Monday, February 2, 2009

Mechanics of Project Finance

Financing of any hydropower project involves getting the money and investing it in the implementation of the project. Largely, this holds true if such a project is being implemented as a government project or grant-funded project. This aspect can be deemed to be project finance in a wide sense whereas it has a specific meaning in limited sense. This can be clarified by contrasting the two meanings.

Whereas if a hydropower project is to be constructed and operated as a business proposition or in the case of a private sector it needs to worry about a number of other issues (more like risks) inherent in both of these activities. Moreover, a private sector entrepreneur also needs to worry about recovery of the investment and a decent return thereon as well as servicing of the debt if any debt financing is involved. This approach is much challenging as well as interesting besides being timely in view of liberalization, privatization and globalization. Therefore, let us examine various issues with respect to such financing by considering a number of financing scenarios.

Purely equity financing of a hydropower project is a rarity, especially because this sector is capital-intensive with a long gestation period. But it is not unthinkable. Full equity financing of a hydropower project is basically applicable in the case of a private sector flush with fund, not needing to borrow from anywhere. Literally, in this context, financing involves using or investing own fund to construct or erect a project. There is not much to worry about in such a scenario as far as mobilizing fund is concerned or if a grant is available for the purpose.

Such a mode of financing has a few demerits for the investor. First of all, s/he[1] will solely be exposed to the full risk of the project. The developer’s exposure will be limited if s/he is able to leverage non-recourse fund[2] from lenders. Moreover, return on equity generally tends to be higher, depending upon the extent of leverage gained by higher ‘debt to equity’ ratio if the rate of return on total investment is higher than the rate of interest on loan.

At another extreme of the financing spectrum is borrowing full amount of the cost of the project. But such a scenario is also rare. Such borrowing is possible where the developer is able to provide full collateral, including an adequate margin against the loan, or enjoy high credit rating and is able to borrow against its balance sheet, or is able to provide a third party guarantee, including guarantee of the parent company. From the standpoint of exposure, in this scenario too, the developer or the surety or the developer’s parent company is exposed to the full risk of the project. A prudent businessperson will also stay away from such a type of financing.

However, when we are discussing debt financing, let us touch on a few of the concepts related to ‘debt’. The term, debt, is generally used interchangeably with loan, but there are a number of instruments available for the purpose and there are a number of different types of debt or loan.

Unsecured Debt
Generally, a borrower that enjoys high credit rating is able to borrow without providing any security in the form of collateral or guarantee from its parent company or third party. Such borrowing is known as unsecured loan. Financial institutions rely on the credit rating of the borrower based on its balance sheet in providing unsecured loan. Large, financially strong corporate undertakings are able to borrow without putting up collateral or providing other forms of security.

Secured Debt
Where a lender provides loan to a borrower on the basis of security furnished by the borrower, the debt is secured. Security against a loan may be perfected in several ways. The oldest form of security for the purpose of borrowing is pledging real property (even precious metal) as collateral. One may mortgage landed property in one’s ownership in order to borrow. In such an instance, a lender will be willing to advance a loan up to the value of such property minus a margin. An illustration is borrowing up to, say, 60 per cent of the value of land to construct a building on that land. In this instance, one real property is being mortgaged to create another real property. Another version of secured loan is where the lender keeps the title to the property procured with the loan as collateral. This happens in ‘lease purchase’. Here also, the margin will come to play in the form of down payment by the borrower. In both of these scenarios, the lender is able to resort to the property on which it has lien in case of default by the borrower.

Security for a loan can also be perfected without putting up real property as collateral. Financial institutions lend money against third party guarantee; a parent company can also stand guarantee for the loan taken by its subsidiary. In the event of default by the borrower, the loan and other amounts due in respect of such a loan will be recovered by the lender from such a guarantor.

‘Project Finance’ can be described as lending money for a project by accepting the ‘project’ itself as the collateral so that the lender is enabled to step into the shoes of the borrower to continue with the project, whether under construction or in operation, in the event of default of lenders’ terms, conditions and covenants by the borrower. This is basically a way of perfecting security of a debt without having to put up collateral or furnish third party guarantee. It can also be described as a mix of debt and equity financing or ‘an instrument to perfect security of debt’.

This kind of financing can be loosely compared with ‘hire-purchase’, as the collateral for such financing is the item being procured under the scheme. However, project finance is distinct from hire-purchase because the assets procured under the latter scheme are registered in the lender’s name and repossession of the said asset, as a part of foreclosure, is rather simple while it is not so in the former. The exposure of both the developer and the lender is in proportion to their investment, essentially as per the debt to equity ratio. Moreover, the margin is available to the lender based on the debt to equity ratio.

Mechanisms and Mechanics of Perfecting Security under Project Finance
The following factors must be considered in loaning money on project finance basis for a hydropower project in order to perfect security:

1. Revenue: watertight arrangement for commercial operation during debt service period:
a) PPA – Assign it to the lender(s) with the Nepal Electricity Authority’s (NEA) consent.
b) Ensure that the revenue stream received from NEA is directed to a bank account specified by the lender. NEA will have to be approached for their concurrence.
c) Designate such a bank account as an ‘escrow account’ in which the lender shall have the first lien.
d) Allow the developer to withdraw money from such an account without any hindrance only to the extent necessary to operate the project plant and to maintain the plant in top condition pursuant to ‘prudent operating practices’.
e) Money to be automatically transferred to the lenders for their debt service (both principal and interest thereon) on specified dates.
f) Allow the developer to withdraw money from the account for the distribution of dividend to its shareholders, to the extent permissible based on fund balance in the escrow account after leaving an amount necessary to meet one (or the unit agreed between the borrower and lender) debt service obligation in immediate future.

2. Expenditure: watertight arrangement during construction period
a) Assign all contracts or agreements, inter alia, related to construction, supply, transportation, erection or installation, consultancies (design, engineering, supervision, etc), etc to the lenders so that the lender is able to continue to complete implementation and operation of the project in the case of default by the borrower by being able to step into the shoes of the borrower or have someone do so on the lender’s behalf. (Should even include employment contracts of key personnel that are indispensable for the implementation of the project!)
b) Ensure that the borrower company’s equity-holders inject their equity, at least, on pari passu basis, if not more, during the implementation of the project.
c) Ensure that both debt and equity for the project are injected into a dedicated bank account on which the lender has the first lien and outflows from this account are closely monitored by the lender.
d) Ensure that proper contractual arrangements are made such that (a) cost overrun and (b) time overrun are effectively avoided. (Time overrun tends to be more expensive than cost overrun due to additional interest during construction, loss of revenue and even penalty to NEA for delayed delivery of electricity.).
e) Ensure that there are no gaps and cracks between various contracts or agreements, which could increase the total project cost.
f) Ensure that the borrower company has or is able to access the necessary contingency fund to complete the project even if the project cost goes up due to unforeseen reasons.
g) Payments for construction closely supervised by lenders.

3. Safety-net: success or failure dependent on robust and sturdy safety-net of insurance
a) Risk assessment should be made to prepare a risk profile, which will dictate the insurance program.
b) Ensure that all necessary insurance policies are put in place in order to cover all exposures to all possible risks (e.g., CAR, EAR, TAR, ALOP, increase in cost due to devaluation, contractors’ equipment, third party liability, comprehensive workmen’s compensation, professional liability and so on and so forth). The words of the proposed insurance policies to be finalized in consultation with the lender.
c) Ensure that the lender is mentioned in such insurance policies as the co-insured in order to provide for the eventualities emanating from default by the borrower.
d) Ensure that the project’s cost estimate has adequately budgeted for the payment of insurance premium.

4. Documentation to perfect security
a) Execute loan agreement between the lender and the borrower to sign off on the arrangements agreed and put in place as listed above.
b) Have such agreement ‘registered’ wherein all tangible and intangible (various contracts, agreements, license, etc.) assets are mortgaged against the loan, enabling the lender to foreclose without having to resort to court of law.

Paper presented at the symposium organized by SHPP/GTZ on November 5, 2000

[1] For the sake of simplicity singular pronoun is being used here, but one needs to bear in mind that the pronoun could be referring to a corporate entity, juristic person, as well (in which case the appropriate pronoun, obviously, will be “it”) instead of a natural person.
[2] “Non-recourse funding” is dealt with at length in following pages.

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