Solution Manual for Project Finance in Theory and Practice Designing, Structuring, and Financing Pri

Solution Manual For All Chapters CHAPTER 1: An introduction to the theory and practice of project finance Learning objectives After studying this chapter the reader should be able to: – Identify the factors that characterize project finance deals – Identify the economic reasons that make project finance appealing – Understand the difference between corporate finance and project finance – Understand the nexus of contracts of a project finance deal and identify the main counterparties involved in a project finance transaction – Understand the contamination effect of projects on existing firms – Evaluate the trade off between contamination risk and co-insurance effects

Concept review questions 1. In project finance initiatives, the borrower is: a) the sponsor, as “originator” of the deal. b) a specially created company which is financially and legally dependent on the sponsor. c) a specially created company which is completely independent of the sponsor.

Answer: C

Source: Ch. 1 – Section 1.1 What is project finance?

In project finance initiatives, the debtor is a project company set up on an ad hoc basis that is financially and legally independent from the sponsors. This company is often called a Special Purpose Vehicle (SPV) or a project company.

2. In terms of the use of cash flow generated from project finance deals, the priority is: a) to fund operating costs and service the debt. b) to pay dividends to sponsors. c) to pay parties identified in specific clauses in the contractual framework of the venture.

Answer: A

Source: Ch. 1 – Section 1.1 What is project finance?

In project finance initiatives, cash flows generated by the project must be sufficient to cover payments for operating costs and service the debt in terms of capital repayment and interest. In other words, as the priority use of cash flow is to fund operating costs and service the debt, only residual funds after the latter are covered can be used to pay dividends to sponsors.

3. Complete the following sentence: With the ........... model, the Public Administration delegates planning and realization of the project to a private party, together with operating management of the facility for a given period of time. During this period, the

private party is entitled to retain all receipts generated by operations but is not the owner of the structure: a) BOT. b) BOOT. c) BOO. Answer: A

Source: Ch. 1 – Section 1.3.2 Public sponsors with social welfare goals

In a BOT framework (see Table 1-2), the Public Administration delegates planning and realization of the project to the private party, together with operating management of the facility for a given period of time. During this period the private party is entitled to retain all receipts generated by operations but is not the owner of the structure concerned. The facility will then be transferred to the Public Administration at the end of the concession agreement without any payment being due to the private party involved.

A BOOT framework differs from the above inasmuch as the private party owns the works. At the end of the concession term the works are transferred to the Public Administration and in this case a payment for them can be established.

Lastly, the BOO framework has characteristics in common with the other two. The private party owns the works (as in the BOOT case) but ownership is not transferred at the end of the concession agreement. Therefore the residual value of the project is exploited entirely by the private sector.

4. In project finance initiatives, sponsors normally offer: a) collateral to lenders of the SPV. b) collateral on their personal assets to lenders of the SPV. c) the assets of the SPV as collateral to lenders as security for the project’s receipts and assets.

Answer: C

Source: Ch. 1 – Section 1.1 What is project finance?

A typical characteristic of project finance deals is the need for collateral given by the sponsors to lenders as security for project receipts and assets. This collateral is represented by the project assets (i.e. only the assets owned by the SPV) 5. Corporate finance based lending is not the optimal solution for realizing new projects when such initiatives: a) involve sizeable flows in currencies other than the home currency. b) are less risky than up-and-running projects. c) are very large with respect to the current size of the company concerned.

Answer: C contamination risk

Source: Ch. 1 – Section 1.5.1 Separate incorporation and avoidance of

There are cases in which the corporate finance-based lending approach doesn’t work, or rather, it may give rise to more problems than advantages. Specifically, circumstances which denote overall uncertainty (contamination risk) are when the project in question is very large considering the company's current size, or when it has a higher degree of risk than the average risk level for the asset portfolio in the balance sheet, or when it could potentially be closely linked to the company’s own core business.

6. Contamination risk refers to the possibility that: a) a project won’t be realized because other similar projects are already underway. b) default of the project will jeopardize up-and-running projects. c) a project’s risks can’t be allocated to the different participants in the deal.

Answer: B contamination risk

Source: Ch. 1 – Section 1.5.1 Separate incorporation and avoidance of

When a new project takes on considerable dimensions with respect to the company’s total existing assets, possible default of this venture would jeopardize continuation of the company’s other businesses. This risk can be defined as contamination risk.

7. In project finance initiatives, the degree of leverage depends on: a) the sponsors’ leverage, and is normally higher than in corporate financing. b) project cash flows, and is normally lower than in corporate financing. c) project cash flows, and is normally higher than in corporate financing.

Answer: C

Source: Ch. 1 – Section 1.2 Why do sponsors use project finance?

In project finance initiatives, the degree of leverage is primarily a function of project cash flows, and is usually much higher than in traditional financing.

8. Co-insurance effect refers to: a) the possibility that mutual benefits emerge for the project and the company. b) the possibility to use the same model for dividing up risk among various project finance deals. c) the possibility that the same project risk (e.g. technology risk) can be allocated to several different players.

Answer: A Source: Ch. 1 – Section 1.5.2 Conflicts of interest between sponsors and lenders and wealth expropriation The co-insurance effect represents the positive side of contamination risk from a lender’s standpoint. It refers to the possibility that the failure of a project would be covered by the success of other up-and-running initiatives, so that there would be no negative impact on sponsors or the interests of the SPV’s lenders. The co-insurance effect can be what convinces the parties involved in a project to opt for on-balance sheet rather than off-balance sheet financing.

9. Industrial sponsors are interested in participating in project finance initiatives: a) to exploit the opportunity to build plants and facilities sold to the SPV. b) to exploit the opportunity to realize works while tying up little or no corporate finances. c) because the project is closely linked to sponsors’ own core business.

Answer: C Source: Ch. 1 – Section 1.3.1 Industrial sponsors in project finance initiatives linked to core business The project rationale for industrial sponsors lies in their view of the project financing as an initiative linked to their core business. Clearly their involvement in such projects reduces overall risk because

their underlying interest is not purely financial, but instead is linked to industrial factors. For example, this type of sponsor may also be interested in acting as customer or supplier of the SPV. 10. The contractor is: a) the company or group of companies that are responsible for plant construction. b) the company or group of companies that provide maintenance for the facilities for a given number of years, ensuring efficient operations in keeping with pre-agreed output parameters. c) the supplier or customer, depending on the type of project finance deal.

Answer: A Contract (TKCC)

Source: Ch. 1 – Section 1.4.1 The contractor and the Turnkey Construction

The contractor is the company (or consortium of companies) that wins the tender for the design and construction of a given plant on the basis of a fixed price turnkey contract. Contract obligations are taken on by the main contractor (who commits directly to the SPV) and are later passed on to consortium members.

Questions and exercises 1.

2.

3.

4.

What are the typical features of a project finance deal?

How is WACC calculated?

How are project finance transactions involving the Public Administration organized?

Complete the following table by putting an X in the column that corresponds to the following statements: Corporate finance

Project finance

The borrower’s assets serve as guarantee on the financing.

Leverage depends on cash flows generated by the project and is very high.

Once the deal is in place, the borrower’s financial elasticity is lower than before.

As far as accounting, the only effect will be (debt or equity) participation in an external company.

Future cash flows are the main variables used to quantify the financing.

5.

Referring to the different options given in the table below, calculate the payoffs for lenders and shareholders consequent to the decision to finance on-balance sheet or offbalance sheet for Project 2:

Hypothesis Debt Project 1 (assets in place)

1

2

200

200

Scenarios 3 200

4 200

Debt Project 2 (new project) 100 Expected cash flows project 1 (assets in 75 place) Expected cash flows project 2 (new project) 100

Solution On-balance Off-balance

6.

Scenario 1

Scenario 2

100

100

100

75

150

150

180

100

180

Scenario 3

Scenario 4

Are the following statements true or false?

Hypothesis Debt Project 1 (assets in place) Debt Project 2 (new project) Expected cash flows Project 1 (assets in place) Expected cash flows Project 2 (new project)

Scenarios 1 2

3

4

200 100

200 100

200 100

200 100

50

230

50

230

60

60

180

180

– In Scenario 1 both projects will probably default regardless of whether project financing is used.

– In Scenario 2 on-balance sheet financing and off-balance sheet financing will give the same results.

– In Scenario 3 the use of project finance makes it possible to have an investment payoff.

– In Scenario 4 the use of project finance allows creditors to better safeguard their new investment.

– In Scenario 3 the use of project finance prevents contamination risk in terms of the new project and the existing situation.

7.

8.

What are the characteristics of sponsors and their approach to project finance deals?

Draw up a typical contractual network for a project finance deal, indicating the parties involved.

Answer 1: The following features characterize a project finance deal: – The debtor is a project company set up ad hoc which is economically and legally independent of the sponsors.

– Lenders have only limited recourse over sponsors (or in some cases none at all) after the project is complete.

– Project risks are allocated as appropriate among all project participants.

– The cash flow generated by the initiative has to be sufficient to cover operating costs, service the debt and pay relative interest.

– Sponsors provide collateral to lenders of the SPV as security for the project’s receipts and assets.

Answer 2:

In analytical terms, WACC is a weighted average, as the term suggests. The weights are represented by the ratio of equity over total assets (for ke) and debt over total assets (for kd). Adopting weights calculated by using book values is not entirely accurate from a methodological standpoint; however, given that in project finance deals the value of assets depends on cash flows generated as opposed to the asset values themselves, this is an acceptable simplification.

Answer 3: The role of the Public Administration in the context of project finance initiatives is usually based on either equity contribution in the SPV (institutional PPPs) or on a concession agreement (Contractual PPPs) which entails two possible options. First, the private party may build the work for the use of the same Administration, which pays for the product or service provided. Second, the concession may involve the realization of a project which provides a product or service that is purchased directly by the general public.

Technically, there are several acronyms that stand for the different kinds of concessions. The most common ones are: - BOT (build, operate and transfer); - BOOT (build, own, operate and transfer); - BOO (build, operate, own).

In a BOT framework, the Public Administration delegates planning and realization of the project to the private party, together with operating management of the facility for a given period of time. A BOOT framework is almost exactly the same, except for the fact that the private party owns the works and at the end of the concession term transfers ownership to the Public Administration. With BOO framework, instead, the private party owns the works but ownership is not transferred at the end of the concession agreement. In this last case the residual value of the project is exploited entirely by the private sector.

Answer 4: Corporate finance

Project finance

The borrower’s assets serve as collateral on the financing.

X Leverage depends on cash flows generated by the project and is very high.

Once the deal is in place, the borrower’s financial elasticity X is lower than before.

As far as accounting, the only effect will be (debt or equity) participation in an external company.

Future cash flows are the main variables used to quantify the financing

X

X

X

Answer 5: Solution 1: on balance sheet financing Total cash flows 1+2 Total debt 1+2

175 300

255 300

250 300

330 300

Payoff creditors Payoff shareholders

175 default

255 default

250 default

300 30

Solution 2: off balance sheet financing Total cash flows 2 Total debt 2 Payoff creditors 2 Payoff for shareholders project 1 (dividends)

100 100 100 0

180 100 100 80

100 100 100 0

180 100 100 80

Dividends from project 2 (A) Total cash flows 1 (B) Total cash flow (A+B) Total debt 1 Payoff creditors Payoff shareholders sponsors

0 75 75 200 75 default

80 75 155 200 155 default

0 150 150 200 150 default

80 150 230 200 200 30

Solution On-balance Off-balance

Scenario 1 default Project 2: ok Project 1: default

Scenario 2 Default Project 2: ok Project 1: default

Scenario 3 Default Project 2: ok Project 1: default

Answer 6: Solution 1: on balance sheet financing Total cash flows 1+2 Total debt 1+2 Payoff creditors Payoff shareholders

110 300 110 default

290 300 290 default

230 300 230 default

410 300 300 110

Solution 2: off balance sheet financing Total cash flows 2 Total debt 2 Payoff creditors 2 Payoff for shareholders project 1 (dividends)

60 100 60 default

60 100 60 default

180 100 100 80

180 100 100 80

Dividends from project 2 (A) Total cash flows 1 (B) Total cash flow (A+B) Total debt 1 Payoff creditors Payoff shareholders sponsors

0 50 50 200 50 default

0 230 230 200 200 30

80 50 130 200 130 default

80 230 310 200 200 110

TRUE; FALSE; TRUE; FALSE; FALSE. Answer 7: Ideally, there are four types of sponsors:

Scenario 4 +30 cash-flow Project 2: ok Project 1: +30 cash flow

– – – –

Industrial sponsors who see the initiative as a project that is upstream or downstream integrated or in some way linked to their core business Plant contractors or operators who are interested in participating in the initiative by conferring equity or subordinated debt Public sponsors (the central or local Public Administration, or municipal enterprises) with social welfare objectives Financial investors (infrastructure funds, insurance companies, pension funds and Sovereign Wealth Funds)

The project rationale is different for each of the sponsors listed above.

For a more detailed analysis, see Section 1.3.4.

Answer 8: BANKS

HOST GOVERNMENT

PROJECT SPONSORS

SUPPLIERS

PROJECT COMPANY (SPV)

FINAL CUSTOMER/ BUYERS

FINANCING RELATIONSHIPS RAW MATERIALS

MAINTENANCE COMPANY

CONTRACTORS

MORE OPERATIONAL CONTRACT RELATIONSHIPS

INSURANCE

The figure above serves simply as a generalization, since each project finance deal has its own distinctive organization, depending on the parties who participate, as well as the type of activity involved. (For example, project financing in the health field or in transportation is very different from project financing in the power or in the transportation sector.)

CHAPTER 2 Learning objectives After studying this charter the reader should be able to: – Understand the evolution of the use of project finance among sectors and countries – Know the main figures of project finance and their categorizations – Pinpoint the value drivers of PPP development in Europe

Concept review questions 11. From a historical perspective, fist uses of project finance came into sectors: a) With a low level of technological risk in plant construction. b) With an high level of technological risk in plant construction. c) With an high level of market risk.

Answer: A market segments”

Source: cap. 2 – Section 2.1 “The historical evolution of project finance and

From a historical perspective, then, project finance came into use in well-defined sectors having two particular characteristics. One of these is the presence of a low level of technological risk in plant construction.

12. At the beginning, was the presence of a captive market important for project finance development in some sectors? a) No, it wasn’t. Initially, project finance developed in sectors without buyers. b) Yes, it was. Initially, project finance developed in sectors with a captive market created by solid buyers. c) No, it wasn’t. Initially, project finance developed in sectors with an high level of market risk.

Answer: B market segments”

Source: cap. 2 – Section 2.1 “The historical evolution of project finance and

From a historical perspective, then, project finance came into use in well-defined sectors having two particular characteristics. One of these is the presence of a captive market, created by means of long-term contracts at pre-set prices signed by big, financially solid buyers (offtakers).

13. The evolution of project finance during 1980s to 2000s is characterized by: a) The export of this financing technique to developing countries only. b) The growth in the use of project finance even in lesser traditional sector in developed countries only. c) Both.

Answer: C market segments”

Source: cap. 2 – Section 2.1 “The historical evolution of project finance and

In the period 1980s-2000s, the evolution of project finance followed two different development trends. The first involved exporting the financing technique to developing countries and the second concerned the use project finance for realizing projects with less (or less effective) market risk coverage or projects in which the Public Administration participates to promote works for the public good.

14. World data about project finance deals from 2006 to 2016 show that energy and power sector absorbed a relevant percentage of all project finance loans. What is the most likely reason? a) Energy and power is a captive market and technology risk is low. b) Energy and power is an highly risk sector and operators are attracted by the high expected rate of returns.

c) The data are wrong certainly, because of the high technology risk of energy and power sector.

Answer: A

Source: cap. 2 – Section 2.2 “The world project finance market”

Table 2.2 show that energy and power absorbs between 35% and 50% of all loans granted from 2011 to 2016, followed by transportation and oil and gas, with around 40% of the total. This situation is due to the fact that project finance came into use in well-defined sectors having two particular characteristics: 1. a captive market 2. a low level of technological risk in plant construction 15. Concerning the European market, project finance is most widely used in countries: a) where applications are less numerous and the institutional and legislative context are less advanced. b) where applications are more numerous and the institutional and legislative context are more advanced. c) where applications are more numerous and the institutional and legislative context are less advanced.

Answer: B

Source: cap. 2 – Section 2.3.1 “The European Market”

In Europe, project finance is most widely used in countries in which sectors of application for this technique are more numerous, and above all where the institutional and legislative context are more advanced. These nations already have regulatory frameworks in place and project task forces in action. Moreover, the Public Administration here plays an active role in promoting the use of PPP’s.

16. What are sectors in which PPP’s are more exploited in developing countries (low-tomiddle income countries)? a) Transportation and infrastructure. b) Energy and power. c) Water and education.

Answer: B

Source: cap. 2 – Section 2.3 “The evolution of the PPP market”

There is a various level of distribution of the PPP technique among sectors. In the final part of the period 1990-2016, power, telecom and transportation retain the largest portion of the total PPP market.

Questions and exercices 9.

10.

11.

Answer 1:

What is the path followed by project finance in type of markets and underlying risks?

Is there a relationship between development of PPP’s in the European Union on the one side and kind of sector, institutional level, and legislation on the other side?

Can you resume the historical evolution of project finance and market segments?

h

High

•Industrial Plants •Mining •Oil & Gas •Power Generation

I

IV

II

III

In developed countries

•Toll roads • Telecom •Rail and infrastructure •Hotel/leisure •Water & Sewerage • PFI/PPP In developed countries

Low

High

•Industrial Plants •Mining •Oil & Gas •Power Generation

w

Low

In developing countries

Exposure to market and/or technological risk

Cell II refers to the best examples project finance initiatives; in fact, this is where the technique originated. The two arrows pointing toward Cell I and Cell III indicate market trends underway.

Note that Cell IV shows a risk combination which is not suited to project financing. In fact, high uncertainty, an extremely rigid contract structure and high financial leverage make it difficult for management to respond quickly or adapt to change. In these cases a corporate finance loan is a more appropriate solution.

Be aware that recent technological developments referred to Cells I and II are putting at risk the safest harbours that investors considered as a preferred habitat for asset allocation in the past few years (renewable power generation, smart grids, electric vehicles, energy and gas storage).

Answer 2: At the European level, project finance is most widely used in countries in which sectors of application for this technique are more numerous, and above all where the institutional and legislative context are more advanced. These nations already have regulatory frameworks in place and project task forces in action. Moreover, the Public Administration here plays an active role in promoting the use of PPP’s.

Data reported in Table 2.4 explain this situation in detail.

Answer 3: An accurate answer should underline: – The initial use of project finance during the Roman empire – The first development in America in the XIXth century – The development in the XXth century

* 1930s: field exploration * 1970s: oil sector and energy sector * 1980s and 1990s: two development trends: o the export of the financing technique to developing countries o the use project finance for realizing projects with less (or less effective) market risk coverage or projects in which the Public Administration participates to promote works for the public good

CHAPTER 3 Learning objectives After studying this chapter the reader should be able to: – Recognize and map typical risks in a project finance deal and understand how they are allocated among various parties – Clarify the consequences of single risks and coverage policies that can be adopted for project risk management – Learn the different types of contracts set up by the SPV to manage risks

Concept review questions 17. Risks that arise in the pre-completion phase do not include: a) Technological risk b) Operating risk c) Activity planning risk Answer: B

Source: Ch. 3 – Section 3.1.1. Pre-completion phase risks

Risks that arise during the pre-completion phase are: activity planning risk, technological risk, and construction or completion risk. Among the options listed above, operating risk is not included as it is found during the following phase.

18. Political risk and country risk: a) are unique because there is no coverage for these risks. b) can emerge in various forms. c) is the result of delays or cancellations of permits needed for project startup.

Answer: B

Source: Ch. 3 – Section 3.1.3.7 Political Risk and Country risk

Political risk emerges in various forms; normally the classification of this risk includes investment risks, change in law risks, quasi-political risks.

Coverage for these risks can be implemented in two ways: setting up an agreement with the government of the host country, or using total or partial risk coverage policies offered by multilateral development banks, export credit agencies, or private insurance companies.

19. Environmental risk has to do with potential negative impact that the building project could have on the surrounding environment. Therefore: a) this risk category does not depend on the type of project in question. b) this risk category could also be linked to political risks. c) this risk category isn’t affected by change in law.

Answer: B

Source: Ch. 3 – Section 3.1.3.5 Environmental Risk

This risk has to do with potential negative impact that the building project could have on the surrounding environment. Such risk can be caused by a variety of factors, some of which are also linked to political risk. An example would be public opposition to a project that has major environmental impact.

20. With a turnkey construction contract, the contractor guarantees the SPV: a) the completion date and performance of the plant, but not the cost of the works. b) the performance and the cost of the plant, but not the completion date. c) the completion date, plant performance and the cost of the works.

Answer: C Source: Ch. 3 – Section 3.2.1 Allocation of construction risk: the turnkey (or Engineering, Procurement and Construction – EPC) agreement The turnkey agreement is a construction contract by which the SPV transfers construction risk of the structure to the contractor. In exchange for a set fee, the contractor guarantees the SPV the completion date, the cost of the works, and plant performance

21. Put or pay contracts a) are used to limit or eliminate technological risk. b) have the same criticalities as take or pay contracts. c) are normally drawn up with the SPV’s customers.

Answer: B agreements

Source: Ch. 3 – Section 3.2.2. Allocation of supply risk: Put or Pay

The coverage method for limiting or eliminating supply risk consists in drafting contracts for unconditional supply (put or pay agreements or through put agreements). A put or pay has the same criticalities as a take or pay. In the power sector, for instance, one of the key objectives of a longterm fuel supply agreement is to ensure that price revision mechanisms for input are balanced with those for the sales price of power.

22. Is it possible to shift market risk from the SPV to third parties from the outset? a) Yes, with the stipulation of long-term sale contracts. b) Not always, only when a very small number of purchasers can stipulate long-term purchase contracts with the SPV. c) Yes, always for projects where a concession agreement with the government has been signed.

Answer: B

Source: Ch. 3 – Section 3.2.4 Allocation of market risks

Market risk coverage is not always possible. It is simpler if there is a single buyer of the good or service (the offtaker) but it becomes impossible when dealing with a retail market. For example, it is much easier to draw up long-term sales contracts with an industrial buyer or a utility, as occurs in the power sector. However, the situation becomes more complicated in the transportation sector (roads, tunnels, parking lots, etc.) or when dealing with building hotels or leisure facilities. In these fields, the variability of tourist or traffic flows can never be completely eliminated.

23. What is a tolling agreement?

a) It is a classic take or pay agreement used in the power sector. b) It is a contract with which the toller provides raw material for free in exchange of a service provided by the SPV. c) It is an agreement between the SPV and the supplier of raw material in which the latter is paid an indexed price throughout the life of the project.

Source: Ch. 3 – Section 3.2.4.2 Offtake agreements in PPP initiatives

Answer: B

In a tolling agreement, on one hand a wholesale customer, called the toller, supplies fuel as a “free issue good” to the project company’s plant, and gives this company orders for converting the quantity of fuel delivered into energy. In exchange for services rendered, the SPV, instead, has the right to receive a tolling fee.

Questions and exercises 1.

Complete the table below ticking off the relevant phase for each risk.

Type of risk

Pre-completion phase

Post-completion phase

Risks common to both phases

Coverage method

Activity planning risk Market risk Exchange rate risk Operating risk Interest rate risk Technological risk Inflation risk Construction and/or completion risk Supply risk 2.

3.

4.

5.

6.

What are the key contracts in project finance deals?

Describe the objectives of a risk-matrix and explain how it’s built.

Discuss the meaning of “shadow toll” and how it can be consider a tool for sharing market risk between the Public Administration and the private counterparty.

List the main characteristics of the financial instruments available for managing interest rate risk and exchange rate risk.

Suppose that project sponsors build a facility under a PPP scheme. The public administration pays every cost overrun incurred by the private sponsors during construction and the sponsors fully bear market and operational risk (i.e. the public sector does not pay any availability fee and apply a full set of penalties in case of performance below pre-agreed standards). If the PPP is carried out in a European Union country, how will this contract be recorded by the government? On balance sheet or off balance sheet?

Answer 1: Type of risk

Pre-operations phase

Operations phase

Risks common to both phases

Coverage method

Activity planning risk

Turnkey construction contract Take or pay agreement

X

Market risk

X

Exchange rate risk

X (if only the EPC is denominated in currencies other than the domestic currency of the SPV)

X (when the EPC X (if only contracts contract AND other

of the postcompletion phase are denominated in currency other than the domestic currency of the SPV)

postcompletion contracts are denominated in currencies other than the domestic currency of the SPV)

Operating risk

X Interest rate risk

X Technological risk

X Inflation risk

X Construction and/or completion risk Supply risk

X X

Forward contracts, swaps, options, etc.

Operation and maintenance agreement Forward contracts, swaps, options, etc.

Turnkey construction contract Swaps or specific contractual clauses Turnkey construction contract Put or pay agreement

Answer 2: The key contracts in project finance deals are: – Turnkey construction contract – Offtake agreement – Put or pay agreement – Operations and Maintenance agreement The purpose of these kinds of contracts is to limit or eliminate risks in the pre- and post-completion phases. Moreover, normally the point of reference for these agreements is risk that can’t be managed through the use of financial instruments.

Answer 3: The risk matrix is one possible way to document the participants in a given project finance deal along with the various types of risks inherent to such an initiative.

Normally, compiling and interpreting this matrix is very simple. It allows us to see how each party contributes to eliminating the risks taken on by the SPV. What’s more, we can assess whether every single risk has been properly identified and adequately covered.

Risks in both phases Risk 1

Risk n

Pre-completion phase risks Risk 1

Risk n

Post-completion phase risks Risk 1

Risk 2

Risk n

Special Purpose Vehicle Contractor Technology supplier Operator Buyer Supplier Banks Insurers …

Answer 4: The shadow tolls system is used in the context of building toll roads and upgrading pre-existing roads. With this contract, the Public Administration pays an annual toll to the private concession holder based on the volume of traffic on the road and the service levels. The word “shadow” refers to the fact that the end user does not actually pay a toll to the operator; in fact, there are no tollgates for collecting money. The final cost of road construction is factored into the national budget, and so is paid for by citizens through taxes.

During the term of the concession, the concession awarder pays the holder on the basis of the number of vehicles which travel on the road. Payments are based on a banding system linked to the use of the roadway. Band 1 is used to cover fixed O&M costs and senior debt service. Band 2 serves to cover variable management and O&M costs, and to service the subordinate debt. Lastly, Band 3 is normally earmarked for paying out dividends. For traffic volumes above a given level (Band 4), as decided by the Public Administration and the concession holder, no shadow tolls are paid. As a result, there is a cap on costs for the Public Administration and revenue for sponsors.

Answer 5: The instruments available for managing interest rate and exchange rate risk are described in Section 3.1.3.3.

We can say that covering financial risk in a project finance venture does not differ greatly from policies on managing the corporate treasury or exposures toward banks and financial intermediaries.

In fact, the principles and instruments are identical. The most common instruments are: – forward contracts – options – futures – swaps – FRA (to cover against interest rate risk) Answer 6: It must be recorded on balance sheet because the public sector fully bears construction risk given its commitment to fully refund the private sponsors for any cost overrun incurred during the precompletion phase. See Section 3.2.4.3.

In 2004, Eurostat has set some minimum requirements that enable the Governments of the European Union Countries to record PPPs outside the public accounts only when a material portion of the project risks are borne by the private sector. More precisely, Eurostat has decided that a PPP’s assets can be classified off-balance sheet for Government if the private partners bears the construction risks and at least one of either availability (operational) or demand (market) risk. In these cases, the treatment of the PPP is similar to an operating lease in ESA95; it would be classified as the purchase of services by Government.

CHAPTER 4 Learning objectives After studying this chapter the reader should be able to: – Identify advisors’ roles in project finance deals – Understand when and how each advisor participates in the various development phases of a project finance deal – Know which are the most important documents prepared by every advisor – Understand the key points in the documentation drawn up by advisors during the various development phases of a project finance deal – Identify the critical factors and possible solutions in managing relationships between sponsors and advisors.

Concept review questions 24. From a legal standpoint, building a project finance deal requires: a) specialized expertise in a wide variety of fields. b) a huge quantity of work which is spread out over a very long time horizon. (In fact, activating a project finance initiative is extremely time-consuming.) c) knowledge of relevant legislation rather than prior experience in the field.

Answer: A Source: Ch. 4 – Section 4.1.1. Legal advisor, legal advisors and law firms.

International and local legal counsel Implementing a project finance deal requires: 1. specialized expertise in many different fields (ranging from corporate to financial, real estate to administrative law).

2. adequate knowledge of practical precedents and market practices 3. a huge quantity of work concentrated in a given amount of time

25. Usually, at a chronological level, legal advisors first participate in a project: a) when the project financing is being defined. b) when the group of sponsors is being formed. c) when the project is being set up as an industrial development initiative.

Answer: B. Source: Ch. 4 – Section 4.1.2 Project Financing development stages and impacts on the role of legal advisors Legal advisors follow the development of the project finance deal in question. For this reason, they’re called on right from the initial development phase, especially where several parties are involved.

26. During the construction phase of the project, the independent technical advisor is usually called on to: a) give an opinion on the technical feasibility of the project. b) express a non-binding opinion on whether the right technical choices have been made. c) issue certification on the progress of works.

Answer: C Source: Ch. 4 – Section 4.2.2 Monitoring realization of the project (engineering and construction) The start of the project works requires careful progress monitoring. Consequently, periodic reports should be produced for lenders certifying that the venture is going ahead as planned. So, independent engineers both monitor and certify the works.

In brief, these are the activities they perform: 1. monitor construction of the works 2. issue certified progress reports 3. validate mechanical completion (certify completion of works)

27. During the operations phase of project finance, the independent engineer: a) is not normally involved because operations are handled directly by the O&M agent. b) prepares a period monitoring report that summarizes the valuations of technical variables. c) certifies that works meet contractual conditions Answer: B

Source: Ch. 4 – Section 4.2.4 Monitoring operations management

During the operations phase, after each inspection the independent engineer prepares a periodic monitoring report that summarizes the valuations of technical variables.

28. What are “pure risks”? a) risks linked to contract agreements underlying the project (for example, concession agreements for a project finance initiative involving the construction of a highway). b) risks pertaining to business strategy both in terms of establishing what connections exist with other projects as well as development choices. c) risks linked to accidental causes, which normally generate only losses.

Answer: C finance deals

Source: Ch. 4 – Section 4.3.1 The rationale for using insurance in project

The characteristic feature of pure risks is their unpredictability, inasmuch as they are linked to accidental causes and only generate losses.

29. When should insurance products be used in a project finance deal? a) Due to the contractual structure of project finance, there’s no need for insurance because risks are allocated among various parties by means of legally binding contracts.

b) Insurance should be used when the SPV’s cost of risk mitigation using insurance policies is less than the premium for risk expressed in interbank interest rates requested by banks if no coverage exists. c) Insurance should be used when the SPV’s cost of risk mitigation using insurance policies is more than the premium for risk expressed in interbank interest rates requested by banks if no coverage exists.

Answer: B

Source: Ch. 4 – Section 4.3.2 When should insurance products be used?

Insurance should be used when the SPV’s cost of risk mitigation using insurance policies is less than the premium for risk expressed in interbank interest rates requested by banks if no coverage exists. This assessment is made by the sponsors’ financial advisor.

30. “Investment Risk” policies: a) cover the SPV against risks of currency inconvertibility, expropriation without compensation, war and other political upheavals. b) cover the SPV against risks relating to loss of assets or failure of the concession authority to repurchase the structure. c) consist of insurance relating to risks that can arise during transportation of pieces of parts of the project.

Answer: A Source: Ch. 4 – 4.3.4 Types of conventional and financial insurance products available for project finance deals The definition of an investment risk policy is an insurance contract that covers the SPV from the consequences deriving from the occurrence of risks of currency inconvertibility, expropriation without compensation, war and other political upheavals.

31. Which of the following statements regarding insurance bonding is FALSE? a) Insurance bonding doesn’t impact bank credit facilities. b) Insurance doesn’t adversely affect the borrower’s level of indebtedness. c) Insurance is usually more expensive than bank bonding.

Answer: C

Source: Ch. 4 – Section 4.3.4.1 Bonding

An insurance bonding offers various advantages compared to bank bonding. This is why the former is better suited to complex contractual structures such as those found in project finance.

Specifically, insurance bonding: - doesn't have a negative effect of the borrower's level of indebtedness - doesn't impact bank credit facilities - is generally less costly than bank bonding - can be negotiated with insurers to develop a tailor-made guarantee that is more in line with the demands of the participants in the project finance venture

32. Which of the following is NOT a factor that derives from an integrated package for developers and lenders? a) Disputes are minimized. b) Ad hoc solutions can be created which would not otherwise be available. c) Higher costs are incurred due to the need to come up with tailor-made solutions.

Answer: C content

Source: Ch. 4 – Section 4.3.5 Integrated insurance solutions – structure and

Stipulating an integrated policy can offer certain benefits for those participating in the deal; some are summarized below.

- The integrated package has features not currently available in alternative schemes.

- Many difficulties concerning construction litigation (about 80%) can be avoided.

- The cost is lower than the sum of costs that would be incurred by adopting a conventional system, which also inevitably results in less pervasive coverage. All aspects of minimum premium and duplication of coverage are eliminated at the component level.

Questions and exercices 1. When the group of sponsors is being formed, which experts are involved and what do they do?

2. List and define the characteristics of the project documents needed for the industrial development of a project.

3. What are the key features of the relationship between lawyers and banks during syndication of the financing?

4. Complete the table listing the activities performed by the independent engineer in the various project development phases.

Phase Initial due diligence Monitoring realization of the structure Issue of certified progress reports Monitoring the testing phase Operations management monitoring

Activity of the independent engineer -

5. Which factors are taken into account in the final due diligence report issued by the independent engineer?

6. Who are insurance underwriters? What are the different kinds of insurance underwriters?

7. What insurance products are most commonly used for project finance deals?

8. Complete the following table by marking an “X” next to each type of policy/risk in the column corresponding to the phase when it should be used.

Realization phase Employers’ Third-Party Liability Trasport policy Indirect damages Force majeure Third-Party Liability of the Board of Directors and

Operating phase

Executives Direct material damages

Answer 1: The answer can be summarized in the following table: Requested activity Forming the group of sponsors

Lawyers involved

Organization of the project company

Sponsors’ lawyers

Articles of incorporation of the project company

Sponsors’ lawyers

Agreements among sponsors (joint venture agreement and so on)

Sponsors’ lawyers

Verification of project bankability on a without or limited recourse basis

Sponsors’ lawyers Project company’s lawyers

Answer 2: This issue is addressed in Section 4.1.2.2. “Industrial development of the project – The project documents”.

The list of project documents is as follows: - Concessions from the Public Administration - Permits to realize project works - Contracts for use of third-party assets or rights - Rights relevant to the area where the project works will be developed - Contract for realization of the project works and relevant subcontracts - Operation and Maintenance (O&M) management contracts and technical consultancy contracts - Bonds and guarantees for project contracts - Insurance - Procurement contracts for raw materials required for project operations - Sales contracts Answer 3: This issue is addressed in Section 4.1.2.6 “Syndicating the financing”. A complete answer would include the following considerations: - This phase comes about once structuring the project financing is complete.

- The parties involved are mainly the arrangers and co-arrangers.

- The banks invited to join the syndicate are given the following information: the industrial and technical nature of the project, the financial model, and the regulatory and contractual framework of the project.

Answer 4:

Activities are shown in the table below.

Phase Initial due diligence

Activity of the independent engineer  Perform a critical analysis of the project's technical aspects  Analyze the project's business aspects  Analyze the project's insurance aspects

Monitoring realization of the structure Issue of certified progress reports

   

Monitoring the testing phase

 

Operations management monitoring

 • • • •

Check that progress of works corresponds to initial plans Check procurement activities Check that a given tranche of the works has been executed Check that costs are in line with the EPC contract and with changes during the course of works Periodically inspect the plant Review and check periodic maintenance reports issue by the manager Verify the suitability and application of safety measures Make periodic checks of the plant Check management of the materials and spare parts warehouse Make periodic checks of validity of safety devices and equipment Review historical maintenance reports issued by the manager

Answer 5: Section 4.2.1 gives a number of key points: – During the due diligence exercise, already-available contractual documentation is scrutinized in order to identify critical points as regards relations between the parties involved in the deal, which mainly regard potential technical and technological problems.

– Once the study is complete, a due diligence report is prepared in which the independent engineer gives an opinion on the following issues: (1) whether documentation is complete and the technologies are adequate and reliable; (2) the project's vulnerability if harmful events were to occur (this serves to quantify the Maximum Probable Loss as regards the works in the event of accidental damage); (3) plant safety; (4) financial assumptions concerning construction and management costs for the structures.

Answer 6: Different kinds of insurance underwriters are described in Section 4.3.6 “A classification of insurance underwriters”. We can sum up as follows:  Multilateral insurance underwriters, financial insurance companies controlled by multilateral development banks. The distinctive feature of multilateral agencies is that they can provide coverage not available on the market, especially as regards countries with very low income levels. However, it usually takes a very long time to obtain approval for an application and fees are very high.  Commercial insurance underwriters, insurance companies that offer a complete range of insurance services; they’re highly specialized and can cover particular aspects of an initiative.  Group captive insurance underwriters, which are insurers that operate only with companies that make subscription club payments to obtain their insurance services.  Monoline insurance underwriters, specialized companies that offer credit enhancement guarantees to support securitization and project finance deals.

Answer 7: The types of coverage available for all project finance initiatives alike pertain to: – investment risks – collateral deprivation risks – non-payment risks – contract frustration risks – transportation risks – credit enhancement – political risks – transfer risks Answer 8: Referring to Section 4.3.4., “Types of conventional and financial insurance products available for project finance deals”, the complete table is shown below.

Employers’ Third-Party Liability Transport policy Indirect damages Force majeure Third-Party Liability of the Board of Directors and Executives Direct material damages

Realization phase X X

Operating phase X X

X X

X X

CHAPTER 5 Learning objectives After studying this chapter the reader should: – know the meaning of net operating cash flow (unlevered free cash flow) and its determinants – know how the operating cash flow changes during the various phases of the project life – understand the meaning of optimal capital structure for the deal – understand how sponsors and lenders evaluate whether or not participating in a project finance deal would be economically convenient – know what cover ratios are and how to calculate them – understand the meaning and different alternatives for implementing sensitivity analysis, scenario analysis and simulations

Concept review questions 33. When calculating net operating cash flow (unlevered free cash flow), the following are NOT taken into account: a) changes in net working capital b) taxes c) debt service and dividend payments

Answer: C Source: Ch. 5 – Section 5.1 Analysis of Operating Cash Flows and their behavior in different project lifecycle phases Figure 5-1 indicates that to calculate operating cash flow, we don’t consider the financial side of the deal (i.e. inflows and outflows from financial items – debt service and dividend payments). In fact, computing the unlevered free cash flow of project finance deals is done in order to design the initiative’s optimal capital structure.

34. The pay-back period: a) is the best criterion for valuing investment projects. b) can be used as a complementary indicator to IRR. c) is meaningless when analyzing project finance deals.

Answer: B

Source: Ch. 5 – Section 5.2.1 Equity

Although payback is not an accurate criterion for evaluating the economic convenience of investments projects, it is useful as a complementary indicator to the IRR when choosing among various investment options. The rate of return being equal, in fact, a project which can achieve payback more quickly is more attractive to a risk-averse investor as compared to a similar project that would reimburse investors at a later date. However, in project finance deals when the alternatives to the project under examination are limited, payback can only be considered as a companion criterion to IRR.

35. “Owners’ costs” refer to: a) costs which depend on the financial structure, specifically on the amount of equity contributed by sponsors. b) costs which depend on the financial structure, specifically on the amount of loans granted by the banks. c) costs associated with plant construction that don’t depend on how the project is financed.

Answer: C

Source: Ch. 5 – Section 5.1.1.2 Initial investment cost

Usually all the outlay which derives from investments linked to building the plant are categorized under the heading “Owners’ Costs”, for example the cost of excavating the land before beginning construction, or building access roads to the facility. Such costs arise regardless of the type of financing adopted.

36. The funds set aside in the DSRA (debt service reserve account): a) Are a way creditors use to safeguard even more their rights toward the SPV. b) are already included in the calculation of operating cash flow. c) don’t impact the value of resources potentially available to sponsors.

Answer: A Source: Ch. 5 – Section 5.2 Defining the optimal capital structure and Box 52 An example of the dynamics of the Debt service reserve account

As a precautionary measure, flows relating to the debt service and deposits in a reserve account are subtracted from the cash flow available to project sponsors (please refer to Figure 5-6). Normally this account is established and maintained for the entire duration of the financing. The amount of funds to set aside in this account can be determined in various ways. However, quite a common practice is to decide on an account balance by applying a simple formula which takes into account monthly debt service and the number of months of debt service which has to be covered by the debt service reserve account.

37. With the maturity being equal, from the point of view of a bank lender the facility with a longer average life shows: a) a higher level of risk. b) a lower level of risk. c) the same level of risk.

Answer: A

Source Ch. 5 – Section 5.2.2 Senior debt

The Average Loan Life is calculated as shown below: n

ALL   RP  t t 1

The symbols stand for the following: ALL = average loan life RP = the repayment percentage referring to time period t t = the time period in question (number of the year or the 6-month period being considered) With the maturity being equal, the facility with a longer average life shows a higher level of risk, since repayment of the principal is more concentrated toward the end of the loan life.

38. What condition must be respected for a project finance initiative to be financed with a given financing structure? a) Operating cash flow > debt service b) Operating cash flow < debt service c) Operating cash flow ≥ debt service Answer: A Source: Ch. 5 – Section 5.2.5 Identifying sustainable debt/equity mixes for sponsors and lenders The aim of the advisor and/or arranger is to pinpoint a number of debt/equity mixes that satisfy the following criteria: operating cash flow > debt service. The disequation must be satisfied in all the years when the loans are still in existence. Please note that answer c) is wrong. Although the operating cash flow equals the value of debt service, the situation is excessively risky for both lenders (credit risk) and sponsors (bankruptcy risk). See also Section 5.3.1 (What Cover Ratios can Tell Us and What They Can’t) 39. The SPV’s cost of equity is: a) the weighted average of sponsors’ WACC. b) the sponsors’ weighted average cost of equity. c) independent of the cost of the sponsors’ sources of financing.

Answer: A project sponsors

Source: Source: Ch. 5 – Section 5.2.5.1 The optimal capital structure for

The WACC of the SPV is the average of the cost funding on the debt and the cost of equity. The later is the weighted average of the WACC of each sponsor who participates in the deal. See Figure 5-10.

40. Cover ratios are: a) indicators of financial sustainability for a project finance deal. b) Profitability indicators for a project finance deal. c) profitability indicators for debt capital providers, but not for sponsors.

Answer: A can’t

Source: Ch. 5 – Section 5.3.1 What cover ratios can tell us and what they

Cover ratios are indicators of financial sustainability. These parameters enable us to recognize the sustainability of the capital structure (and repayments on financing we’ve chosen) to realize a project finance deal. Put another way, cover ratios are indices which can show the extent to which a project’s operating flows match those linked to the dynamic of financial items.

41. If the loan life cover ratio is greater than 1: a) it means there would be a cash surplus for sponsors if the investment were liquidated immediately. b) it means there would be a cash deficit for sponsors if the investment were liquidated immediately. c) it means that for every year of project development, the SPV can generate sufficient resources to cover financial outflows.

Answer: A can’t

Source: Ch. 5 – Section 5.3.1 What cover ratios can tell us and what they

In light of the definition of loan life cover ratio, an LLCR which is greater than 1 can be interpreted as a surplus of cash freely available to project sponsors if they were to opt to liquidate the initiative immediately. They could reimburse the entire outstanding debt with the present value of the operating cash flows generated during the remaining loan repayment period.

42. The underlying rationale of sensitivity analysis lies in: a) the creation of a large number of scenarios to show the level of depth attained by the advisor in designing the initiative. b) the evaluation of the effects which derive from variations of all variables that can impact project cash flows. c) the evaluation of the effects which derive from variations in key variables that impact the project.

Answer: C

Sensitivity analyses conducted by the advisor are limited to a few alternative scenarios derived by manipulating only a small number of key variables. The logic behind sensitivity analysis is to verify the project’s degree of resistance to adverse changes in the factors which determine cash flows.

Questions and exercices 7.

8.

9.

10.

11.

What variables have to be estimated to quantify future cash flows?

What are operating cash flows used for during each of the years of the operations phase of the project?

What are the fundamentals that a sponsor would use to value the profitability of a project finance deal? Would the same factors be used by banks?

Describe the key cover ratios and what they mean for a lender who participates in a project finance deal.

From the data in the table below, calculate DSCR, ADSCR, and LLCR for the project, if possible.

Year

Operating cash flow

Debt service

0 1 2 3 Rate

184,000,000 188,000,000 190,000,000

160,000,000 160,000,000 160,000,000 10%

Answer 1: In order to estimate future expected cash flows we must first compile a very detailed set of input variables: – The time horizon for the project – Initial investment costs – The VAT dynamic, when applicable – Public grants, where applicable – Analysis of sales revenues and purchasing costs – Analysis of operating costs during the operating life of the project – Trends in working capital – Taxes – Macroeconomic variables Answer 2: The destination of cash flows during the life of the project satisfies the demands of those who provide capital. Framing the problem in an illustration of the typical waterfall structure, the situation looks like this (See Figure 5-6):

Operating Cash Flow-net (Unlevered Free Cash Flow)

(-) Interest on Senior loan (-) Interest on Subordinated loans (-) Senior loan repayment (-) Subordinated loan repayment

(=) Cash Flow available to Project sponsors

(-) Debt reserve provisions

(-) O&M reserve provisions

(=) Dividends to sponsors

Leaving aside the problem of the reserve account (which is usually dealt with by means of specific contractual clauses that regulate setting up, maintaining, and using this account), in order to answer the question, students need to clarify certain assumptions relating to: – Equity: how much is contributed and when – Senior debt: how much is requested from lenders and how it will be repaid – VAT facility (when applicable): how much is requested and how it will be repaid – Stand-by facility: how much is requested and how it will be repaid Answer 3: Section 5.2.5.1 explains that the factors considered by a sponsor are: – the need to compare expected return on the deal with the cost of capital – the benefit of the limited recourse clause The second part of the answer is explained in Section 5.2.5.2 “The optimal capital structure for lenders” which shows the calculation for return on the deal for arranger banks and participants.

Briefly, remember that the quantification process depends on: – the participation profile (arranger, co-arranger, manager, partecipant, etc.)

– the fee structure applied – the financial structure – the WACC of each bank, and the impact of the bank cost of equity This calculation can also be done by quantifying RAROC (risk adjusted return on capital) Answer 4: The answer can be found in Section 5.3. A complete answer should include the following considerations: – Cover ratios aren’t indicators of profitability. Instead, they measure the financial sustainability of a selected capital structure.

– The match between the cash available (net operating cash flows) cash needed (debt service) is exactly what cover ratios measure.

– There are two key cover ratios: DSCR (and ADSCR) and LLCR. – There are clear connections between DSCR and LLCR.

Answer 5: The answers are as follows: Year

Operating cash flow

Debt service

DSCR

0 1 2 3 Rate

184,000,000 188,000,000 190,000,000

160,000,000 160,000,000 160,000,000 10%

1.15 1.175 1.1875

NPV OCF @ 10%

NPV DS @ 10%

167,272,727 155,371,901 142,749,812

145,454,545 132,231,405 120,210,368

LLCR 1.170

Keep in mind that: OCFt – DSCR  Kt  It n OCF1 OCF2 OCFn OCFt   ...   K  I K2  I2 Kn  In K I  t 1 t t – AVDSCR  1 1 n n

sn

OCFt

 (1  i)  DR

– LLCR  t  s

t

Ot

The average debt service in our example is (1.15+1.175+1.1875)/3 = 1.171

CHAPTER 6 Learning objectives After studying this chapter the reader should be able to: – Identify the activities involved in advisory and arranging, and the characteristics of the parties who offer these services – Understand the process of syndication and identify the participants in the loan syndicate – Understand what fees are paid in a project finance deal and how they’re calculated – Recognize the characteristics and methods of intervention commonly found among international financial institutional, multilateral development banks, development agencies, export credit agencies.

– Understand and assess the different funding options available for a project finance deal: equity, mezzanine financing, senior debt, project leasing, project bonds

Concept review questions 43. Advisory services for project finance initiatives: a) are inextricably related to the aspects of the financing b) require huge amounts of capital c) can be provided by parties other than financial intermediaries Answer: C finance funding

Source: Ch. 6 – Section 6.1. Advisory and Arranging Activities for project

The focus of advisory services is to define the risk profile, time schedule, and size of a deal. As such services don't require huge amounts of capital, they can be provided by parties other than financial intermediaries.

44. Assessing the risks inherent to a given project, and assistance in drawing up the business plan and various contracts are typical responsibilities of: a) the advisor. b) the sponsor. c) the arranger.

Answer: A

Source: Ch. 6– Section 6.1.1 Advisory services

Advisory services include all studies and analyses required to make a preliminary valuation of the financial feasibility of a project. This is done by means of a clear understanding of the sponsors’ goals, an assessment of the risks inherent to the project and proposals for managing them, assistance in drafting contracts and obtaining necessary permits, assistance in drafting and/or revising the business plan, etc.

45. The arranger’s job is to: a) manage default risk for the project. b) structure and manage the financing package for the transaction. c) express an opinion on the financial feasibility of the project.

Answer: B

Source: Ch. 6 – Section 6.1.2 Arranging Services

Arranging consists of obtaining a mandate from the SPV borrower to structure and manage the financing contract. The arranger has to be able to contact the widest possible number of banks and/or institutional investors interested in participating in the deal and must then be the coordinator representing all lenders 46. Participants: a) handle the flows of debt payment during the life of the project. b) are responsible for drafting the project documentation. c) are lenders of the project company.

Answer: C

Source: Ch. 6.2 – Other roles in Syndicated loans

These are banks and financial intermediaries that lend an amount below the threshold established for the lending commitment without getting involved in any additional activity.

47. The success fee: a) is always a fixed amount. b) is always established on a percentage basis linked to the value of the debt. c) is always established on a percentage basis linked to the total value of the SPV’s assets.

Answer: B

Source: Ch. 6 – Section 6.3.1 Fees for advisory services

The success fee is established on a percentage basis to provide an incentive for the advisor. As for market standards, success fees range from 0.5% to 1% of the debt value. Section 6.3.1. clarifies why this percentage is calculated on the debt amount instead of the SPV’s assets (total project value).

48. The commitment fee: a) is paid only if the SPV uses the funds made available to it. b) is linked to the total value of funds made available. c) compensates the undrawn portion of funds made available to the SPV by the bank syndicate Answer: C

Source: Ch. 6 – Section 6.3.3. Fees to participants and the agent bank

The commitment fee is calculated on the basis of time with reference to the difference between the maximum amount made available to the SPV (committed amount) and the amount disbursed at the beginning of each reference period. The reason for this payment is that while lender banks may not have materially disbursed certain funds, they are required to back up committed loans with equity based on capital requirement coefficients established by each country's banking supervisory authority under the framework of Basel Accords. Given that the bank's equity capital should be remunerated, the commitment fee should enable lenders to obtain compensation to partly cover this notional cost.

49. In the partnership model between the MLA and institutional investors (IIs): a) the MLA originates the loan and offers the possibility to IIs to participate to the financing when the project meets some pre-agreed eligibility criteria. b) the IIs originate the deal and then ask the MLA to participate to the financing for a fraction of the total amount. c) the MLA segregates a portfolio of Project Finance loans in a Special Purpose Vehicle that issues asset-backed securities to be sold to IIs. Answer: A

Source: Ch. 6 – Section 6.2.2.1 The partnership/co-investment model

Section 6.2.2.1 presents the alternatives available to IIs to allocate resources to infrastructure. The partnership model/co-investment represents a cooperation between banks and IIs with the former providing skills and expertise to IIs willing to invest in long term infrastructure projects.

50. Which statement referring to the role of multilateral financial institutions is false? a) In accordance with their policies, they don’t take on financial commitments in countries with high political risk. b) They participate in privatization. c) They also promote private financing.

Answer: A Multilateral Banks

Source: Ch. 6 – Section 6.4 International Financial Institutions and

International Financial Institutions (IFIs) play a leading role in project finance deals, in particular in developing countries. There are three reasons why: their institutional mandate makes provisions for taking on financial commitments in countries where high political risk prevails; they serve as guides in privatization policies; they continue to promote financing the private sector and private investments.

51. Not included among bilateral agencies are: a) development agencies. b) export credit agencies (ECAs). c) banks.

Answer: C Source: Ch. 6 – 6.5 Bilateral Agencies: Developmental Agencies and Export Credit Agencies (ECAs) Bilateral agencies are those linked to governments of individual countries for economic policy purposes and commercial and international promotion of the countries businesses. This category can be further divided into developmental agencies and export credit agencies.

52. By means of the mechanism establishing pro-rata equity payments: a) sponsors make resources available before drawdowns on the loan are made. b) sponsors make resources available after the entire loan has been utilized. c) every payment is subdivided proportionally as to borrowed capital and risk capital.

Answer: C Source: Ch. 6 – Section 6.7.1 Timing of the equity contribution and stand-by equity and equity acceleration The pro-rata payment clause establishes that each payment will be subdivided as to borrowed capital and equity capital in a proportion corresponding to a pre-agreed debt-to-equity ratio. In this case the creditors ask the sponsors to make stage payments and to issue a letter of credit to cover future payments.

53. Mezzanine finance: a) obliges sponsors to inject more capital. b) allows senior lenders to benefit from a higher level of protection against bankruptcy of the SPV. c) lowers the level of guarantees for all lenders.

Answer: B subordinated loans

Source: Ch. 6 – Section 6.8 Funding options: mezzanine finance and

The role played by mezzanine financing is more similar to that of equity capital than debt capital.

On the one hand, in fact, the guarantee level for pure lenders is higher given the subordination clause associated with mezzanine financing; on the other, lenders who are more willing to take a risk will profit from the enhanced project value if it should perform really well.

54. The base facility (or base loan): a) can be used and repaid at the SPV’s discretion. b) is a revolving credit. c) funds construction of the plant and facilities.

Answer: C

Source: Ch. 6 – 6.9.1 Base facility

The majority of the financing constitutes the base facility. This is debt granted to the SPV to finance plant construction and a portion of indirect investments (capitalized interest and fees). Clauses covering utilization and repayment of the base facility are very strict and therefore the SPV is left with very little discretion. Repayments are structured based on the cash flow trend forecast in the financial plan; the base facility is not a revolving credit.

55. If a bank facility is not completely paid back at the end of its tenor and the borrower is not able to refinance the loan, the SPV is forced into bankruptcy. Which is the repayment method underlying this statement? a) Balloon repayment b) Hard mini perm c) Soft mini perm Answer: B

Source: Ch. 6 – Section 6.9.7 Repayment options

With the hard mini perm, the duration of the loan is set on a time horizon of 7-8 years and forces the SPV to refinance the loan before the maturity of the mini perm. If it is not able to do so, the SPV gets bankrupt.

The soft mini perm is formally a long term loan that does not foresee the default of the SPV. The loan maturity remains long but the loan agreement includes incentives to the borrower that encourage it to refinance the loan before the final maturity (typically a fast growing step up spread on the base interest rate).

Balloon repayment simply indicate that a portion of the principal is still due at the end of the agreed tenor.

56. Why might a sponsor find it economically convenient to refinance loans once the construction phase for the project in question has been successfully completed? a) to cut down on the length of the project at hand so as to move on to new ones. b) to reduce the severity of certain covenants. c) to modify the characteristics of the underlying project.

Answer: B

Source: Ch. 6 – Section 6.9.8 Refinancing loans already granted to the SPV

Refinancing is structured with the aim of improving the NPV and internal rate of return for the deal's sponsors. In fact their objectives are to free up cash blocked to service reserve accounts (especially the debt reserve); to reduce spreads paid above base interbank interest rates; to extend the tenor of the debt; to introduce a new form of funding alongside the bank loan, based on a bond issue, which will mean diversifying the group of lenders; to reduce the severity of certain covenants.

57. Which of the following factors is not typical of a private placement with respect to a public placement? a) strict regulatory constraints b) speed of structuring the deal c) lower cost of funding Answer: A

Source: Ch. 6 – Section 6.11.2.2 Target Investors

The advantages of a private placement as compared to a tender offer are:

– – – –

the lack of strict regulatory constraints speed of structuring the deal possibility to tailor the characteristics of the bond to suit the requirements of investors lower cost of funding

58. Municipal bonds: a) are not structured in the same way as project bonds. b) can only be sold by private placement. c) are issued by a public body.

Answer: C

Source: Ch. 6 – Section 6.11.3 Municipal bonds

Municipal bonds are a special category of bonds issued by public bodies. While these are not part of the project bond category, they are structured in the same way. These bonds can either be sold by public placement to retail investors or by private placement targeting institutional investors.

59. The bond paying agent: a) can also act as trustee. b) serves exclusively as an advisor. c) can represent the interests of sponsors.

Answer: A

Source: Ch. 6 – Section 6.11.5.2 Bond Paying Agent and Trustee

The role of bond paying agent equates to that of an agent bank in the case of a bank loan. The bond paying agent and the trustee can be the same institution.

60. The underwriting agreement: a) deals with the relationships among the underwriting syndicate and the group of banks that handle the sale of securities to final investors. b) addresses the relationships among members of the underwriting syndicate. c) regulates the relationships between issuer and lead manager.

Answer: B

Source: Ch. 6 – Section 6.11.5.5 The Subscription Agreement

Efforts of members of the underwriting syndicate (managers and other bank underwriters) in terms of individual quotas underwritten are detailed in the underwriting agreement.

61. In Islamic finance, what are Sukuk? a) Sukuk are financial contracts similar to the Western Joint Venture b) Sukuk are Sharia compliant contracts that are similar to a bond issue in Western Economies. c) Sukuk are financial contracts similar to Western Leasing contracts Answer: B

Source: Ch. 6 – Section 6.12.3 Sukuk

Sukuk is the equivalent of bonds in Western economies. However, given the principle of riba, they cannot yield a predefined interest rate and are always linked to a real asset which is the basis of the agreement between the parties involved in the transaction.

Given this characteristics, Sukuk can be structured also as partnership/participation contracts (Section 6.12.3.2) or on sale and leasing contracts (Ijara, Salam, Istisnaa) (Section 6.12.3.3)

Questions and exercices 1.

Calculate the fees paid all players, keeping in mind their roles in the project financing deal and the return on funded capital:

Syndicated Amount

500

Advisor success fee Arranging fee Co-arranging fee Up-front fee

0.75% 1.00% 0.80% 0.20%

Subject A B C D E F

2.

3.

4.

5.

6.

7.

8.

9.

10.

Subject A B C D E F Underwritten Amount 300 200

Role Advisor Lead Arranger Co-Arranger Lead Manager Manager Co-Manager Funded Amount 0 30 20 150 100 200

Explain the roles of the advisor and the arranger in project finance initiatives. Also, list the other possible members of a loan syndicate.

What’s the success fee and how is it calculated?

What’s the purpose of the commitment fee?

In what ways are multilateral development agencies different from bilateral agencies?

Illustrate the structure of the World Bank Group.

Illustrate the fee structure in project finance.

On 1 Jan 20XX, Bank XYZ makes 100 million available to the ABC SPV at a 5% fixed rate with a commitment fee of 0.8%. On the same day, the company decides to use 45 million of the committed amount. What would the bank request as a commitment fee on 6 April 20XX? (Use the business year and 360 as divisor.)

Give a numerical example of the positive effects of the use of mezzanine debt, based on these data: Ksenior debt Kmezzanine debt

8% ROI

10%

11% Tax

50%

Asset

150

Consider the data in the table below, and answer the following question: Can the use of mezzanine debt be advantageous for an initiative’s senior lenders in case of default?

Base your answer on the various percentages of recovery on asset value given default.

Financial structure 1

Financial structure 2

Assets Senior debt Mezzanine debt Equity

11.

12.

13.

14.

15.

110 75 0 35

Assets Senior debt Mezzanine debt Equity

110 65 10 35

Illustrate the concepts of the dividend trap and negative equity.

List the key features of the facilities included in the senior debt category in a project finance deal.

Beginning with the reasons why a sponsor might decide to refinance loans already granted, illustrate the two possible options: hard and soft refinancing.

Describe the various categories of project bonds.

Provide a series of assessment criteria for the use of project bonds.

Answer 1: Using the available information, first we can assign a reference fee to each player: Party A B C D E F

Role Advisor Lead Arranger Co-Arranger Lead Manager Manager Co-Manager

Fee Success fee Arranging fee Co-Arranging fee Up-front fee Up-front fee Up-front fee

As we know, the sponsors of a project only make two payments: to the advisor and to the arranger.

In the specific example, here’s the situation: Party A B

Fee received 3.75 5

Party B, as the arranger of the deal, has to “return” part of the fees collected: Fee Arranging fee Co-Arranging fee Up-Front fee Total

B 5 -1.6 -1.3 2.1

C

D

E

F

1.6 0.4 2

0.3 0.3

0.2 0.2

0.4 0.4

All this results in an overall return for each player as follows:

Return on Funded Capital

B

C

D

E

F

7.00%

10.00%

0.20%

0.20%

0.20%

Answer 2: The answer refers to Sections 6.2, “Other roles in syndicated loans” and 6.1 “Advisory and Arranging activities for project finance funding.” A complete answer should include the following points: – The difference between lending and advisory services – The kinds of banks that serve as advisors and those that provide lending or arranging services – The responsibilities of the advisor and the arranger, and the possibility that in a given project the same party can take on both roles – The role of managers – The role of partecipants – The role of the agent bank – The role of the documentation bank Answer 3: This fee is paid by sponsors once the study and planning mandate has led to a successful conclusion. As opposed to other fees, the success fee is always established as a percentage of the debt value – not the project value. There are two possible explanations for this practice: 1. The first is that, intuitively, it wouldn't make sense for sponsors to pay a fee on funds they contribute themselves.

2. The second is to motivate the advisor to plan deals with the highest possible debt-to-equity ratio, with obvious benefits on the rate of return for the SPV’s sponsors.

The level of the success fee will be inversely proportionate to the size of the project; a smaller (bigger) project will command a higher (lower) percentage. The degree of innovation inherent to the project will, instead, directly affect the fee: an extremely innovative venture will require a greater effort by the advisor and therefore will justify the request for a more generous fee.

Answer 4: The commitment fee is calculated on the basis of time with reference to the difference between the maximum amount made available to the SPV and the amount disbursed at the beginning of each reference period.

The reason for this payment is that while lender banks may not have materially disbursed certain funds, they are required to set aside part of their capital for committed loans based on equity coefficients established by each country's banking supervisory authority. Given that the bank's equity capital should be remunerated, the commitment fee should enable lenders to obtain compensation to partly cover this notional cost.

Answer 5: The answer is addressed in Section 6.4 “International financial institutions and multilateral banks” and 6.5 “Bilateral Agencies: Developmental agencies and export credit agencies (ECA’s)”.

A complete answer should take the following issues into consideration: – The reasons underlying the establishment of international financial institutions – Characteristics and methods of intervention of multilateral agencies – Characteristics and methods of intervention of regional banks – Characteristics and methods of intervention of development agencies – Characteristics and methods of intervention of credit export agencies Answer 6:

For the answer, see Section 6.4.1.1, “World Bank Group”.

A complete answer should illustrate: – The structure of the Group – The major activities of each component – Investment targets and options of every member of the Group Answer 7: See Section 6.3, “The Fee structure”.

An adequate answer should include the following points: – Which parties are actually paid by the sponsors (advisor and arranger) – The breakdown of the remuneration for advisory services (retainer fee and success fee) – The breakdown of the remuneration for arranging services (arranging fee and fixed fees, where applicable – consider underwriting activity) – How managers in an initiative are paid (up-front fee and commitment fee) – How the agent bank is compensated (agency fee) Answer 8: The commitment fee is calculated as follows (See Section 6.3.3.): For the period January 1st -April 6th the available capital has been 100 million. It will become (10045) = 55 million from April 6th onwards.

So, the data for the calculation are: Committed loan in the period = 100 million Days = (30+30+30+6) = 96 Fee = 0.8% Committed fee = 100 * 0.8% * (96/360) = 213,333 Euro Answer 9: Here’s one possible example: Ksenior debt Kmezzanine debt

8% ROI

10%

11% Tax

50%

Asset

150

Financial Structure 1

Financial Structure 2

Asset

150

Asset

150

Senior debt

100

100

Mezzanine debt

0

Senior debt Mezzanine debt

Equity

50

Equity

30

EBIT Interest senior debt

15

EBIT Interest senior debt

15

8

20

8

Interest mezzanine debt

0

Interest mezzanine debt

2.2

EBT

7

EBT

4.8

Taxes

3.5

Taxes

2.4

Net Earnings

3.5

Net Earnings

2.4

ROE

7.00%

ROE

8.00%

Answer 10: The advantage/disadvantage for senior lenders depends on the level of recovery of the project company’s activities. In fact: Financial Structure 1 % Realized Realized asset value value 20% 30% 40% 50% 60% 70% 80% 90% 100%

22 33 44 55 66 77 88 99 110

Payment Payment Payment senior mezzanine shareholders debt debt 22 33 44 55 66 75 75 75 75

0 0 0 0 0 0 0 0 0

Senior debt losses

0 0 0 0 0 0 5 15 25

-71% -56% -41% -27% -12% 0% 0% 0% 0%

Payment Payment Payment senior mezzanine shareholders debt debt

Senior debt losses

Financial Structure 2 % Realized Realized asset value value 20% 30% 40% 50% 60% 70% 80% 90% 100%

22 33 44 55 66 77 88 99 110

22 33 44 55 65 65 65 65 65

0 0 0 0 1 10 10 10 10

0 0 0 0 0 2 13 24 35

-66% -49% -32% -15% 0% 0% 0% 0% 0%

Answer 11: Dividend trap: – emerges every time the cash flow available to sponsors is higher than net income. The difference can arise in the first years of the project’s life when depreciation is very high and cuts into profits (without impacting the value of operating cash flow)

–

prompts sponsors to use mezzanine debt/shareholders’ subordinated debt rather than equity

Negative equity: – a problem that emerges when equity is substituted with subordinated debt granted by sponsors to avoid the dividend trap – higher subordinated debt means interest costs rise and there will be lower profits/higher losses, and so erosion of the sponsors' capital base will be heavier When sponsors and arrangers establish the capital structure and the subordinated debt/equity mix, they have to keep the trade-off in mind between eliminating the dividend trap and the problem of negative equity. In fact, legislation in many countries does not allow negative equity.

Answer 12: The answer can be found in Sections 6.9.1 “Base facility”, 6.9.2 “Working capital facility”, 6.9.3 “Stand-by facility”, 6.9.4 “VAT facility”. A complete answer should also include a comparison of the different facilities in terms of tenor, discretion in terms of utilization, and function in the context of the deal.

Answer 13: The aim of a sponsor in refinancing the SPV’s loans is to improve equity IRR. Specifically the sponsor hopes to: – free up cash blocked to service reserve accounts (especially the debt reserve) – reduce spreads paid above base interbank interest rates – extend the tenor of the debt – introduce a new form of funding alongside the bank loan, based on a bond issue, which will mean diversifying the group of lenders – reduce the severity of certain covenants

Soft financing involves renegotiating conditions inasmuch as this approach doesn't entail changing the financial leverage decided for the project or tenor of the loan. In effect, the waiver can be useful to sponsors in pursuing the three of the objectives listed above, i.e. to free up cash blocked to service reserve accounts (especially the debt reserve), to reduce spreads paid above base interbank interest rates, and to reduce the severity of certain covenants.

Hard refinancing can be considered true refinancing. It concerns the agreements between the sponsors and pool of lenders, and leads to a change in the level of leverage for the deal or tenor of the loan In this case, all of the objectives listed above can be attained.

Answer 14: Project bond categories are discussed in Section 6.11.2, “Various Categories of Project Bonds.” A correct outline for this answer would include: – A description of the typical features that characterize individual bond issues – Aspects of interest to consider as regards each variable described (for example, the role of the regulatory framework in shaping the investor target, or the role of the monoline insurer in the broader context of guarantees) – The names given to various types of bonds Answer 15:

In valuing the economic convenience of the use of project bonds as compared to more traditional project loans, we have to consider a large number of factors: – Investor Target – Tenor of the loan – Preservation of the borrower’s financial flexibility – Inflation linked bonds – Structure for utilization and repayment of funding – Credit policies and market sentiment – Fixing the financing terms and conditions – Confidentiality – Covenants and monitoring management of the project – Renegotiating contractual conditions and refinancing Some of these make the use of bonds more convenient in economic terms; others suggest the use of bank loans. See Section 6.11.4.

CHAPTER 7 Learning objectives After studying this chapter the reader should be able to: – Understand why legal aspects are crucial in a project finance deal – Identify the main categories of legal documents – Know the contents of the credit agreement and of the other finance documents – Know the economic reasons for setting up security interests on project assets and which security interests can be given to project lenders – Know the main characteristics and contents of the project documents and project key contracts from a legal standpoint

Concept review questions 62. Why can we say that there are defensive reasons for the creation of a SPV? a) Because project lenders can avoid the sharing of project cash flows with the sponsoring firm’s creditors. b) Because monitoring construction and operations is facilitated by the creation of a special project company. c) Because the creation of a project company allows lenders to fully control project cash flows.

Answer: A

Source: Ch. 7 – Section 7.1.1.1 Defensive/Protective Reasons

If there are previous or ongoing activities which have nothing to do with the project, there is a risk that liabilities deriving from or connected to such activities could contaminate the assets of the borrower company. On one hand, without recourse lenders would be exposed to risks unrelated to the project, which would create an imbalance in the financial structure of the project. On the other hand, non-project lenders would benefit from the liquidity injection and project-related investments added to the assets of their borrower.

63. What is a due diligence report? a) It is a document containing information and a description of the legislative and/or regulatory framework in a given sector.

b) It is a two-part document which summarizes the project’s main characteristics from a legal point of view c) It is a document which discusses risk analysis and describes the project’s weaknesses.

Answer: B

Source: Ch. 7 – Section 7.2.1.1 The Legal Due diligence report

The due diligence report is a summary of the project from a legal standpoint, an essential tool for lenders in order to evaluate a project. The due diligence report constitutes the basic document of analysis for the project and for its bankability on a without recourse basis. The report is actually made up of two documents with distinctive characteristics and objectives, but which are combined on every single page of the report: a description of the legal context of the project and an analysis of its risk.

64. The credit agreement is a project document which can be classified into the category of: a) The security documents b) The project agreements c) The finance documents Answer: C

Source: Ch. 7 – Section 7.2.2. Classification of project documents

Finance documents include the credit agreement (often referred to as the facilities agreement) and other documents closely related to it. Actually, there is a primary finance document (the credit agreement) and a series of contract documents which are instrumental and correlated to it.

65. In a project finance credit agreement, lenders have included a clause which authorizes the SPV to withdraw funds for the payment of the first tranche of works to the contractor only after construction permits from the Public Administration have been obtained. Such a clause is defined: a) Condition precedent b) Reserved Discretion c) Representation Answer: A Drawdowns

Source: Ch. 7 – Section 7.2.3.4 Conditions Precedent. Availability of

From a technical/legal standpoint most conditions precedent can be defined as provisions which suspend the obligations of the lenders to make the funds granted in the credit agreement available to the borrower project company. Conditions precedent represent the contractual mechanism that entitles lenders to check that the transaction meets all the substantial and formal criteria before these funds are actually advanced to the project company 66. Is it possible for the SPV to repay the loan in advance with respect to the original final loan maturity? a) Yes, but the project company must demonstrate that it has sufficient funds to successfully carry out the project until its final maturity. b) No, it is never possible to prepay a project loan c) Yes, but only if a special reserved discretion is included in the credit agreement.

Answer: A facility

Source Ch.7 – Section 7.2.3.6

Repayment of the loans. Cancelling the

The project company is given the chance to cancel undrawn funds made available through the credit agreement. This is usually called the right to cancel the loan, by which the lenders’ commitment decreases proportionally.

However, cancellation is usually subject to one condition: the project company must show it has adequate resources to complete the project.

67. In legal terms, a declaration made by the borrower regarding the validity of security interests granted to its creditors and included in the credit agreement is defined as: a) Condition precedent b) Representation c) Reserved discretion Answer: B

Source Ch. 7 – Section 7.2.3.10 Representations

Representations are specific statements by the borrower, who warrants their truth for the benefit of lenders. These declarations may address a vast and diverse number of issues. Among others, one representation is on the validity of security interests granted by the borrower or by third parties (sponsors as far as pledges on the borrower’s shares are concerned) as security for the credit agreement.

68. Suppose that a transfer of shares in the project company takes place which is not allowed by the credit agreement. How would you define such event? a) Negative covenant b) Event of default c) Negative reserved discretion Answer: B Source: Ch. 7 – Section 7.2.3.12 Events of Default and Their Consequences.

The financial crisis of the transaction Among other possible events of default, there is the transfer of shares in the project company which takes place and is not permitted by the credit agreement, or the security over such shares is released and it is not re-granted in a timely fashion.

69. When does the enforcement of security interests by lenders normally takes place? a) When a condition precedent has been fulfilled b) When an event of default occurs c) Immediately after the commercial operating date (start up of the operating phase) Answer: B Documents

Source Ch. 7 – Section 7.2.4.2 Common Provisions in the Security

In the complex structures of project finance, security interests can be enforced only in the context and under the circumstances which regulate default situations and the remedies lenders can apply, according to the terms of the credit agreement. Consequently, the enforcement of security interests is normally limited to cases of events of default. Often an additional condition is set: that lenders have exercised the right to trigger an acceleration of the loan. The point at which security interests become enforceable represents the boundary line between the rights of sponsors to keep the project

company running the project and the option of lenders to take every necessary action to protect their credits toward the project company.

Questions and exercices 1.

Fill in the following table marking with an X the column which defines the clause included in each row.

Clauses Obligations to use the funds made available through the credit agreement solely for the purposes set out in that document.

Declaration that the project company has been incorporated and exists in accordance with applicable law Obligations to comply with reserved discretions Declaration about the absence of rights granted to third parties that would subordinate the obligations toward project creditors Obligations to comply with environmental laws and regulations Non-payment of amounts due at maturity in accordance with the credit agreement Representations on the absence of litigation, or situations that could results in litigation, involving the

Positive Covenant

Negative Covenant

Representation Reserved Discretion

Event default

of

project company.

Representations made in the credit agreement prove materially untrue.

Negative pledge Plant must stop operations for spare parts substitution and creditors allow the SPV to do so Some key counterparty to some project agreement is subject to liquidation or insolvency procedures Obligations of the borrower not to dispose of its assets (except in specific circumstances as for obsolete assets) Obligations not to undertake any merger, de-merger or other corporate restructuring 2.

What is a “materiality test” and why is the definition of materiality so important for project sponsors?

3.

How can lenders get full control of the project in case of default with sufficient rapidity?

4.

Can the sponsors be one of the parties which subscribe an intercreditor agreement with other lenders?

Answer 1: Clauses

Positive Covenant Obligations to use X the funds made available through the credit agreement solely for the purposes set out in that document.

Declaration that the project company has

Negative Covenant

Representation Reserved Discretion

X

Event default

of

been incorporated and exists in accordance with applicable law Obligations to X comply with reserved discretions Declaration about the absence of rights granted to third parties that would subordinate the obligations toward project creditors Obligations to X comply with environmental laws and regulations Non-payment of amounts due at maturity in accordance with the credit agreement Representations on the absence of litigation, or situations that could results in litigation, involving the project company.

Representations made in the credit agreement prove materially untrue.

Negative pledge Plant must stop operations for spare parts substitution and creditors allow the SPV to do so Some key counterparty to some project agreement is subject to liquidation or insolvency procedures Obligations of the borrower not to dispose of its assets

X

X

X

X

X X

X

X

(except in specific circumstances as for obsolete assets) Obligations not to undertake any merger, de-merger or other corporate restructuring

X

Answer 2: The credit agreement includes a detailed set of events of default. However creditors can enforce the security package only if the consequences of the event are material. Materiality is subject to a “materiality test”. Very often legal procedures build a specific definition, so the materiality test is that the event in question has a “material adverse effect” (or similar). The importance of the definition of materiality for sponsors is crucial, since it is clear that the materiality test for the borrower represents the final defensive barrier against the possibility of lenders declaring an event of default.

In any case, normally the notion of material adverse effect has to involve an event that either hinders the ability of the borrower (or some other relevant entity) to fulfill its contract obligations, or that jeopardizes the rights of lenders as established in the finance documents.

Answer 3: The conditions that enable lenders to takeover the control of the project are the results of different contractual clauses: 1. the security package 2. the direct agreements The security package is the alarm system for the deal which is activated if the project or financing does not work properly. Security interests segregate a given asset as security for a credit and the lender acquires the following rights over the secured asset:   

the right to have it sold to a third party, and to convert the asset into cash the right of pre-emption the right to obtain priority over other potential creditors of the right to enforce the security over an asset even if said asset is purchased by a third party. In other words, in theory a security interest “follows” the secured asset, and secures it throughout all its later sales until the debt is repaid in full.

A standard security package for a project finance deal includes a pledge on the project company’s shares, security on the project company’s receivables, security on the project company’s bank accounts, and a mortgage on project assets.

On the other hand, direct agreements are contracts executed directly by the lenders and the key counterparties to the project agreements. They are legal instruments that lenders use to reserve the right to intervene directly in the relationship between the project company and third parties. The two most important objectives of such contracts are to safeguard the project agreements, on one hand and on the other to establish a sort of lenders’ right to “take over” these agreements.

Answer 4:

The aim of the intercreditor agreement is to regulate the relationships among the lenders who participate in the deal. The intercreditor agreement is indispensable when there are different categories of lenders; the position of each one in relation to the borrower and to other creditors is regulated in order to achieve the financial structure proposed for the deal.

The agreement also regulates the rights of the hedging contract counterparties (often called finance parties, not only in project finance) related to the security package.

Furthermore, this contract usually also includes provisions relating to the pool of lenders and the decision-making procedures they will follow during the life of the loan. The intercreditor agreement contains the decision-making rules for the lenders’ syndicate (generally based on the vote of the majority of the economic participation in the financing).

Less frequently, the intercreditor agreement also regulates the reciprocal relationships among different categories of lenders involved in the same project (public bodies, supranational organizations, and subordinated or mezzanine creditors).

The sponsors – being the equity contributors – shouldn’t be considered a party involved in such agreements but if they also contribute subordinated debt, the intercreditor agreement must also address the regulation of the subordination clause. In order to make effective the subordination of sponsors’ credits toward the project company with respect to lenders’ credits, in many cases sponsors are required to be parties to the intercreditor agreement.

CHAPTER 8 Learning objectives After studying this chapter the reader should be able to: – Know how the reform of the Basel Capital Accord (Basel III) has impacted the business of project and infrastructure finance – Understand the characteristics of initiatives which are categorized as “specialized lending” according to the Basel Committee – Identify the areas of analysis that have to be monitored to quantify the credit risk of a project finance deal – Understand the variables that determine Value at risk for project finance deals – Understand the concept of project default in project finance deals – Understand the problems involved in estimating a project’s LGD (loss given default)

Concept review questions 70. Which one of these statements is NOT a factor in classifying a deal as specialized lending: a) The primary source of loan repayment is the repayment capacity of an up-andrunning company. b) The counterparty currently has no substantial assets other than those used for the project/initiative. c) The loan is granted to a legally recognized entity which is created specifically to finance and/or manage the work in question.

Answer: A Source: Ch. 8 – Section 8.1 The Basel Committee’s Position on Structured Finance Transactions (Specialized Lending, SL) According to the indications provided by the Basel Committee, in order to include a deal in the category of specialized lending, one of the characteristics taken into consideration is that repayment depends primarily on the cash flow generated by the project rather than the more general repayment

capacity of an up-and-running company. For this reason, Answer A is not correct, because it indicates the standard condition of a corporate finance transaction.

71. Object finance is: a) a transaction which isn’t classified as specialized lending. b) a type of transaction involving the purchase of large plants and machinery; repayment of this type of financing depends for the most part on the cash flows produced by the financed asset. c) a type of transaction (essentially a short-term one) involving buying raw materials needed for a project’s activity. The cash flows generated by the sale of these “commodities” are the source of loan repayment.

Answer: B lending

Source: Ch. 8 – Section 8.1.1. Classes of transactions included in specialized

Object finance transactions consist in buying plants and machinery (in particular big ticket) for which loan repayment is based mainly on cash flows generated by the financed asset. The most obvious example is that of big ticket leasing in which the borrower buys or builds and later leases the asset to the lessee.

72. The rating system provided by the Basel Committee for project finance initiatives establishes: a) 4 categories (strong, good, satisfactory and weak) to be applied to each of 5 criteria (financial strength, political and legal environment; asset characteristics, transaction characteristics-strength of sponsors, mitigants and security package). b) 5 categories (strong, good, satisfactory, weak and default) to be applied to each of 4 criteria (financial strength; political and legal environment; transaction characteristics-strength of sponsors; mitigants and security package). c) 5 categories (strong, good, satisfactory, weak and default) for each of 5 criteria (financial strength; political and legal environment; asset characteristics; transaction characteristics-strength of sponsors; mitigants and security package).

Answer: A Source: Ch. 8 – Section 8.2 Rating criteria for specialized lending and their application to project finance The Basel Committee provides for 4 grades (plus default) and 5 criteria for project finance deals, or for all initiatives classified as specialized lending.

73. According to Basel rules, the banks that adopt an IRB foundation system for project finance transactions have to: a) use the same formulae as for corporate loans. b) use weights relating to the 4 categories (strong, good, satisfactory, weak and default). c) apply specific formulae for exposures classed as specialized lending.

Answer: A Source: Ch. 8 – Section 8.3 The Basel Accord and the treatment of credit risk for project finance loans: is project finance more risky than corporate loans?

The Committee’s position is to treat project finance in a similar fashion as corporate exposures in terms of models and algorithms applied. Therefore, there are no provisions for a specific measuring system (which means that letter C is incorrect).

For banks that use the standardized approach the Committee delineates 8 weights relating to the 4 rating grade slotting criteria outlined above (strong, good, satisfactory, weak, and default, see Table 8.3). Instead for banks which use the IRB Foundation Approach, the document sets out mathematical functions and variables to slot into the formulae which are used in the same way as for corporate exposures.

74. Expected loss is: a) the average amount which isn’t paid by the borrower to the lender; it depends on counterparty risk, the transaction amount, and the possibility to recover the loan. b) the loss that a lender expects from a position that’s covered by an adequate equity level. c) The value resulting from the application of formulae set down in the document issued by the Basel Committee.

Answer: A Source: Ch. 8 – Section 8.5 An introduction to the concepts of expected loss, unexpected loss and Value at Risk Expected loss is the average amount which will not be repaid to the lender in a credit transaction; this figure is computed as the product of the exposure at default (EAD), the probability of default (PD), and the loss given default (LGD).

75. Consider a project finance loan whose outstanding today is $98 million (including $2 million in accrued interest and expenses). Suppose the bank quantify the expected recoverable value in $97 million at the time of default. How much is the expected recovery rate? a) 99% b) 101% c) 1% Answer: A

Source: Ch. 8 – Introduction.

The recovery rate would be 99% (= $97 million/$98 million), while the LGD would be 1% (= 100% – 99%).

76. Consider the previous deal. Suppose that the PD of the typical project finance loan for the bank is 10%. If you suppose to recover the recovery rate of question 6, how much is the Expected Loss (EL) for the loan? a) 10% b) 1% c) 0.1% Answer: C

Source: Ch. 8 – Introduction.

The Expected loss is PD times LGD. In our case LGD = 1% and PD = 10%, so EL is 0.1% (10% x 1%).

77. In project finance deals, normally: a) there’s no correlation between PD and LGD values. b) there’s a positive correlation between PD and LGD. c) there’s a negative correlation between PD and LGD. Source: Ch. 8 – Section 8.9.1 Deterministic vs. Stochastic LGD Estimates

Answer: B

In project finance deals there is normally a strong positive correlation between probability of default and LGD. Since the value of the project often depends solely on the value of future cash flows, a reduction in the value of these flows has the joint impact of increasing PD and decreasing the present value of the cash flows after default, thereby reducing the recovery ratio for the banks that financed the project.

78. If a bank were to adopt the standard approach, as provided by the Basel Committee, the project finance solution would be economically convenient: a) in every case. b) only for rating categories of top quality (AAA to A-) and lower quality (BB- and from B to C). c) only for rating categories above “A-”.

Answer: B Source: Ch. 8 – Section 8.3. The Basel Accord and the treatment of credit risk for project finance loans The Basel Framework of 2004 has not been modified by Basel III. The original penalization of project finance loans carries over for transactions which fall in the highest rating classes (from AAA to A-) and for weaker rating classes. See also Table 8.6.

79. The VaR approach makes it possible to quantify: a) the maximum potential loss within a certain time interval and level of probability; “”is normally used to signify VaR. b) the maximum potential loss within a certain time interval and level of probability; this loss can be exceeded only in a given α% (e.g. 1%) of cases. c) the average loss that can be incurred in a project finance initiative within a certain number of years.

Answer: B Source: Ch. 8 – Section 8.5 An Introduction to the Concepts of Expected Loss, Unexpected Loss and Value at Risk Value at Risk is defined as the maximum potential loss that a portfolio or a financial institution may incur within a certain time interval and level of confidence; this loss can be exceeded only in a given α% (e.g. 1%) of cases.

Questions and exercices 5.

Mark an X next to the variables that can be linked to the 4 categories in the columns of the table below.

Criterion

Financial

Political and

Transaction

Strength of

Security

strength

legal environment

characteristics

sponsors

package

Track record and financial standing Operating risk Market risk Financial leverage Force majeure risk Reserve funds Ratio of loan life to project life Supply risk Government support Assignment to creditors

Answer 1: Criterion

Track record and financial standing Operating risk Market risk Financial leverage Force majeure risk Reserve funds Ratio of loan life to project life Supply risk Government support Assignment to creditors

Financial strength

Political and legal environment

Transaction characteristics

Strength of sponsors

Security package

X X X X X X X X X X