Project Finance in Theory and Practice - Designing, Structuring, and Financing Private and Public Projects

459 Pages·2013·7.4 MB·English

Project Finance in
Theory and Practice
Designing, Structuring,
and Financing Private
and Public Projects
Stefano Gatti
AMSTERDAM•BOSTON•HEIDELBERG•LONDON
NEWYORK•OXFORD•PARIS•SANDIEGO
SANFRANCISCO•SINGAPORE•SYDNEY•TOKYO
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Projectfinanceintheoryandpractice:designing,structuring,andfinancingprivateandpublicprojects/Stefano
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Preface to the Second Edition
The first edition of this book was published at the end of 2007, with its preface dating back to June
2007.Atthattime,financialmarketsworldwidewereattheirpeaksinmostofthesegmentsoffinancial
intermediation.Thegrowthwassustainedbyaverylongperiodofexpansivemonetarypolicybythe
Federal Reserve, with very low levels of real interest rates, growth of equity indices and prices,
expansion in the real estate and credit markets, and an increased use of a new generation of
increasingly complex asset-backed securities and structured debt products. In Europe, many colum-
nists were criticizing the more conservative policy of the European Central Bank and its excessive
attentiontoinflationary pressures rather than economic growth.
In this favorable environment, the syndicated loans market and project finance reached their
unsurpassedpeaksin2007.Thesyndicatedloansmarketregisteredaround4.5trillionU.S.dollars,of
which around5% was represented by project finance.
We all know what happened after 2007. With the bankruptcy of Lehman Brothers, the whole
economic system started a period of prolonged recession and of overall weak macroeconomic
performance compared tothe previous decade.
The massive interventions put in place by the central banks and in particular the extraordinary
quantitativeeasingactionsbytheFederalReserveattemptedtorestorenormalizedmarketconditions.
After 2009, the United States began showing signs of recovery. However, the financial crisis had
already spilled over from the private sector (the financial sector) to public deficits. The more recent
crisis of the sovereign debt in peripheral countries in Europe (Portugal, Italy, Ireland, Greece, and
Spain,orthe PIIGS,astheyare frequentlylabeled)hasplungedEurope intoadouble-diprecession,
and the credit crunch determined by the need for bank recapitalization has strongly reduced the
commitment tolend by the banking system. Some of the intermediariesthat inthe first part of2000
were very active in the syndicated loans and project finance markets have almost completely with-
drawn from this business. The market recorded a remarkable downturn from around 4.5 trillion US
dollars in 2007 to 3.6 trillion US dollars at the end of 2011 (with a dramatic bottom in 2009 at 1.5
trillionUSdollars).Thedecliningtrendwasmirroredintheprojectfinancemarket,withfiguresfalling
fromaround220billionUSdollarsin2007toabottomof138billionUSdollarsin2009.In2011,the
marketforprojectfinanceloansreturnedtothepre-crisisperiodwithavalueofabout214billionUS
dollars.
Thischangedlandscapehasradicallymodifiedthewaytoapproachaprojectfinancedealandthe
deal structuring. This holds true for project sponsors, banks, investors in infrastructures, project
bondholders, and public authorities.
The second edition starts exactly where the first stopped. Although the fundamentals of project
financeremainunchanged,theprocessthatleadstothefinancingisnowverydifferentfromwhatwas
depictedinthefirstedition.Almostallthechaptershavebeeninfluencedbythenewmacroeconomic
scenario,andallofthemincludespecificreferencesastohowtherecentfinancialturmoilhasaffected
the business.
Thisneweditionincludesseveralneworrevisedsections.Iwanttosummarizethemostrelevant.
Chapter1includesanew,expandedsectiondedicatedtotheemergingroleofinfrastructurefunds
asequityproviderstospecial-purposevehicles(SPVs).Whileinthepast,theownershipofanSPVwas
almost exclusively represented by industrial or public sponsors, nowadays industrial developers are
xv
xvi Preface to the Second Edition
lookingwithincreasinginterestattheopportunitiesofferedbyspecializedinvestorsininfrastructure.
Afterapauseingrowthbetween2008and2009,theflowoffundsinvestedbyinfrastructurefundshas
almost recovered tothe levelofthe peaks recorded in2007.
Chapter2hasbeenrevisedandnowincludesupdatedtimeseriesonthemarkettrendsforproject
finance and public-private partnerships (PPPs).
Chapter4hasbeenexpandedinthesectiondedicatedtothemonolineinsurers.Beforethefinancial
crisis, these intermediaries boosted the growth of the securitization market, providing convenient
creditenhancementwiththeirhighratings.ThecollapseofLehmanBrothersspurredachainreaction
of downgrades and bankruptcies of these monoliners. The wrapped bonds market (for asset-backed
securities [ABS], butalso for project finance)isnowalmost inexistent.
Chapter 6 is probably the chapter that has been modified the most. The sections relative to
multilateralbanksandexportcreditagencies(ECAs)havebeenupdatedwiththeinclusionofthenew
lines of products made available in response to the financial turmoil. Special sections have been
included to explain how the new methods of syndication (club deals) work and why the crisis has
forced banks to propose new ways to amortize long-term loans (mini perm structures) to project
sponsors.Furthermore,carefulattentionhasbeendedicatedtoprojectbonds.Curiously,althoughthe
market for these instruments has almost evaporated after the defaults and downgrades of the mono-
liners,theEuropeanmarketisnowexperiencingarevivedinterestinthistypeoffinancing,whichis
seenbytheEuropeanUnionasapossiblesolutiontothedownwardtrendinbankloansdedicatedto
infrastructures. The 2020 EuropeanUnion ProjectBond initiativeisdiscussed indetail.
Chapter 8 includes a new section dedicated to how the Basel Capital Regulations have been
modified in response to the crisis (Basel III) and how the changes have affected the project finance
market.Furthermore,acompletelynewsectionisdedicatedtoareviewoftheperformanceofproject
finance loans in terms of probability of default and loss given default from a long-term perspective.
Overall,thedataindicatethatprojectfinanceisaresilientassetclasseveninperiodofseverefinancial
stress, much more resilientthan othertraditional loans.
Thesecond edition also includesnewcase studies.
Thefirst,CaseStudy3(QuezonPowerLtd),referstoaverylargepowergenerationinfrastructure
located in the Philippine Islands and focuses on the application of risk analysis/risk management
techniques and how a change in the soundness of the SPV’s key counterparts can affect its cost of
funding. The second new case study, Case Study 4 (Milan Metro Line 5), focuses on transportation
infrastructures,inparticulartheexpansionoftheundergroundmetropolitanrailwaynetworkinMilan.
Itisusefultoanalyzehowtheconcessionagreementcanbesetupinordertosharerisksinafairway
between the awarding public authorityand the private sponsors.
At the end of this long period of manuscript revision, let me express my renewed thanks to my
contributorsinthisvolume:AlessandroSteffanoniandDanieleCorbino(forthereleaseoftheExcel
file supporting the Italy Water Case), Massimo Novo (for Chapter 7), Sarah De Rocco, Fabio Lan-
driscina, and Mark Pollard (for the insurance section in Chapter 4). Thanks also to Scott Bentley,
KathiePaoniandAndreCuelloatElsevierfortheprecisesupportandusefulsuggestionsthroughout
the preparation ofthe new edition.
Let me thank also the colleagues who in several occasions have shared with me ideas and
comments on my research work: Veronica Bonetti, Simone Mauro, Andrea Sironi, Francesco Saita,
AlvaroRigamonti,MauroSenati,GiancarloForestieri,Emilia Garcia-Appendini,Andrea Resti, Ben
Esty, Bill Megginson and Dario Scannapieco (who were so kind to take the time to write the
Preface to the Second Edition xvii
presentation),StefanieKleimeier,MarcoSorge,BlaiseGadanecz,IanCooper,MichelHabib,Robert
Hauswald, Yener Altunbas, Frederic Blanc Brude, Timo Valila, Stefano Caselli, Paolo Colla,
Giacomo Nocera, Sergio Ferraris, Marco Percoco, Veronica Vecchi, Mark Hellowell, and Issam
Hallak. A special thanks to Gimede Gigante for excellent research assistance and help in updating
most of the data in Chapters 2 and 6.
Itriedtoputeverypossibleeffortintopreparingthisnew,updated,andexpandededition.Myhope
istohavepreparedabookthatisattheforefrontofknowledgeonprojectandinfrastructurefinancing
and that is a useful tool for academics, practitioners, and students in their day-to-day work in this
fascinating field of finance.
Stefano Gatti
Milan,July2012
Contents
Preface tothe Second Edition.............................................................................................................xv
Preface tothe FirstEdition................................................................................................................xix
Scannapieco’s Foreword...................................................................................................................xxiii
Foreword............................................................................................................................................xxv
Aboutthe Author and the Contributors...........................................................................................xxix
CHAPTER 1 Introduction to the Theory and Practice of Project Finance............1
Introduction................................................................................................................1
1.1 What Is Project Finance?...........................................................................................1
1.2 Why DoSponsors Use Project Finance?..................................................................2
1.3 Who Are the Sponsorsof aProject Finance Deal?..................................................4
1.3.1 Industrial Sponsors inProject FinanceInitiativesLinked
toaCoreBusiness...........................................................................................4
1.3.2 PublicSponsors with Social Welfare Goals....................................................4
1.3.3 Contractor/SponsorsWho Develop, Build, or Run the Plant.........................8
1.3.4 Financial Investors...........................................................................................9
1.4 Overview ofthe Features ofProject Finance..........................................................11
1.4.1 TheContractor andthe TurnkeyConstructionContract (TKCC)................12
1.4.2 Operationsand Maintenance Contractor and the O&M Agreement............12
1.4.3 Purchasersand Sales Agreements.................................................................13
1.4.4 Suppliers and RawMaterial Supply Agreements (RMSAs)........................13
1.4.5 Project Financeas aRisk Management Technique......................................13
1.5 TheTheory ofProject Finance................................................................................14
1.5.1 Separate Incorporation and Avoidanceof Contamination Risk...................15
1.5.2 Conflicts ofInterestbetweenSponsors andLenders
andWealthExpropriation..............................................................................19
1.5.3 Project Financeinthe Academic Literature.................................................21
CHAPTER 2 The Market for Project Finance: Applications and Sectors...........27
Introduction..............................................................................................................27
2.1 Historical EvolutionofProject Finance andMarket Segments.............................27
2.2 TheGlobal Project Finance Market........................................................................29
2.3 TheEvolutionofthe PPPMarket...........................................................................34
2.3.1 TheEuropean Market....................................................................................37
CHAPTER 3 Project Characteristics, Risk Analysis, and Risk Management......43
Introduction..............................................................................................................43
3.1 Identifying Project Risks.........................................................................................45
3.1.1 PrecompletionPhase Risks............................................................................45
3.1.1.1 ActivityPlanningRisk...................................................................................45
3.1.1.2 TechnologicalRisk........................................................................................46
v
vi Contents
3.1.1.3 ConstructionRiskorCompletionRisk.........................................................46
3.1.2 Postcompletion Phase Risks..........................................................................47
3.1.3 Risks Foundin Boththe Pre- andPostcompletion Phases...........................47
3.1.3.1 InterestRateRisk..........................................................................................48
3.1.3.2 ExchangeRateRisk.......................................................................................49
3.1.3.3 DerivativesContractsforManagingInterestRateRisk
andExchangeRisk........................................................................................49
3.1.3.4 InflationRisk.................................................................................................52
3.1.3.5 EnvironmentalRisk.......................................................................................54
3.1.3.6 RegulatoryRisk.............................................................................................55
3.1.3.7 PoliticalRiskandCountryRisk....................................................................55
3.1.3.8 LegalRisk......................................................................................................56
3.1.3.9 CreditRiskorCounterpartyRisk..................................................................57
3.2 Risk Allocationwith Contracts Stipulated by the SPV..........................................57
3.2.1 AllocationofConstruction Risk: The Turnkey(or Engineering,
Procurement, and Construction[EPC]) Agreement......................................58
3.2.2 AllocationofSupply Risk: Put-or-PayAgreements.....................................60
3.2.3 AllocationofOperational Risk: Operationsand
Maintenance (O&M)Agreements.................................................................61
3.2.4 AllocationofMarket Risk.............................................................................62
3.2.4.1 OfftakeAgreements.......................................................................................64
3.2.4.2 OfftakeContractsinthePowerSector..........................................................64
3.2.4.3 OfftakeAgreementsinPPPInitiatives..........................................................71
3.3 Summary of the Risk Management Process...........................................................75
CHAPTER 4 The Role of Advisors in a Project Finance Deal...........................77
Introduction..............................................................................................................77
4.1 TheRole ofLegalAdvisors inProject Finance Deals...........................................78
4.1.1 LegalAdvisor, LegalAdvisors, and LawFirms: International
andLocal LegalCounsel...............................................................................79
4.1.2 Project Financing DevelopmentStagesand Impacts on
the Role ofLegalAdvisors...........................................................................81
4.1.2.1 FormingtheGroupofSponsors....................................................................81
4.1.2.2 IndustrialDevelopmentoftheProjectdTheProjectDocuments................83
4.1.2.3 ProjectFinancingdTheFinanceDocuments...............................................85
4.1.2.4 TheDueDiligenceLegalReport..................................................................86
4.1.2.5 LegalOpinions...............................................................................................87
4.1.2.6 SyndicatingtheFinancing.............................................................................88
4.1.2.7 TheOperatingPeriod:MaintenanceoftheProjectFinancing.....................89
4.2 TheRole ofthe Independent EngineerinProject FinanceDeals..........................89
4.2.1 Initial Due Diligence Reporting....................................................................90
4.2.1.1 DocumentsRequiredfortheDueDiligenceActivity..................................91
4.2.1.2 AccessoryServices........................................................................................92
4.2.1.3 DocumentsProducedduringtheDueDiligenceActivityPhase..................92
Contents vii
4.2.2 Monitoring Realizationof the Project (Engineering andConstruction)......92
4.2.2.1 MonitoringConstructionoftheWorks.........................................................93
4.2.2.2 IssuingProgressReports...............................................................................95
4.2.2.3 ValidationofMechanicalCompletion(WorksCompletionCertificate)......96
4.2.3 Assistanceat the Time ofPlant Acceptance.................................................97
4.2.3.1 ValidationoftheProvisionalAcceptanceCertificate(PAC)........................98
4.2.3.2 MonitoringtheTestingPhase........................................................................99
4.2.3.3 ValidationoftheFinalAcceptanceCertificate(FAC)................................101
4.2.4 Monitoring OperationsManagement..........................................................102
4.3 TheRole ofInsurance Advisors and InsuranceCompanies inProject
FinanceDeals.........................................................................................................103
4.3.1 Rationale for Using Insurancein Project FinanceDeals............................104
4.3.2 When Should InsuranceProductsBe Used?...............................................105
4.3.3 Areas Wherethe Insurance Advisor Is Involved........................................106
4.3.3.1 PreliminaryInsuranceReportPhase...........................................................106
4.3.3.2 FinalInsuranceReportPhasedConstructionPhase...................................106
4.3.3.3 FinalInsuranceReportPhasedOperationsPhase......................................107
4.3.3.4 TheMostProblematicAreas.......................................................................107
4.3.4 Types of Conventionaland FinancialInsurance Products
Available for Project FinanceDeals............................................................108
4.3.4.1 InsuranceCoverageduringtheConstructionPhase...................................109
4.3.4.2 InsuranceCoverageduringtheOperationsPhase......................................111
4.3.4.3 Bonding........................................................................................................111
4.3.5 IntegratedInsuranceSolutionsdStructureand Content.............................112
4.3.6 Classificationof InsuranceUnderwriters....................................................113
CHAPTER 5 Valuing the Project and Project Cash Flow Analysis .................. 117
Introduction............................................................................................................117
5.1 Analysis of Operating CashFlows andTheir BehaviorinDifferent
Project Life Cycle Phases......................................................................................118
5.1.1 Inputsfor CalculatingCashFlows..............................................................121
5.1.1.1 TheTimingoftheInvestment.....................................................................121
5.1.1.2 InitialInvestmentCost.................................................................................123
5.1.1.3 VATdValue-AddedTax..............................................................................125
5.1.1.4 PublicGrants...............................................................................................126
5.1.1.5 AnalysisoftheSalesContract,theSupplyContract,
andOperatingExpenses..............................................................................129
5.1.1.6 TrendsinWorkingCapital..........................................................................131
5.1.1.7 Taxes............................................................................................................135
5.1.1.8 MacroeconomicVariables...........................................................................135
5.2 Definingthe Optimal Capital Structure for the Deal............................................136
5.2.1 Equity...........................................................................................................138
5.2.2 Senior Debt..................................................................................................139
5.2.3 VAT Facility.................................................................................................142
viii Contents
5.2.4 Stand-by Facility..........................................................................................143
5.2.5 Identifying Sustainable Debt/EquityMixesfor Sponsors andLenders.....144
5.2.5.1 OptimalCapitalStructureforProjectSponsors.........................................144
5.2.5.2 OptimalCapitalStructureforLenders........................................................147
5.3 CoverRatios...........................................................................................................152
5.3.1 What CoverRatios Can Tell Us andWhat TheyCannot...........................154
5.3.1.1 DebtServiceCoverRatio(DSCR).............................................................154
5.3.1.2 LoanLifeCoverRatio(LLCR)..................................................................156
5.3.2 CoverRatios asan Applicationofthe Certainty Equivalents
Method.........................................................................................................159
5.4 Sensitivity Analysis and Scenario Analysis..........................................................160
5.4.1 Which VariablesShould Be Tested inSensitivity Analysis?.....................162
CHAPTER 6 Financing the Deal .................................................................. 167
Introduction............................................................................................................167
6.1 Advisory and Arranging Activities for Project FinanceFunding........................167
6.1.1 Advisory Services.......................................................................................169
6.1.2 ArrangingServices.....................................................................................173
6.1.3 Integrationof Advisoryand ArrangingServices.......................................174
6.2 Other Roles inSyndicated Loans.........................................................................180
6.2.1 Single-stage Syndication, Two-stage Syndication, andClub Deals..........181
6.3 FeeStructure.........................................................................................................183
6.3.1 Fees for Advisory Services.........................................................................183
6.3.2 Fees for Arranging Services.......................................................................184
6.3.3 Fees to Participants and the Agent Bank...................................................184
6.3.4 Example ofFee Calculation.......................................................................186
6.4 International Financial Institutionsand Multilateral Banks................................188
6.4.1 Multilateral Organizations..........................................................................190
6.4.1.1 WorldBankGroup.....................................................................................191
6.4.2 RegionalDevelopmentBanks....................................................................197
6.4.2.1 EuropeanInvestmentBank(EIB)..............................................................198
6.4.2.2 AfDB(AfricanDevelopmentBank)..........................................................199
6.4.2.3 IDB(IslamicDevelopmentBank)..............................................................201
6.4.2.4 ADB(AsianDevelopmentBank)..............................................................202
6.4.2.5 EuropeanBankforReconstructionandDevelopment(EBRD)................203
6.4.2.6 Inter-AmericanDevelopmentBank(IADB)..............................................204
6.5 Bilateral Agencies: DevelopmentalAgencies andExportCredit
Agencies (ECAs)..................................................................................................204
6.5.1 DevelopmentalAgencies............................................................................204
6.5.2 Export Credit Agencies(ECAs).................................................................206
6.5.2.1 FinancingActivity......................................................................................207
6.5.2.2 InsuranceActivity.......................................................................................208
6.6 Other Financial Intermediaries InvolvedinProject Finance...............................212
6.7 Funding Options: Equity......................................................................................217
Contents ix
6.7.1 Timing of the Equity Contribution and Stand-by Equity
and Equity Acceleration............................................................................217
6.7.2 Can Sharesin anSPV Be Listed ona Stock Exchange?.........................219
6.8 Funding Options: Mezzanine Financing andSubordinated Debt.......................219
6.9 Funding Options: SeniorDebt.............................................................................229
6.9.1 The Base Facility.......................................................................................229
6.9.2 WorkingCapital Facility...........................................................................229
6.9.3 Stand-byFacility.......................................................................................230
6.9.4 VAT Facility...............................................................................................230
6.9.5 Loan Remuneration...................................................................................230
6.9.6 Loan Currency...........................................................................................231
6.9.7 Repayment Options...................................................................................231
6.9.8 Refinancing Loans Already Granted tothe SPV......................................238
6.9.8.1 SoftRefinancing(Waiver).........................................................................238
6.9.8.2 HardRefinancing.......................................................................................239
6.10 Project Leasing....................................................................................................242
6.10.1 Valuing the Convenienceofa Project Leasing.......................................243
6.10.2 The Tax Effect.........................................................................................245
6.11 Project Bonds.......................................................................................................246
6.11.1 InvestorsinProject Bonds.......................................................................248
6.11.2 Various Categoriesof Project Bonds......................................................249
6.11.2.1 NationalityoftheIssuerinTermsofIssueCurrency
forSecuritiesandPlacementMarket...................................................249
6.11.2.2 TargetInvestors.....................................................................................250
6.11.2.3 CapitalandInterestPaymentGuarantees.............................................251
6.11.2.4 SubordinationClauses...........................................................................252
6.11.2.5 InterestCalculationMethod.................................................................252
6.11.2.6 CapitalRepaymentMethod..................................................................252
6.11.3 Municipal Bonds.....................................................................................253
6.11.4 When Should Project BondsBe Used?..................................................254
6.11.4.1 InvestorTarget.......................................................................................255
6.11.4.2 TenorofFinancing................................................................................255
6.11.4.3 PreservationoftheSponsors’FinancialFlexibility.............................255
6.11.4.4 Inflation-LinkedBonds.........................................................................256
6.11.4.5 StructureforUtilizationandRepaymentofFunding..........................256
6.11.4.6 CreditPoliciesandMarketSentiment..................................................256
6.11.4.7 FixingtheFinancingTermsandConditions........................................257
6.11.4.8 Confidentiality.......................................................................................257
6.11.4.9 CovenantsandMonitoringManagementoftheProject......................257
6.11.4.10 RenegotiationofContractualConditionsandRefinancing................258
6.11.5 Procedurefor Issuing Project Bonds.......................................................258
6.11.5.1 RatingAgencies....................................................................................259
6.11.5.2 BondPayingAgentandTrustee...........................................................262
6.11.5.3 ChoiceoftheProjectBondBookrunner..............................................263