Qualitative Risk Analysis (1) Flashcards
Sponsors critical role with risk towards lenders:
anticipate how those lenders are likely to approach particular types of risk;
* understand what risks, and what level of such risks, lenders can normally be persuaded to bear;
* appreciate how to present project risks in a manner likely to achieve the desired result and;
* have a clear picture of how potentially unacceptable risks (for the banker) can be made acceptable through mitigation or allocation.
Qualitative Risk Analysis types (in order of preferred analysis)
Sponsor
Country
Construction
Technology
Supply
Offtake
Operation and maintenance
Regulatory/Compliance
Insurance
lenders usual approach
lenders will always try to make sure that their cashflow model is more conservative than that of the sponsors - because of their risk-reward relationship with the project. So, to rush out potential debt values based on raw numbers supplied by the borrower is a little dangerous. So, to carry out some qualitative risk analysis makes sense before any numbers are run. Even here it is helpful to address a project’s risks in a logical order so as to deal with potential “on/off switches” early in the process.
sponsor risk and mitigation
As we know, project financing is deliberately structured so as to limit the debt providers’ recourse to the wider revenue streams and asset base of the sponsor(s).
lenders assess the sponsor
an assessment of the sponsors is generally the starting point for the wider qualitative analysis of the risks of the financing; and * if the sponsor risks appear unacceptable it is unlikely that a project lender will be able to proceed much further – or at least not without some form of credit risk enhancement. So, the “smell test” on the sponsor is very important and can be something of an “on/off” switch.
Other project risks may be more like “volume controls”, affecting aspects of project structure such as the debt:equity ratio or the (interest) risk margin to be applied. Sponsor risk is definitely one of the more “binary” issues. If sponsor risk appears unacceptable a lender will often decline to pursue the project further.
the kyc process
Lenders – especially perhaps commercial banks – are heavily regulated organisations. They are required to apply “Know Your Customer” or “KYC” rules.
These are aimed in particular at preventing the use of banks and other businesses for money-laundering. These rules are strict and mandatory and non-compliance carries heavy penalties for the institutions – and the individuals – involved.
Banks typically use the KYC process to develop a detailed understanding of a potential client before commencing a business relationship, with a view to minimizing the risk of fraud.
KYC will involve customer identification procedures and analysis of any risk factors which might impact the bank’s business or reputation. This could include investigation of the potential for corruption or the inappropriate exercise of political influence.
liquidity
When thinking about whether or not to work with new project sponsors, lenders will also be influenced by the level of liquidity available in the banking market. The financial crisis of 2008-9 sharply reduced the lending capacity of many banks (and in many cases also their ability to accept emerging-market risk).
In such circumstances, lenders were much more likely to use their limited resources for long-standing clients, rather than making them available to untried new borrowers. This allowed them to strengthen and increase their return on long-standing relationships.
relationship factor
This “relationship factor” can be a real advantage for borrowers/sponsors when speaking to their house banks about project financing, especially when credit capacity is tight. It is not without its downside, however.
If the project does experience severe difficulties, lenders may use the existence of the relationship to “twist arms”. They may exert pressure on the sponsors to provide support (e.g. additional equity or cashflow deficiency payments) over and above that agreed at the time the project financing was put in place. If the debt facilities are truly non recourse, then the sponsor can of course simply refuse, on the basis that the banks must shoulder the risks for which they have been paid.
This does happen in practice, and when structuring financings lenders must assume that it could happen. If a sponsor does “walk away” though it would also be naïve for him to assume that there will be no effect on the relationship with his relationship banks, particularly when other debt facilities are required or existing loans come up for renewal.
experience and track record
Lenders will always analyse the experience and track record of prospective sponsors in delivering projects similar to the one being considered, on schedule and within budget. A good history in this area is a major plus-point for a lender who, as we shall see below, is at most risk during the project’s construction period.
This does not mean that financings cannot be structured for smaller, independent company sponsors with no such track record. Such loan facilities are frequently developed by lenders for start-up renewable power and oil & gas companies for example. It does however make lenders look much more carefully at the construction arrangements to be used in such cases and whether they are adequate to control construction-period risk adequately.
management skills and experience
Independent sponsor companies in the extractive industries (oil & gas/mining) often have owners and/or senior managements made up of highly talented individuals drawn from multinationals or much bigger companies. They may have financed the foundation and early development of their company from personal funds, have raised equity resources and perhaps have acquired a development asset from a major company. Debt finance may now be required to part-fund the development of this asset.
The relatively small scale of projects in the renewable energy field also offers scope for the establishment of independent developers, frequently by enthusiasts for the sector or by those who have developed or enhanced specific types of technology.
The commitment of such sponsors to their projects and their tenacity in carrying them forward is often extremely impressive. The individuals involved in such companies’ leadership teams can often demonstrate a high level of technical, engineering and commercial skill, backed up by many years of experience – albeit in much larger corporate groups.
Such commitment is very important to lenders. But there must be a commitment to a commercial approach too. Any hint that the project being considered is a “pet” asset with which the sponsors have “fallen in love” while working at a much bigger company is likely to be viewed with concern. Similarly, if it appears that the individuals behind the sponsor company see the project as a “pension fund” for them after many years employed by multinationals, lenders will not react very favourably.
hard nosed approach
The providers of debt funds will be looking for a very hard-nosed attitude towards value, and evidence that the sponsor understands how value will be created by the project, what will need to be done to protect that value, and how (and in what timeframe) the value will ultimately be realised.
A critical factor in achieving the above is access to financial understanding and expertise. Especially with smaller sponsors, lenders will want to spend significant time and effort assessing the experience and track record of the finance director and any other financial staff, whose abilities and performance will be acutely important, in particular if the project encounters serious difficulties. The finance director is likely to be the main discussion partner of the lenders and as such his/her understanding of project financing in particular will be of the utmost importance for the effective and timely closing of the financing, however well supported he or she may be by legal counsel and other advisers.
equity injection risk of sponsors
However much gearing a lender may be prepared to consider, the sponsor will be required to inject some of the funds required to construct the project as equity finance.
, this will usually be paid in as a small amount of equity share capital and a much larger amount of inter-company loans from the sponsor to the project vehicle company.
Bank lenders often talk of the equity injected by the sponsors as the sponsors’ “pain capital”. If a bank were prepared to accept 100% of the risk of a project, the sponsors would effectively have nothing at risk and the temptation in times of difficulty would be to simply “hand over the keys” to the lenders.
For this reason, the lenders will want to make that the sponsors have enough funds at risk to give them a strong motivation to step in if the project gets into difficulty
. In the highly liquid credit markets before Credit Crunch some PPP projects were financed with equity injections of less than 10%. This implies that the lenders in such cases saw very little risk of
disruption to a highly predictable CFADS stream.
timing of equity injection
Whatever the size of the equity amount in cash terms, lenders will need to be satisfied that the sponsors either have such funding available at their disposal or that they will be able to provide it as and when necessary during the construction period of the project.
Should it, for example, be injected into the project SPV and spent on project costs before any bank debt is used?
This approach (often referred to as “front-ended” equity) will be preferred by lenders who are dealing with a relatively weak sponsor, whose credit risk they do not wish to accept throughout the whole of the construction period.
In such circumstances lenders will tend to insist on equity being fully paid in and used before the lenders’ loans can be used
how this might work for a project having a three-year construction period and a 70:30 gearing level
All of the equity funding is used – in this case in year 1 of construction – following which the loan funds are drawn to meet the balance of the construction cost. Because there is no cashflow from the project until it begins commercial operations, the interest due on drawings under the loan is of course “capitalised”, i.e. it is added to the loan drawings until completion is achieved.
Sponsors do not like front-ended equity injection. Where project IRR is the prime consideration for a sponsor, front-ended equity will be unattractive and
the sponsor will prefer at the very least for equity to be injected on a pro-rata basis with debt (also known as “side-by-side” equity and debt)
so that equity outflows are slowed down and spread over the life of the construction period.
Because equity contributions are made over time in this case, from the beginning of the build period and in parallel with drawings of debt, loans will be outstanding for a longer period, but the impact on the sponsor’s IRR will of course tend to be positive given the impact of the time value of money. For this reason, even financially weak sponsors will frequently try to negotiate a pro rata treatment.
Where a bank is facing a weak sponsor balance-sheet and/or where the funds for equity injection have not yet been raised by a small sponsor, it is not likely that it will agree to pro-rata treatment. If the necessary equity funding has been raised and is available in cash, lenders do sometimes agree to pro-rata treatment, subject to the equity funds being held on a blocked account and drawn upon as required.
project lenders do agree to back-ended equity. Naturally however they will only do so where they are completely comfortable with the credit risk of the sponsor. The lenders do not after all want to provide their loans and then find that they have to lend further funds,
equity bridge financing
funded the equity injection by means of a second loan facility, a so-called “equity bridge financing” (see chart above). The funds lent under the equity bridge facility are then repaid at project completion by the sponsor, who will typically guarantee the equity bridge facility (together with all accrued interest) from their first drawing until completion of the project. This means of course that the lenders are providing 100% of the cost of construction of the project. They are not accepting 100% of the risk of construction, however, because of the guarantee provided by the sponsor.
If the sponsor is a major corporate, however, whose equity injection risk is undoubted, then this type of structure is fully achievable. The equity bridge loan will of course bear interest, so that the overall amount of interest capitalised will increase. It should be remembered though that the interest margin payable on the equity bridge facility will reflect the corporate risk of the provider of the guarantee. It is therefore usually substantially below the margin payable on the main project loan.
COUNTRY/POLITICAL RISK ANALYSIS & MITIGATION
we shall see that country / political risk is also something of a binary type of risk – an “on-off switch” rather than a “volume control” as regards its impact on lender appetites. We shall also see that country risk frequently also tends to drive the sources of finance which are used to fund projects. Projects in countries where political risk is low will tend to be financed from private sector sources – generally commercial banks, funds and bond investors. As political risk increases, public sector sources tend to play a larger and larger role.
what do banks understand by country risk
Where a sponsor presents a project for financing which is situated, for example, in one of the countries of the Organisation for Economic Cooperation & Development (OECD), country/political risk will generally not be a concern. Where the host country is more of an emerging market, potential lender banks will have to consider whether they are able to accept – in addition to the risks specific to the project itself
Project banks are generally much more willing to accept commercial risk than political risk
It is not surprising therefore that (not unlike sponsor risk) country/political risk can be an on/off switch for lenders which will prevent them from financing a project in a higher-risk environment – however good its sponsor, economic prospects or other characteristics. Banks may often express this by saying that they do not have sufficient “country limit” capacity.
country risk 1 - country limits
Banks are required to record their loans and other exposures to borrowers outside their own base country of operations. They must also to report such commitments to the central bank which has oversight responsibility for them (in the UK this would be the Bank of England). Central banks will wish to ensure that commercial banks under their supervision do not develop excessive exposures to potentially risky emerging market countries in particular which, if not honoured, might threaten the creditworthiness or even the survival of the commercial banks.
how lenders manage country limits
Lenders will typically manage such exposures by having some form of country risk committee which will meet periodically to decide on appropriate levels of “country limit” for the countries in which they do business. As the political/country risk of a given country increases a bank will seek to reduce its exposure – by not making new loans to entities within that country or by not renewing existing facilities as they run off. The country limits established for countries of the OECD will tend to be very large in comparison to those approved for higher-risk markets.
Country limits will generally be divided into a short-term sub-limit and a medium- or long-term sub-limit. The former will tend to be significantly larger than the latter and will be used in particular for self-liquidating exposures such as trade in goods, with credit periods of up to (say) 18 months. Project lenders will need access to medium/long-term limits if they are to be able to lend to a project within the relevant country without credit enhancement.
or OECD-based projects there will generally not be a country risk issue, because banks will be happy to accept country exposure without any form of credit enhancement. Similarly, if one bank or a syndicate of banks has (singly or as a group) sufficient unused country limit, financing may proceed without country-risk credit enhancement (often referred to as a “clean commercial” basis).
Expropriation, confiscation and nationalisation
if a host country government steps in to take control of the project SPV and/or to seize its assets, then in the absence of any special support or insurance arrangements the lenders will run the risk of losing all or a part of their loans
the level of compensation and its adequacy for repaying project debt is hard to predict.
Expropriation need not happen as a single step. “Creeping” expropriation can also occur, where incremental steps are taken by a host country (discriminatory law/tax changes, delays in the making of payments or granting of approvals, imposition of import duties on capital equipment etc.) with the unstated (but clear) intention of making life increasingly difficult for the foreign investor. Eventually the investor may accept the loss of his investment and effectively hand over the project to local interests.
ECN risk can often emerge in a transaction as a result of a change of regime, with a new government taking a hostile view of inward investments approved by its predecessor.
ECN risk is undoubtedly one of the reasons why project banks tend to regard projects which:
are export-orientated;
* earn hard currency revenues;
* make a major contribution to the host country’s balance of payments;
* involve offshore delivery of product (such as oil, gas and minerals) and offshore payment structures as being somewhat less prone to interference than domestically orientated projects.
Even a government with a radically different political flavour from its predecessor will often respect the “goose that lays the golden egg” and avoid interfering with a major source of export earnings.
War, civil war and domestic unrest
domestic or cross-border violence, sabotage and terrorism and what the insurance industry terms “SRCC” (strike, riot and civil commotion) can all potentially damage a project’s prospects of being constructed on time and to budget and of generating steady cashflow to service its debt. Increasing uncertainty regarding such risks of violence and unrest are therefore likely to make a bank cut back its country limit.
