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Project Finance in Theory and Practice

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Project Finance in Theory and Practice Project Finance in Theory and Practice This page intentionally left blank Project Finance in Theory and Practice Designing, Structuring, and Financing Private and Public Projects Stefano Gatti AMSTERDAM • BOSTON • HEIDELBERG • LONDON NEW YORK • OXFORD • PARIS • SAN DIEGO SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO Academic Press is an imprint of Elsevier Academic Press is an imprint of Elsevier 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA 525 B Street, Suite 1900, San Diego, California 92101-4495, USA 84 Theobald’s Road, London WCIX 8RR, UK This book is printed on acid-free paper. Copyright ß 2008, Elsevier Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher. Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone: (+44) 1865 843830, fax: (+44) 1865 853333, E-mail: [email protected]. You may also complete your request on-line via the Elsevier homepage (http://elsevier.com), by selecting ‘‘Support & Contact’’ then ‘‘Copyright and Permission’’ and then ‘‘Obtaining Permissions.’’ Library of Congress Cataloging-in-Publication Data Application Submitted British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN 13: 978-0-12-373699-4 For information on all Academic Press publications visit our Web site at www.books.elsevier.com Printed in the United States of America 07080910987654321 Abbreviated Contents Foreword by William L. Megginson xiii Preface xvii Acknowledgments xix About the Author xxi Chapter 1 Introduction to the Theory and Practice of Project Finance 1 Chapter 2 The Market for Project Finance: Applications and Sectors 19 Chapter 3 Project Characteristics, Risk Analysis, and Risk Management 31 Chapter 4 The Role of Advisors in a Project Finance Deal 63 Chapter 5 Valuing the Project and Project Cash Flow Analysis 101 Chapter 6 Financing the Deal 147 Chapter 7 Legal Aspects of Project Finance 233 Chapter 8 Credit Risk in Project Finance Transactions and the New Basel Capital Accord 289 v vi ABBREVIATED CONTENTS Case Studies Case Study 1 Cogeneration 323 Case Study 2 Italy Water System 331 Appendix to Case Study 2: Structure and Functioning of the Simulation Model 341 Case Study 3 Hong Kong Disneyland Project Loan 359 Glossary and Abbreviations 379 References 395 Index 401 Contents Foreword by William L. Megginson xiii Preface xvii Acknowledgments xix About the Author xxi Chapter 1 Introduction to the Theory and Practice of Project Finance 1 Introduction 1 1.1 What Is Project Finance? 2 1.2 Why Do Sponsors Use Project Finance? 2 1.3 Who Are the Sponsors of a Project Finance Deal? 4 1.3.1 Industrial Sponsors in Project Finance Initiatives Linked to a Core Business 4 1.3.2 Public Sponsors with Social Welfare Goals 5 1.3.3 Contractor/Sponsors Who Develop, Build, or Run the Plant 6 1.3.4 The ‘‘Purely’’ Financial Investor 7 1.4 Overview of the Features of Project Finance 7 1.4.1 The Contractor and the Turnkey Construction Contract (TKCC) 8 1.4.2 Operations and Maintenance Contractor and the O&M Agreement 9 1.4.3 Purchasers and Sales Agreements 9 1.4.4 Suppliers and Raw Material Supply Agreements (RMSAs) 9 1.4.5 Project Finance as a Risk Management Technique 10 vii viii CONTENTS 1.5 The Theory of Project Finance 10 1.5.1 Separate Incorporation and Avoidance of Contamination Risk 11 1.5.2 ConXicts of Interest Between Sponsors and Lenders and Wealth Expropriation 15 Chapter 2 The Market for Project Finance: Applications and Sectors 19 Introduction 19 2.1 Historical Evolution of Project Finance and Market Segments 19 2.2 The Global Project Finance Market 22 2.2.1 A Closer Look at the European Market 26 2.2.2 PPP Development 27 Chapter 3 Project Characteristics, Risk Analysis, and Risk Management 31 Introduction 31 3.1 Identifying Project Risks 32 3.1.1 Precompletion Phase Risks 33 3.1.2 Postcompletion Phase Risks 35 3.1.3 Risks Found in Both the Pre- and Postcompletion Phases 35 3.2 Risk Allocation with Contracts Stipulated by the SPV 45 3.2.1 Allocation of Construction Risk: The Turnkey (or Engineering, Procurement, and Construction—EPC) Agreement 45 3.2.2 Allocation of Supply Risk: Put-or-Pay Agreements 48 3.2.3 Allocation of Operational Risk: Operations and Maintenance (O&M) Agreements 49 3.2.4 Allocation of Market Risk 49 3.3 Summary of the Risk Management Process 61 Chapter 4 The Role of Advisors in a Project Finance Deal 63 Introduction 63 4.1 The Role of Legal Advisors in Project Finance Deals 64 4.1.1 Legal Advisor, Legal Advisors, and Law Firms: The International Part and Local Legal Counsel 65 4.1.2 Project Financing Development Stages and Impacts on the Role of Legal Advisors 66 4.2 The Role of the Independent Engineer in Project Finance Deals 75 4.2.1 Initial Due Diligence Reporting 76 4.2.2 Monitoring Realization of the Project (Engineering and Construction) 78 CONTENTS ix 4.2.3 Assistance at the Time of Plant Acceptance 83 4.2.4 Monitoring Operations Management 87 4.3 Role of Insurance Advisors and Insurance Companies in Project Finance Deals 88 4.3.1 Rationale for Using Insurance in Project Finance Deals 89 4.3.2 When Should Insurance Products Be Used? 90 4.3.3 Areas Where the Insurance Advisor Is Involved 91 4.3.4 Types of Conventional and Financial Insurance Products Available for Project Finance Deals 93 4.3.5 Integrated Insurance Solutions—Structure and Content 97 4.3.6 Classification of Insurance Underwriters 98 Chapter 5 Valuing the Project and Project Cash Flow Analysis 101 Introduction 101 5.1 Analysis of Operating Cash Flows and Their Behavior in Different Project Life-Cycle Phases 102 5.1.1 Inputs for Calculating Cash Flows 105 5.2 Defining the Optimal Capital Structure for the Deal 116 5.2.1 Equity 118 5.2.2 Senior Debt 119 5.2.3 VAT Facility 121 5.2.4 Stand-by Facility 123 5.2.5 Identifying Sustainable Debt/Equity Mixes for Sponsors and Lenders 124 5.3 Cover Ratios 132 5.3.1 What Cover Ratios Can Tell Us and What They Can’t 134 5.3.2 Cover Ratios as an Application of the Certainty Equivalents Method 139 5.4 Sensitivity Analysis and Scenario Analysis 140 5.4.1 Which Variables Should Be Tested in Sensitivity Analysis? 141 Chapter 6 Financing the Deal 147 Introduction 147 6.1 Advisory and Arranging Activities for Project Finance Funding 147 6.1.1 Advisory Services 149 6.1.2 Arranging Services 152 6.1.3 Integration of Advisory and Arranging Services 153 6.2 Other Roles in Syndicated Loans 157 6.3 Fee Structure 157 6.3.1 Fees for Advisory Services 158 x CONTENTS 6.3.2 Fees for Arranging Services 159 6.3.3 Fees to Participants and the Agent Bank 159 6.3.4 Example of Fee Calculation 160 6.4 International Financial Institutions and Multilateral Banks 162 6.4.1 Multilateral Organizations 164 6.4.2 Regional Development Banks 171 6.5 Bilateral Agencies: Developmental Agencies and Export Credit Agencies (ECAs) 178 6.5.1 Developmental Agencies 178 6.5.2 Export Credit Agencies (ECAs) 179 6.6 Other Financial Intermediaries Involved in Project Finance 183 6.7 Funding Options: Equity 186 6.7.1 Timing of the Equity Contribution and Stand-by Equity and Equity Acceleration 186 6.7.2 Can Shares in an SPV Be Listed on a Stock Exchange? 188 6.8 Funding Options: Mezzanine Financing and Subordinated Debt 188 6.9 Funding Options: Senior Debt 194 6.9.1 The Base Facility 195 6.9.2 Working Capital Facility 195 6.9.3 Stand-by Facility 196 6.9.4 VAT Facility 196 6.9.5 Loan Remuneration 196 6.9.6 Loan Currency 197 6.9.7 Repayment Options 197 6.9.8 Refinancing Loans Already Granted to the SPV 201 6.10 Project Leasing 208 6.10.1 Valuing the Convenience of a Project Leasing 208 6.10.2 The Tax Effect 210 6.11 Project Bonds 211 6.11.1 Investors in Project Bonds 214 6.11.2 Various Categories of Project Bonds 215 6.11.3 Municipal Bonds 219 6.11.4 When Should Project Bonds Be Used? 220 6.11.5 Procedure for Issuing Project Bonds 224 Chapter 7 Legal Aspects of Project Finance 233 Introduction 233 7.1 The Project Company 234 7.1.1 Reasons for Incorporating the Project in a Project Company 235 7.1.2 The Project Company as a Joint Venture: Another Reason to Develop a Project in an SPV 236 CONTENTS xi 7.1.3 The Project Company and Groups of Companies 237 7.1.4 Corporate Documentation: Articles of Incorporation 237 7.1.5 Outsourcing the Corporate Functions of the Project Company: How the Company/Project Is Actually Run 238 7.2 The Contract Structure 239 7.2.1 Before the Financing: The Due Diligence Report and the Term Sheet 239 7.2.2 ClassiWcation of Project Documents 242 7.2.3 The Credit Agreement 243 7.2.4 Security Documents: Security Interests and What They Do 265 7.2.5 Other Finance Documents 274 7.2.6 Project Agreements 278 7.3 Refinancing Project Finance Deals 285 Chapter 8 Credit Risk in Project Finance Transactions and the New Basel Capital Accord 289 Introduction 289 8.1 The Basel Committee’s Position on Structured Finance Transactions (Specialized Lending, SL) 290 8.1.1 Classes of Transactions Included in Specialized Lending 291 8.2 Rating Criteria for Specialized Lending and Their Application to Project Finance 292 8.2.1 Financial Strength 293 8.2.2 Political and Legal Environment 293 8.2.3 Transaction Characteristics 294 8.2.4 Strength of Sponsors 294 8.2.5 Mitigants and Security Package 294 8.2.6 Summary of Grading Criteria 294 8.3 Rating Grade Slotting Criteria of the Basel Committee and Rating Agency Practices 296 8.4 The Basel Accord: Open Issues 297 8.4.1 EVects of the Basel Proposal on the Syndicated Project Finance Loan Market 298 8.5 Introduction to the Concepts of Expected Loss, Unexpected Loss, and Value at Risk 304 8.6 Defining Default for Project Finance Deals 306 8.7 Modeling the Project Cash Flows 308 8.7.1 DeWning a Risk Assessment Model 308 8.7.2 Identifying Project Variables and Key Drivers 309 8.7.3 Input Variables: Estimation and Data Collection 314 8.7.4 Estimating Project Cash Flow and Valuing Results 317 xii CONTENTS 8.8 Estimating Value at Risk through Simulations 317 8.9 Defining Project Value in the Event of Default 319 8.9.1 Deterministic vs.
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