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Lecture Two

FINA 522: Project Finance and Risk Management

Updated: 06 March 2007

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Project Finance and

Managing Project Risks

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Definition of Project Completion• Principle Categories of Risk: Pre-Completion and Post-

Completion

• Physical Completion

– Project is physically complete according to technical design criteria.

• Mechanical Completion

– Project can sustain production at a specified capacity for a certain period of time.

• Financial Completion (financial sustainability)

– Project can produce under a certain unit cost for a certain period of time & meets certain financial ratios (current ratio, Debt/Equity, Debt Service Capacity ratios)

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Management and Alleviation of RisksPrinciple Categories of Risk: Pre-Completion and Post-Completion

A:Pre-Completion Risks:Some Examples ofWays to Reduce or Shift Risk

Types of Risks Away from Financial Institution

•Participant Risks-Sponsor commitment to project - Reduce Magnitude of investment? -Require Lower Debt/Equity ratio

-Finance investment through equity

then by debt

– Financially weak sponsor - Attain Third party credit support for weak sponsor (e.g.,Letter of Credit)

- Cross default to other sponsors•Construction/Design defects - Experienced Contractor

- Turn key construction contract

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Management and Alleviation of Risks

A:Pre-Completion Risks (cont’d):Some Examples ofWays to Reduce or Shift Risk

Types of Risks Away from Financial Institution

•Process failure - Process / Equipment warranties•Completion Risks

– Cost overruns - Pre-Agreed overrun funding- Fixed (real) Price Contract

– Project not completed - Completion Guarantee- Tests: Mechanical/Financial for

completion– Project does not attain - Assumption of Debt by Sponsors if

mechanical efficiency not completed satisfactorily

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B. Post-Completion RisksSome Examples ofWays to Reduce or Shift Risk

Types of Risks Away from Financial Institution

• Natural Resource/Raw Material– Availability of raw materials - Independent reserve certification

- Example: Mining Projects: reserves twice planned mining

volume- Firm supply contracts- Ready spot market

• Production/Operating Risks– Operating difficulty leads to - Proven technology insufficient cash flow - Experienced Operator/ Management Team

- Performance warranties on equipments

- Insurance to guarantee minimum cash

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Some Examples of

Ways to Reduce or Shift Risk

Types of Risks Away from Financial Institution

• Market Risk–Volume -cannot sell entire output - Long term contract with creditworthy

buyers :take-or-pay; take-if-delivered; take-and-pay

–Price - cannot sell output at profit - Minimum volume/floor price provisions - Price escalation provisions

• Force Majeure Risks–Strikes, floods, earthquakes, etc. - Insurance

- Debt service reserve fund

B. Post-Completion Risks

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Some Examples ofWays to Reduce or Shift Risk

Types of Risks Away from Financial Institution

• Political Risk–Covers range of issues from - Host govt. political risk assurances

nationalization/expropriation, - Assumption of debtchanges in tax and other laws, - Official insurance: OPIC, COFACE, EXIM

currency inconvertibility, etc. - Private insurance: AIG, LLOYDS- Offshore Escrow Accounts

- Multilateral or Bilateral involvement

• Abandonment Risk–Sponsors walk away from project - Abandonment test in agreement for banks to run project closure based on historical and

projected costs and revenues

• Other Risks: Not really project risks but may include:–Syndication risk - Secure strong lead financial institution–Currency risk - Currency swaps / hedges –Interest rate exposure - Interest rate swaps –Rigid debt service - Built-in flexibility in debt service

obligations–Hair trigger defaults

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INSTRUMENTS FOR RISK MANAGEMENT

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• A forward contract obligates the contract seller to deliver to the contract buyer (1) a specified quantity (2) of a particular commodity, currency, or some other item (3) on a specified future date (4) at a stated price that is agreed to at the time the two parties enter into the contract.

• A futures contract is similar to a forward contract except that (1) a futures contract is traded on an organized exchange (whereas forwards are traded over-the-counter) and (2) a futures contract is standardized (whereas forward contracts are customized as to the item involved or the time of delivery).

• Forwards and futures enable project sponsors to sell their output for future delivery.

• They are, at least, guaranteed quantity and price for items that can be sold on this basis.

• Forwards and futures are available for most commodities and all major currencies.

Hedging with Forwards and Futures

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• Among the other strategies for transferring risks to others

through the financial markets, the gold loan is worth noting.

• A sponsor of a gold mining project can borrow gold (i.e., the

physical commodity) and sell the gold to raise cash to finance

construction.

• The gold loan is repaid out of production from the mine.

Commodity based Loans

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FINANCING RISK

• The traditional method of eliminating (or at least controlling) such risk exposure involved arranging fixed-rate debt for the project.

• However, floating-rate lenders, typically commercial banks are often more willing to assume greater completion or other business risks than fixed-rate lenders, such as life insurance companies and pension funds.

• The availability of interest rate risk hedging vehicles enables project sponsors to eliminate interest rate risk without having to accept a trade-off involving other risk exposures.

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Interest Rate Cap Contract

• A contract that protects the borrower (the project) against increases in interest rate by obligating another party, for a fee, to pay the difference between the market interest rate and the cap rate whenever the market interest rate is higher than the cap rate.

• Example 1: A 3-month LIBOR cap contract that specifies a cap rate of 6 percent would pay the holder whenever 3-month LIBOR rises above 6 percent.

• Suppose the loan agreement specifies an interest rate of LIBOR +1.25 percent with quarterly resets.

• If LIBOR is, say, 8 percent on the interest rate reset date, the borrower will have to pay the lender 9.25 percent interest for that interest period but will receive 2 percent (8 percent — 6 percent) interest under the cap contract. The borrower's true interest cost can never rise above 7.25 percent, the cap rate plus 1.25 percent.

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Managing Interest Rate Risk:Interest Rate Swap Agreement

• An agreement between two parties to exchange interest rate

payments based on a notional principal amount.

• A project borrowing at a floating interest rate can enter into an

agreement under which it agrees to pay a fixed rate of interest

and receive a floating rate of interest.

• Floating-rate interest receivable under the swap cancels out the

floating-rate interest payable under the bank loan agreement.

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An Interest Rate Swap

Bank Project Swap

Counterparty

Loan

Pay LIBOR +1% Receive LIBOR

Pay 8%

Net interest cost: Pay LIBOR + 1% under loan

Receiver LIBOR under swap

Pay 8% under swap

Pay 9%

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Managing Currency RiskA Currency Swap

• A swap in which one party sells currency to another party, subject to an agreement to repurchase the same currency at the same exchange rate at a set date in the future.

• Typically used to hedge against loans denominated in a currency different than that in which project revenues are denominated.

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A Currency Swap

Bank Project Swap

Counterparty

Loan in local currency

Pay 8% (LC) Receive 8% (LC)

Pay 10% USD

Net interest cost: Pay 8% in LC under loan Receive 8% in LC under swap Pay 10% in USD under swap Pay 10% in USD

LC = Local currency USD = US dollars

Revenue in USD

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POLITICAL RISK• Political risk can be ameliorated by borrowing funds for the project from local

banks (which would suffer financially if the project is unable to repay project debt

because its assets were expropriated).

• It can also be mitigated by borrowing funds for the project from the World Bank,

the Inter-American Development Bank, or some other multilateral financing

agency, if the host country is relying on such agencies to fund public expenditures

(expropriation would jeopardize such funding).

• In addition, project sponsors can often arrange political risk insurance to cover a

wide range of political risks.

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ENVIRONMENTAL RISK• Environmental risk is present when the environmental effects of a

project might cause a delay in the project's development or

necessitate a costly redesign.

• For example, in connection with a mining project, disposal of

tailings is often a very sensitive environmental issue that can add

significantly to the cost of operations.

• Interestingly, the frequent changes in environmental regulations in

the United States (at both the state and federal levels), and, the legal

challenges mounted by environmental groups, have given rise to

significant environmental risks for environmentally sensitive

projects in the United States.

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FORCE MAJEURE RISK• This category concerns the risk that some discrete event might impair, or prevent

altogether, the operation of the project for a pro longed period of time after the project has been completed and placed in operation.

• Lenders normally insist on being protected from loss caused by force majeure.• Certain events of force majeure, such as fires or earthquakes, can be insured against. • Lenders will require assurances from financially capable parties that the project's debt

service requirements will be met in the event force majeure occurs. • If force majeure results in abandonment of the project, lenders typically require

repayment of project debt on an accelerated basis.• In the case of events covered by insurance, lenders will require the project sponsors to

pledge the right to receive insurance payments as part of the security for project loans.