
Who are the players in a project finance investment?
The project company: A legally independent company that is set up to conduct a certain (often infrastructure) project
Sponsors: Firms, governments, or international organizations that provide equity in the project company
Lenders: Firms (usually banks) that provide debt capital to the project company
Mega-projects usually provide predictable and stable cash flows
What is project finance?
One of the main purposes of project finance is to allocate risk to specialized entities who have some experience managing these risks.
In addition because there’s typically stable and predictable CF involved we can use much higher debt ratios which are isolated financially from the parent company through a non-recourse agreement.
What are the 5 traits that are defining for project finance?
1: The project company (SPV) is legally and financially independent from the sponsor.
2: Debtors have very limited or no recourse to the sponsors in the case of cash flow shortfalls etc.
- If the project company cannot repay its loans then that’s the bank’s problem because there’s no other source of repayment.
3: Project risks are allocated equitably among all parties involved (different risk profiles than usually for debt vs. equity)
4: Cash flows generated from the project must be sufficient to cover operating expense and debt service. Only after those payments funds flow to sponsors that provided the equity.
5: Collateral to lenders is often the asset created in the project
Why is project finance a thing?
1: Because risk allocation is direct, debt-to-equity ratios can be higher in PF than in normal investments. You can take on a lot more debt than normal and the SPV will not contaminate the parent companies’ balance sheet.
2: Sponsors do not have to take on the full risks of non-performance because of the non- recourse clause. This means that a sponsor firm‘s overall cost of capital remains untouched
3: In order to compute the cost of capital for a project, and also for the parent company, we can under project-finance essentially conduct two fully separate calculations and we don’t have to aggregate the two things because there’s a non-recourse clause involved that separates the SPV from the parent companies both legally and financially.
Which sponsors engages in project finance?
1: Industrial sponsors with PF linked to core business
2: Public sponsors with social welfare goals: 1) Build, operate, transfer (BOT) contracts: A private firm is in charge of building and operating a facility for a while, then the facility is transferred to a public entity 2) Build, own, operate, transfer (BOOT) contracts: In addition to BOT, here the private entity also owns the facility for a while 3) Build, operate, own (BOO) contracts: In this case, ownership is not transferred to a public entity
3: Sponsors who develop, build, and run the plant
4: Financial investors
Describe the project finance risk management technique
1: Risk identification
2: Risk analysis
3: Transfer risk to actors used to deal with the type of risk
4: Residual risk management
In a way the whole project finance setup is designed to distribute risk
What affects the cost of capital in project finance?
1: If the new project is large compared to firm size. If the project is almost as large as the existing firm then there will be interactions between business and financial risk.
2: If risk in the new project is substantially higher than in the firm average. We would then have to think of the risk in the company over all changing because of this project.
3: If there is a strong link to existing firm activities (lack of diversification). Cash flows will be highly correlated and as a consequence we get even higher risk.
How is the return of the firm (A) and the return of the project (B) computed?
It is the weighted average of the two projects. The expected return of the two projects are independent of their correlation
How is the risk underlying the portfolio (consisting of A and B) calculated?
The risk depends on the correlation between the two projects. In below formula w_A and w_B are the relative sizes of the projects
How does risk management in PF differ from risk management in corporate finance?
The project is isolated in the sense that there’s no second power plant or production plant that can take over some of the production, so if there’s 1 entity (i.e. 1 production plant) then there’s no alternative. Therefore, risk management in project finance has to be more detailed and cover more potential outcomes than under corporate finance because otherwise we don’t have the flexibility to cover potential shortfalls.
How does EPC contracts work as risk management tools?
Engineering, Procurement, and Construction (EPC) agreements transfers construction risk to the constructing entity
Constructor guarantees completion date, cost of the works, and plant performance
If there’s a shortfall there will be an extra payment for non-delivery or the company can sub-contract parts of the construction.
What is put or pay agreements?
The supplier either supplies the raw materials or has to provide a payment that is high enough to cover the costs associated with having another supplier supply the raw materials.
If the supplier isn’t able to provide the service that is contracted then there will be an alternative supplier from which the SPV buys supplies and then the original input supplier will have to pay the difference between the price paid by the SPV to the alternative supplier and the originally agreed payment (for what the original supplier would receive from the SPV in payment).
How does O&M agreements allocate operational risk?
Operations and Maintenance (O&M) agreements allocate operational risk to the contractor in charge of running a facility
We have the SPV that pays a periodic fee to the operator and the operator will incur the operating costs and make sure things are going well.
Because there’s usually a lot of uncertainty about what actually happens at for an example a power plant and it’s difficult to specify all contingencies there is typically an agreement where the SPV pays a compensation bonus to the operator depending on the operating performance of the production plant.
How does off take agreements limit market risk for the SPV?
We have a guarantee by the offtaker to take off a certain amount of products and they will then pay for this.
If the SPV is not able to supply the good or service to the offtaker than the offtaker has the same rights as the SPV had in the earlier example – to find an alternative supplier and the SPV has to pay the difference.
