Project Finance

Project Finance


It is a wide context exists behind the project finance which includes the concept by which the financing for building up of infrastructure and industrial projects has been done. It includes the sources of funds that bring by project sponsors as equity, project lenders syndicate of banks those provide loans to the project company. This has been defined by, Vinter as “ ...Financing the development or exploitation of a right, natural resource or other asset where the bulk of financing is not to be provided by any form of share capital and is to be repaid principally out of the revenues provided by the project”.[1] Under project finance, banks provide finance for a single project or for a particular economic unit and take a large part of risk of the success or failure of that project , they are the lenders and the project sponsors act as borrowers and formed a project company which is called a special purpose vehicle for the construction of the particular economic unit, that company mainly made for the definite purpose of building up of infrastructure unit where the bulk of financing bring in, by the lenders to the project or by syndicate loans in which group of lenders arranged or structured that loan by the administration whether of commercial bank or investment bank which are known as arrangers. Project may be an Oil & Gas field; a mine; telephone or cable network; a toll tunnel; bridge on highway; a refinery; power station or pipeline; office or shops.

According to the, Willie Tan, “...Project finance is a form of financing a capital intensive project (such as an infrastructure project) on non-recourse or limited recourse basis through a special project vehicle (SVP).”[2] The recourse for lenders is largely the revenues generated by the project for loan repayment with project assets as collateral .The limited recourse feature of project financing more attractive to sponsors because it is off-balance sheet. As the risky nature of non-recourse finance, lenders require some form of contingent financial support from sponsors over and above their equity shares and third party guarantee. The government may be called to guarantee repayment and for providing limited contingency support, if the borrower is a local public agency. In the circumstances if the project is delayed and required additional funds. In many cases, equity from a sponsor or a few sponsors is insufficient because of large investment and desire not make, SPV a failure. Hence, the equity must be supplemented by funds from other equity investors. On the debt side, lending is often syndicated under a lead bank or arranger to pool the funds and spread the risk among a few lenders. To attract more funds from other investors issuing of local, regional or global bonds possible when project is near completion. At the completion of the project, the permanent lender (such as mutual fund, real state, investment trust, or insurance company) obtain construction loan from syndicate of construction lenders. This is the form of financing has been arranged which looks complicated. But, without this form of financing to pool recourses and share the risk, many projects may never have gotten off the ground.

If we look at the history of project finance, it has a long dating back to Greek and Roman times and has supported many of the major industrial construction success of the 19th and 20th centuries. Many of the achievements of the industrial revolution, Victorian age and the post war period may not have been possible without recourse to specialist financing. The use of project finance in developing countries diminished after the Asian crisis in the late 1990's.However, although its use subsequently peaked in 2000 with recovery in emerging and industrialised countries.[3]

So, the project financing, by setting up of SPV' special purpose vehicle ‘ which is particularly called a project company whose main purpose is to facilitate a purposed project by sponsors in which those financings are designed to avoid uncertainties, in terms of the risk allocated with project, which can lead to project failure if the risk cannot be resolved. That is why project finance has structured in sense that the risk could be minimised. For example:- The construction contract between the project company and the contractor is the basis to provide a complete construction work on the prices which were agreed between the contractor and the company and on a confirm date should deliver the project. But, there is a risk whether the work completes on time or not even the contractor also uncertain about the future complexities that would come in and delayed the project. For avoiding these consequences project company, gives attractive premium for bearing that risk to the contractor because contractor is the only one who can judge those risks and avoid them by itself and complete the project on-time. In doing so the amount of contract must be good enough to satisfy the contractor and risk premium would be good. Project Company by doing that avoid the risk of increased debt and equity, if there is delay of the construction work of the project. So, by giving reward to the contractor the project company achieves the profitability in the construction work of the project and project would be completed on time. This is called structured project financing. In which the project sponsor assumes some uncertainty in the project in return for a reduction in risk premium otherwise payable to various contracting parties. The financing is not without recourse to the project sponsor, however, because the lender will require that the risk not allocated to various project contracting parties, such as fuel supplier, be retained by the project sponsor. The structured project finance technique requires that the project sponsor has the asset to infuse additional capital or debt into the project company if necessary.[4] Those things have to be considered after the feasibility study which says;

Feasibility study comes after, the sponsors presents the proposed project and structure of their proposed project, for the arrangements of funds before the lenders. And the feasibility consultants, done their study to see whether the project being capable of lending or not as the general source of debt comes from the cash flow of the project performance.

2-First Step in Project Financing: The Feasibility Study.

In project financing, before the structuring of the major project the feasibility study of the project has to be done, which is related to the future performance of the project, that is, the study have to be carried out by consultants. That study reveals about how the project performed during its construction period from the starting and till the end. Does it be able to covered the debt at its completion, does the lender fully paid and what were the risk during the project work and how the has to be allocated between the parties relating to the project or the contractors of the project and sub contractors. There would have to be a proper risk management and risk sharing approach. Mainly the feasibility study has to done in order to judge the financial viability of the project or it is done before the lenders provide huge funds to the project company. This study is the analysis of every technical and financial aspect of the project and various phases in the project development and feasibility study shows the time frame for the completion of the various phases of the project development. It includes the description of the project which means the nature of the project in relation to what sort of project it is, and the description of the sponsor(s) and the formation of the project company called SPV (special purpose vehicle) which is carrying the activities that are involved in a particular project or we can called SPV is the centre of all the parties relating to the project. Or it is the main transporter of the project; it is formed as a company. Another comes the project site in the feasibility study, where the project is located, would it be possible for the construction site to avail the required definite resources for the construction work, like the availability of water and power, which should be available near the project site. Another part come the government arrangements in relation to its policies with respect to the industry. Then, there comes the sources of funds which are generally from the bank, investors, and other lending institution etc. The next item is feed stoke agreement between a feed stoke supplier and the project company for the supply of the feed stoke, energy, raw material, other resources to the project for example the: in power plant project supplier will supply fuel and in paper mill project, wood pulp and off take agreement which is an agreement between the licenser and the developer providing for a calculation to determine payment against supply. Then there comes a construction contract which determines the contract between the project company and the contractor for construction work in the project. Another part of the feasibility study is the management of the project where it means that the management of the company comprises of managers, directors, employees, subordinates etc all together performing their work for the project company which is solely made for carrying out project work. After that there comes the market analysis which has to be covered to help in establishing and determining economic levels of output and plant size. After that there comes a presentation of financial data or financial projections which covers preliminary estimates of sales revenue, capital costs and operating costs for different alternatives along with their profitability. Feasibility study should present estimates of the working capital requirements to operate the unit at a viable level. So that viability of the project is maintained and important part of the feasibility study is that, the project sponsors should be able to know the required and necessary amount of expenditure needed during construction.[5]

First of all it is important to understand what is the purpose of project financing , what it facilitate , what is the serves to the government of the country in which project has been taking place in terms of government objectives, the sponsors objective and the lenders objectives.

3-Government's objective

The government's objective is in the public interest, when it allow the private sector to develop a project (whether or not in conjunction with it) it will have concerns or objective to satisfy national interest and have the project completed to its specification on time, to bring back the project into its ownership after the project has been completed by the private sector sponsor under the public-private partnership. Typically a joint venture consortium has been made in which there are private sponsor who facilitate the certain project. Under the BOT (build operate transfer) project finance model. In which concession is granted to the concession holder who is required to build the relevant project facilities or piece of infrastructure, operate them for a fixed period and, at the end of such period, transfer them back to the person who originally granted the concession. Therefore those types of project have definite life and as a part of the skill when the project are put out to tender is to put together a financing package which will insure that the lenders get repaid and the shareholders get a sufficient return on their investment before the concession terminates.

The other objectives is to have adequate safeguards and assurances that the project will be operated properly and in the public interest, to reduce or eliminate the need to use the government's own funds or borrowings although in certain type of projects government provide subsidy in order to make the project viable. To limit undertakings given by the state but in certain type of projects it is essential e.g. to construct roads to a new airport. Another aspect of government is to transfer the ownership of the project to the other private sector entities if the original private sector sponsor failed to provide required level of service or run into financial difficulties. Or, to regain the control of the project into public ownership if the private sponsors completely failed or run into financial problems or difficulties.

4-The Private Sector Sponsors

Those were the parties who were sponsoring the project and their role should be to make the project viable to earn profits out of it by completing the project on time. It's not absolutely certain that the project completed without having any risk in it, project sponsors have to make a strategic approach to share the risk during the construction of the project and the burden of risk is distributed among, the banks funded the project, the contractors, suppliers, off-taker, host government.[6] To carry out a project “off balance sheet”, typically it refers to separate legal entities (separate companies of which parent holds less than 100% ownership) those entities were created to carry out project without having showing any borrowings from the lenders and financers of the parent company and the debts of the project.[7]

Those private entities were mainly subsidiaries of the big company. It is most favourable to form a subsidiary or a special purpose vehicle by sponsor to carry out project. Because, it is easy to raise funds in the capital market for those subsidiaries as the investors were looking to invest in those particular type of subsidiary. But these off balance sheet financing could become a nightmare for the shareholders and lenders. As those, subsidiaries were made for earning wrongly not for the definite purpose of doing business. Because of that off balance sheet financing method those debt generally can't be seen on the accounts of those subsidiary companies and the parent company keep going on increasing funds from the capital market and the shares price is increasing. For ex.: Collapse of Enron, which was a very big, U.S. established company and because of scandal it felled to ground. Enron established over 2000 subsidiary. And it was also financing many big projects in various countries including Dabhol power company based in India which is formed to manage the Dabhol power plant by Enron international in corporation with Bechtel corporation and General electrical. Due to the political reasons project was failed.[8] But Enron's directors were liable for its collapse and the accounting board who unseen the accounts of the company and the debts which were getting higher and higher, they were just want to earn big money by wrong way and forged with the trust of shareholders and ultimately the result of their fraud and forged ways the company's landed in crash to the ground and making the economy down, downfall of the Enron result's in big economic crisis and affect the whole world. That's why off balance sheet financing called to be curse for the shareholders and lenders at that time, as the misuse of it result in the big economic problems of that era. It could be said that often “off balance sheet” financing used in wrong way which is unfavourable for the risk bearers: shareholders and lenders, but the off balance sheet is effective and its advantage can still be achieved with a project company which is a true joint venture.

5-The Lenders

There are various types of lenders in a project. Construction lenders often comprise a syndicate of banks that provides short-term construction and land loans for commercial projects or long term loans for infrastructure projects. International agencies such as the World Bank, International Finance Corporation (IFC), European Investment Bank, and Asian development Bank (ADB) are often construction lenders in infrastructure projects. Permanent lenders are required in commercial property projects to “take-out” the short-term loan from the construction lender. The Permanent lender may comprise institutional investors such as Real Estate Investment Trusts (REITs) and insurance companies.[9] These were the main finance provider in any big infrastructure project and their objective lies behind the risk they were taking in financing a project. As there were various risk involved in project and the bank also averse of that risk but only be able to assume measurable risk or measured risk by allocating various project risk analyst, bank provide loans to the project and taking a greater part in the risk of the project construction and its completion that's why bank should have its own objectives including earning profits from the project. As the bank is the main participant in project financing so it wanted to have control over the decisions of the project because they are funding greater part of project's cost.

Now from the discussion above we have come across various aspects of project financing including its meaning, First step in project financing, objectives of various project relating parties including Government, Sponsors and Lenders. Those were the parties which serve as the basis of project finance structuring. There were different type of structure used for main infrastructural projects including power projects and airport project. In this piece of work by discussing various elements that were originally used in financing power projects with the contrast of studying power project of Enron International, in India. The elements of its structuring, financing, risk segmentation, jurisdiction, contracts and causes of its failure. As have to be discussed and then go on the conclusion.

6-Project Financing Structure For Power Projects.

Enron was the biggest U.S. based company which has different financing activities in all the parts of the world as it was bigger equity investor of the mid nineties and the company going on expanding. It facilitates financing of projects in different parts of the world. It facilitates the power project in India in the year 1995, Maharashtra. By establishing Dabhol power company which is an subsidiary of Enron international for the generation of electricity and the purchaser of that electricity is Maharashtra state electricity board. With the combined effort of General electric company which provided the generating turbines and Bechtel Corporation which constructed physical plant, U.S. based companies. As it could be understood easily by power project financing structure below.

Here, above is the project financing structure for the power project and in contrast with the Dabhol power company it has to be understood. In that structure it could easily be seen that the Concessionaire consortium is formed which is financed through the sponsors who provide equity into the project company which is provided by the Enron international. As the domestic capital market was weak, that's why this subsidiary DPC is an unlimited liability Special purpose company (SPC) to domicile the project. Enron development corp., Bechtel enterprises inc. And GE capital which has signed a long term power purchase agreement (PPA) with the MSEB, a state owned enterprise. So it could be seen that Dabhol power company is an independent power producer or subsidiary of Enron international. And the off take purchaser of the electricity is (MSEB) which is state owned enterprise. It could be seen that the source of finance is from the equity investors of Enron international who were equity investors along with GE and Bechtel and in a company called Dabhol power company in Maharashtra state of India. These three group controlled DPC through chain of companies based in Mauritius in which 80 % of shares held by Enron whereas Bechtel and GE held 10% of shares in company DPC.[11] DPC & MSEB who has a power purchase agreement (PPA). The PPA defines respective roles and obligations of DPC and MSEB under the tariff structure. The project has to be completed in two phase, phase 1 was ready by 1999 at a total cost of USD1.1 billion.

6.1- Lenders to DPC.

Sources of funds available to the DPC include Bank Lending, Institutional Lenders, Export Credit agencies, International agencies.

Lenders to DPC include Foreign lenders- ABN AMRO, Standard Chartered, BNP Paribas, Calyon, CSFB, etc. This has approximate stake of USD 325 million.

It also include domestic lenders- the largest being IDBI, ICICI, SBI, Canara Bank and IFCI, this has approximate of Rs. 62 billion.

There were Export credit agencies JBIC, US EXIM, Belgium OND. with approximate stake of USD 480 million. Multinational export credit financing has become increasingly common but requires considerable coordination and extensive discussions with the various agencies involved. The type of credit can be supplier, buyer, or a specific credit with governmental participation. In some countries, e.g., the U.K. export credit involve, financing by banks with insurance provided by the export credit agency. In other, e.g. U.S. (Eximbank) and Australia (EFIC) Japan Exim this is either supplemented or substituted by direct lendings by the export credit agency involved. As in the case of DPC this is involved.

Sources of funds also from the investment company called Overseas private investment company (OPIC), USA which has approximate stake of USD 250 million.[12]

6.2-The Contractual Framework

The contractual framework consist of power purchase agreement, EPC contract, O&M contract, Gas supply agreement, Government Guarantees, Loan agreements.

6.2.A- Power purchase agreement.

The salient features of this agreement which is signed between DPC (Dabhol power company) and MSEB (Maharashtra state electricity board) are that DPC has the responsibility of designing, construction, maintenance of the power plant. DPC has construction contracts for the construction of the power plant and the designing of the construction work as well as the turnkey contracts with the contractor, in which risk is determined previously by the contractor in exchange of rewards by the company. For the supply of fuel to the power plant DPC entered into fuel supply contract with the supplier in consultation with the MSEB. The land for the construction of the power station, power to the plant, communication, water and the roads on the construction site were to be provided by MSEB and Government of Maharashtra (GOM). Transmission lines were to be build by the MSEB from the power station to MSEB grid. Power plant was to be available for the production of commercial power within 33 months otherwise if the project is delayed then DPC has to pay 14000 U.S. dollar per day to MSEB as penalties. As MSEB had to build the transmission lines, if it failed to do so then also there was an obligation to pay the decided payments of the generated electricity to the power company. Often the electricity could not be transmitted in the lines. And under those circumstances the construction cost will increased, for recovering the increased cost in construction delay the power tariff had to be adjusted.

6.2.B- EPC Contract.

The EPC (Engineering, procurement, and construction contract) contract combines the three stages of construction under one contract. It is sometimes called fast-track contract, in that it enables progress on a project to proceed on an overlapping basis, at a faster pace than if the three stages followed in series. There is an EPC contract between the DPC and the consortium of Bechtel and GE. According to this EPC contract the DPC and the consortium had to complete the project on time and deliver the project within definite period.

6.2.C- O&M Contract.

The operation and maintenance contract the Dabhol power company and the consortium of Bechtel and GE, was with the Alstom power company which acted as the facility operator then, who specifies the responsibilities of the operator (including staffing), takeover procedures from the contractor, the period of operation, the maintenance and repairs required, and fees.

6.2.D- Gas Supply Agreement.

It was also an important contract between the Oman gas company and the Dabhol power company for the supply of Gas to the plant.

6.2.E- Government Guarantees.

it may be called as sovereign guarantee which has required where the purchaser of the project output is a state agency. As in case of DPC, MSEB was government's agency that' why Government of Maharashtra has guaranteed duty of MSEB under the Power purchase agreement with the DPC, which has to be completed in two phase, that's why GOM has guaranteed for both the phases. Or in that case of DPC the Government of India has counter guaranteed the Government of Maharashtra guarantee for the first phase of construction period or completion. Because of the involvement of the international lending agencies the World Bank requires the counter guarantees from the sovereign to guarantee the state agency.

6.2.F- Loan Agreement.

[1] Graham D. Vinter, Project Finance( 2nd edn Sweet & Maxwell, London 1998) XXXI.

[2] Willie Tan, Principles of Project and Infrastructure Finance (1ST edn Taylor and Francis, Oxford 2007) 2.

[3] Willie Tan, Principles of Project and Infrastructure Finance (1ST edn Taylor and Francis, Oxford 2007) 3.

[4] Scott L. Hoffman, The Law and Business of International Project Finance ( 3rd edn CUP, Cambridge2008) 6.

[5] Introduction to Project Finance-A Guide for Contractors and Engineers accessed 22 March 2010.

[6] Graham D. Vinter, Project Finance (2nd edn Sweet & Maxwell, London 1998) 3.

[7] Rick Wayman, ‘'Off-Balance Sheet Entities'' accessed 31st March 2010.

[8] Scott L. Hoffman, The Law and Business of International Project Finance.( 3rd edn CUP, Cambridge2008) 23.

[9] Joseph Tanega, International Project Finance( 1st edn, Butterworths, London 2000) P.29

[10] Figure,‘'Project financing structure'' , accessed 1st April 2010.

[11]Tony Allison, ‘'Enron's eight year struggle in India'', accessed 2nd April 2010.

[12] ‘ Case study: Dabhol power company limited' accessed 2nd April 2010.

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