CU-MBA-SEM-III-Project Finance and Financial Modeling- Second draft-converted

MASTER OF BUSINESS ADMINISTRATION SEMESTER III PROJECT FINANCE AND FINANCIAL MODELING MBA502

CHANDIGARH UNIVERSITY Institute of Distance and Online Learning Course Development Committee Prof. (Dr.) R.S.Bawa Pro Chancellor, Chandigarh University, Gharuan, Punjab Advisors Prof. (Dr.) Bharat Bhushan, Director – IGNOU Prof. (Dr.) Majulika Srivastava, Director – CIQA, IGNOU Programme Coordinators & Editing Team Master of Business Administration (MBA) Bachelor of Business Administration (BBA) Coordinator – Dr. Rupali Arora Coordinator – Dr. Simran Jewandah Master of Computer Applications (MCA) Bachelor of Computer Applications (BCA) Coordinator – Dr. Raju Kumar Coordinator – Dr. Manisha Malhotra Master of Commerce (M.Com.) Bachelor of Commerce (B.Com.) Coordinator – Dr. Aman Jindal Coordinator – Dr. Minakshi Garg Master of Arts (Psychology) Bachelor of Science (Travel &Tourism Management) Coordinator – Dr. Samerjeet Kaur Coordinator – Dr. Shikha Sharma Master of Arts (English) Bachelor of Arts (General) Coordinator – Dr. Ashita Chadha Coordinator – Ms. Neeraj Gohlan Academic and Administrative Management Prof. (Dr.) R. M. Bhagat Prof. (Dr.) S.S. Sehgal Executive Director – Sciences Registrar Prof. (Dr.) Manaswini Acharya Prof. (Dr.) Gurpreet Singh Executive Director – Liberal Arts Director – IDOL © No part of this publication should be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of the authors and the publisher. SLM SPECIALLY PREPARED FOR CU IDOL STUDENTS Printed and Published by: TeamLease Edtech Limited www.teamleaseedtech.com CONTACT NO:01133002345 For: CHANDIGARH UNIVERSITY 2 Institute of Distance and Online Learning CU IDOL SELF LEARNING MATERIAL (SLM)

First Published in 2021 All rights reserved. No Part of this book may be reproduced or transmitted, in any form or by any means, without permission in writing from Chandigarh University. Any person who does any unauthorized act in relation to this book may be liable to criminal prosecution and civil claims for damages. This book is meant for educational and learning purpose. The authors of the book has/have taken all reasonable care to ensure that the contents of the book do not violate any existing copyright or other intellectual property rights of any person in any manner whatsoever. In the event the Authors has/ have been unable to track any source and if any copyright has been inadvertently infringed, please notify the publisher in writing for corrective action. 3 CU IDOL SELF LEARNING MATERIAL (SLM)

CONTENT Unit-1: Project Finance .........................................................................................................5 Unit 2- Investment Consultants...........................................................................................35 Unit 3 Project Risk And Mitigants......................................................................................48 Unit 4-Project/ Program Risks And Mitigants ....................................................................63 Unit 5- Sources Of Financing .............................................................................................98 Unit 6- Project Evaluation.................................................................................................124 Unit 7-Project Evaluation Solutions .................................................................................162 Unit 8- Credit Agreement .................................................................................................178 Unit 9- Financial Modeling...............................................................................................215 Unit 10 - Financial Modeling............................................................................................234 Unit 11- Basic Excel For Financial Modeling ..................................................................246 Unit 12- Advance Modeling Technique............................................................................276 Unit 13- Investment Banking M & A ...............................................................................307 Unit 14- Valuation.............................................................................................................334 4 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-1: PROJECT FINANCE 5 Structure 1.0 Learning Objectives 1.1 Introduction 1.2 Uses for Project Finance 1.3 Why Use Project Financing 1.4 Advantages of Project Finance 1.5 Disadvantages of Project Finance 1.6 Common Misconceptions about Project Finance 1.7 Description of a Typical Project Finance Transaction 1.8 Project Financing Phases 1.9 Key Features of Project Financing 1.10 What are the Various Stages of Project Financing 1.11 Types of Sponsors in Project Financing 1.12 Project Structure and Participants 1.13 Parties to Project Financing 1.14 Overview of Project Finance 1.15 Financing Sources Used in Project Financing 1.16 Overview of Project Finance 1.16.1 Investment Funds 1.16.2 Institutional Lenders 1.16.3 Leasing Companies 1.16.4 Vendor financing of equipment 1.16.5 Contractors 1.16.6 Sponsors 1.16.7 Supplier financing 1.16.8 Host government 1.17 Summary 1.18 Key Words 1.19 Learning Activity 1.20 Unit End Questions 1.21 References 1.0 LEARNING OBJECTIVES After studying this unit, you will be able to: • Describe why Project Finance is necessary CU IDOL SELF LEARNING MATERIAL (SLM)

• Identify scope of Project Finance • Explain how project finance transactions work • Pros and Cons of Project Finance • Who are the stake holders in Project Finance • What are the various sources used for Project Financing 1.1INTRODUCTION What is ‘project finance’? The term features prominently in the press more specifically with respect to infrastructure, public and private venture capital needs. The press often refers to huge projects, such as building infrastructure projects like highways, Eurotunnel, metro systems, or airports. It is a technique that has been used to raise huge amounts of capital and promises to continue to do so, in both developed and developing countries, for the foreseeable future. While project finance bears certain similarities to syndicated lending, there are a host of specific issues that mean that it is essentially a specialized discipline unto itself, effectively a discrete subset of syndicated lending. Project finance is generally used to refer to a non-recourse or limited recourse financing structure in which debt, equity and credit enhancement are combined for the construction and operation, or the refinancing, of a particular facility in a capital-intensive industry. Credit appraisals and debt terms are typically based on project cash flow forecasts as opposed to the creditworthiness of the sponsors and the actual value of the project assets. Forecasting is therefore at the heart of project financing techniques. Project financing, together with the equity from the project sponsors, must be enough to cover all the costs related to the development of the project as well as working capital needs. Project finance risks are therefore highly specific and it is essential that participants such as commercial bankers, investment bankers, general contractors, subcontractors, insurance companies, suppliers and customers understand these risks since they will all be participating in an interlocking structure. These various participants have differing contractual obligations, and the resultant risk and reward varies with the function and performance of these various parties. Ideally, the debt servicing will be supported by the project cash flow dynamics as opposed to the participants, who at best provide limited coverage. 1.2USES FOR PROJECT FINANCE • Energy Project finance is used to build energy infrastructure in industrialized countries as well as in emerging markets. • Oil Development of new pipelines and refineries are also successful uses of project finance. Large natural gas pipelines and oil refineries have been financed with this 6 CU IDOL SELF LEARNING MATERIAL (SLM)

model. Before the use of project finance, facilities were financed either by the internal cash generation of oil companies, or by governments. • Mining Project finance is used to develop the exploitation of natural resources such as copper, iron ore, or gold mining operations in countries as diverse as Chile, Ghana and Australia. • Highways New roads are often financed with project finance techniques since they lend themselves to the cash flow based model of repayment. Project finance techniques have enabled projects to be built in markets using private capital. These private finance techniques are a key element in scaling back government financing, a central pillar of the current ideological agenda whose goals are well articulated by Grover Norquist, a US Republican ideologue and lobbyist, who says ‘I don’t want to abolish government. I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub.’ On the basis of such ideological agendas and lobbyists’ machinations are the macroeconomic policies, upon which project finance feeds, made, thus transferring the control of public services from the electorate to private, unaccountable and uncoordinated interests. Such agendas make project financing a key method of using private capital to achieve private ownership of public services such as energy, transportation and other infrastructure development initiatives. The goal ultimately is to make government irrelevant and achieve a two-tier society where government panders to the marginalized and infrastructure development and exploitation are handed over to private capital, free from the encumbrances of electoral mandates. Some of these sectors include: Telecommunications: The burgeoning demand for telecommunication and data transfer via the Internet in developed and developing countries necessitates the use of project finance techniques to fund this infrastructure development. Other: Other sectors targeted for a private takeover of public utilities and services via project finance mechanisms include pulp and paper projects, chemical facilities, manufacturing, hospitals, retirement care facilities, prisons, schools, airports and ocean- going vessels. 1.3WHY USE PROJECT FINANCING Non-recourse/limited recourse Non-recourse/limited recourse is one of the key distinguishing factors underlying project finance. Classic long term lending typically depends on cash flows but the facilities’ ultimate credit rationale resides upon the creditworthiness of the borrower, since the lender will have a claim over the company’s assets. 7 CU IDOL SELF LEARNING MATERIAL (SLM)

In a project financing, this is rarely the case since the size of the operation may dwarf the size of the participating companies’ balance sheets. Moreover, the borrowing entity may be a special purpose vehicle with no credit history. This is why it is useful to distinguish between non-recourse and limited recourse project financings. • Non-recourse project financing Non-recourse project financing means that there is no recourse to the project sponsor’s assets for the debts or liabilities of an individual project. Non-recourse financing therefore depends purely on the merits of a project rather than the creditworthiness of the project sponsor. Credit appraisal therefore resides on the anticipated cash flows of the project, and is independent of the creditworthiness of the project sponsors. In such a scenario, the project sponsor has no direct legal obligation to repay the project debt or make interest payments. • Limited recourse project finance In most project financings, there are limited obligations and responsibilities of the project sponsor; that is, the financing is limited recourse. Security, for example, may not suffice to fully guarantee a project. The main issue here is not that the guarantees offered fully mitigate the project but rather implicate the sponsor’s involvement sufficiently deeply in order to fully incentivize the sponsor to ensure the technical success of the project. How much recourse is necessary to support a financing is determined based on the unique characteristics of the project. The project risks and the extent of support forthcoming from the sponsors will directly impact the risk profile of the project, as well as the syndication strategy. For example, if the lenders perceive that a substantial risk exists during the construction phase of a project, they could require that the project sponsor inject additional equity should certain financial ratio covenants be violated. Other mechanisms subject to negotiations between the agent bank and project sponsors are also possible. 1.4ADVANTAGES OF PROJECT FINANCE • Non-recourse/limited recourse financing: Non-recourse project financing does not impose any obligation to guarantee the repayment of the project debt on the project sponsor. This is important because capital adequacy requirements and credit ratings mean that assuming financial commitments to a large project may adversely impact the company’s financial structure and credit rating (and ability to access funds in the capital markets). • Off balance sheet debt treatment: The main reason for choosing project finance is to isolate the risk of the project, taking it off balance sheet so that project failure does not damage the owner’s financial condition. This may be motivated by genuine economic arguments such as maintaining existing financial ratios and credit ratings. Theoretically, therefore, the project sponsor may retain some real financial risk in the 8 CU IDOL SELF LEARNING MATERIAL (SLM)

project as a motivating factor, however, the off balance sheet treatment per se will effectively not affect the company’s investment rating by credit rating analysts. • Leveraged debt: Debt is advantageous for project finance sponsors in that share issues (and equity dilution) can be avoided. Furthermore, equity requirements for projects in developing countries are influenced by many factors, including the country, the project economics, whether any other project participants invest equity in the project, and the eagerness for banks to win the project finance business. • Avoidance of restrictive covenants in other transactions Because the project financed is separate and distinct from other operations and projects of the sponsor, existing restrictive covenants do not typically apply to the project financing. A project finance structure permits a project sponsor to avoid restrictive covenants, such as debt coverage ratios and provisions that cross-default for a failure to pay debt, in the existing loan agreements and indentures at the project sponsor level. • Favourable tax treatment Project finance is often driven by tax efficient considerations. Tax allowances and tax breaks for capital investments etc. can stimulate the adoption of project finance. Projects that contract to provide a service to a state entity can use these tax breaks (or subsidies) to inflate the profitability of such ventures. • Favourable financing terms Project financing structures can enhance the credit risk profile and therefore obtain more favourable pricing than that obtained purely from the project sponsor’s credit risk profile. • Political risk diversification Establishing SPVs (special purpose vehicles) for projects in specific countries quarantines the project risks and shields the sponsor (or the sponsor’s other projects) from adverse developments. • Risk sharing Allocating risks in a project finance structure enables the sponsor to spread risks over all the project participants, including the lender. The diffusion of risk can improve the possibility of project success since each project participant accepts certain risks; however, the multiplicity of participating entities can result in increased costs which must be borne by the sponsor and passed on to the end consumer often consumers that would be better served by public services. • Collateral limited to project assets Non-recourse project finance loans are based on the premise that collateral comes only from the project assets. While this is generally the case, limited recourse to the assets of the project sponsor is sometimes required as a way of incentivizing the sponsor. • Lenders are more likely to participate in a workout than foreclose: The non- recourse or limited recourse nature of project finance means that collateral (a half- completed factory) has limited value in a liquidation scenario. Therefore, if the project is experiencing difficulties, the best chance of success lies in finding a workout 9 CU IDOL SELF LEARNING MATERIAL (SLM)

solution rather than foreclosing. Lenders will therefore more likely cooperate in a workout scenario to minimize losses. 1.5 DISADVANTAGES OF PROJECT FINANCE • Complexity of risk allocation: Project financings are complex transactions involving many participants with diverse interests. This results in conflicts of interest on risk allocation amongst the participants and protracted negotiations and increased costs to compensate third parties for accepting risks. • Increased lender risk: Since banks are not equity risk takers, the means available to enhance the credit risk to acceptable levels are limited, which results in higher prices. This also necessitates expensive processes of due diligence conducted by lawyers, engineers and other specialized consultants. • Higher interest rates and fees: Interest rates on project financings may be higher than on direct loans made to the project sponsor since the transaction structure is complex and the loan documentation lengthy. Project finance is generally more expensive than classic lending because of: ▪ the time spent by lenders, technical experts and lawyers to evaluate the project and draft complex loan documentation; ▪ the increased insurance cover, particularly political risk cover; ▪ the costs of hiring technical experts to monitor the progress of the project and compliance with loan covenant; ▪ The charges made by the lenders and other parties for assuming additional risks. • Lender supervision: In order to protect themselves, lenders will want to closely supervise the management and operations of the project (whilst at the same time avoiding any liability associated with excessive interference in the project). This supervision includes site visits by lender’s engineers and consultants, construction reviews, and monitoring construction progress and technical performance, as well as financial covenants to ensure funds are not diverted from the project. This lender supervision is to ensure that the project proceeds as planned, since the main value of the project is cash flow via successful operation. • Lender reporting requirements: Lenders will require that the project company provides a steady stream of financial and technical information to enable them to monitor the project’s progress. Such reporting includes financial statements, interim statements, reports on technical progress, delays and the corrective measures adopted, and various notices such as events of default. • Increased insurance coverage: The non-recourse nature of project finance means that risks need to be mitigated. Some of this risk can be mitigated via insurance 10 CU IDOL SELF LEARNING MATERIAL (SLM)

available at commercially acceptable rates. This however can greatly increase costs, which in itself, raises other risk issues such as pricing and successful syndication. • Transaction costs may outweigh the benefits: The complexity of the project financing arrangement can result in a transaction whose costs are so great as to offset the advantages of the project financing structure. The time-consuming nature of negotiations amongst various parties and government bodies, restrictive covenants, and limited control of project assets, and burgeoning legal costs may all work together to render the transaction unfeasible. 1.6 COMMON MISCONCEPTIONS ABOUT PROJECT FINANCE There are several misconceptions about project finance: • The assumption that lenders should in all circumstances look to the project as the exclusive source of debt service and repayment is excessively rigid and can create difficulties when negotiating between the project participants. • Lenders do not require a high level of equity from the project sponsors. This may be true in absolute terms but should not obscure the fact that an equity participation is an effective measure to ensure that the project sponsors are incentivized for success. • The assets of the project provide 100% security. Whilst lenders normally look for primary and secondary sources of repayment (cash flow plus security on project assets), the realizable value of such assets (e.g. roads, tunnels and pipelines which cannot be moved) are such that the security is next to meaningless when compared against future anticipated cash flows. Security therefore is primarily taken in order to ensure that participants are committed to the project rather than the intention of providing a realistic method of ensuring repayment. • The project’s technical and economic performance will be measured according to pre-set tests and targets. Lenders will seek flexibility in interpreting the results of such negotiations in order to protect their positions. Borrowers on the other hand will argue for purely objective tests in order to avoid being subjected to subjective value judgements on the part of the lenders. • Lenders will not want to abandon the project as long as some surplus cash flow is being generated over operating costs, even if this level represents an uneconomic return to the project sponsors. • Lenders will often seek assurances from the host government about the risks of expropriation and availability of foreign exchange. Often these risks are covered by insurance or export credit guarantee support. The involvement of a multilateral 11 CU IDOL SELF LEARNING MATERIAL (SLM)

organization such as the World Bank or regional development banks in a project tends to ‘validate’ a project and reassure lenders’ concerns about political risk. 1.7 DESCRIPTION OF A TYPICAL PROJECT FINANCE TRANSACTION Project finance transactions are complex transactions that often require numerous players in interdependent relationships. To illustrate, we provide an organization diagram of the various players seen from the viewpoint of an agent bank in a generic project finance transaction: • The core of a project financing is typically the project company, which is a special purpose vehicle (SPV) that consists of the consortium shareholders (such as contractors or operators who may be investors or have other interests in the project). The SPV is formed specifically to build and operate the project. The SPV can be structured either as a local project company or a joint venture (JV) consortium. • The SPV is created as an independent legal entity, which enters into contractual agreements with a number of other parties necessary to the project. The contracts form the framework for project viability and control the allocation of risks. • The project company enters into negotiations with the host government to obtain all requisite permits and authorizations, e.g., an oil or gas production licence, a mining concession, or a permit to build and operate a power plant. • A syndicate of banks may enter into a financial agreement to finance the project company. There may be several classes of lending banks, e.g. ▪ international banks lending foreign currency; ▪ local banks lending domestic currency for local costs; ▪ export credit agencies lending or guaranteeing credits to finance suppliers to the project of their national equipment; and ▪ international agencies lending or guaranteeing development credits (World Bank, Asian Development Bank, African Development Bank, European Bank for Reconstruction and Development). • The project company enters into various contracts necessary to construct and operate the project: The major types of contracts include: • EPC contract (engineering, procurement and construction) – to build and construct the project facility; • O&M contract (operation and management) – to manage and operate the facility and project during its operational phase; • supply contract (the project company enters into contracts with suppliers to ensure an uninterrupted supply of raw materials necessary for the project); 12 CU IDOL SELF LEARNING MATERIAL (SLM)

• Off-take agreements (the project company enters into contracts with purchasers of the project company’s product or service). 1.8 PROJECT FINANCING PHASES Project financings can be divided into two distinct stages: • Construction and development phase – here, the loan will be extended and debt service may be postponed, either by rolling-up interest or by allowing further drawdowns to finance interest payments prior to the operation phase. The construction phase is the period of highest risk for lenders since resources are being committed and construction must be completed before cash flow can be generated. Margins might be higher than during other phases of the project to compensate for the higher risks. The risks will be mitigated by taking security over the construction contract and related performance bonds. • Operation phase – here, the lenders will have further security since the project will begin to generate cash flows. Debt service will normally be tailored to the actual cash flows generated by the project – typically a ‘dedicated percentage’ of net cash flows will, via security structures such as blocked accounts, go to the lenders automatically with the remainder transferred to the project company. The terms of the loan will frequently provide for alternative arrangements should cash flows generate an excess or shortfall due to unanticipated economic or political risks arising. Objectives During Project Financing, a Special Purpose Vehicle (SPV) is appointed to ensure that the project financials are managed properly to avoid non-performance of assets due to project failure. Since this entity is established especially for the project, the only asset it has is the project. The appointment of SPV guarantees the lenders of the sponsors’ commitment by ensuring that the project is financially stable. 1.9 KEY FEATURES OF PROJECT FINANCING Since a project deals with huge amount funds, it is important that you learn about this structured financial scheme. Below mentioned are the key features of Project Financing: • Capital Intensive Financing Scheme: Project Financing is ideal for ventures requiring huge amount of equity and debt, and is usually implemented in developing countries as it leads to economic growth of the country. Being more expensive than corporate loans, this financing scheme drives costs higher while reducing liquidity. Additionally, the projects under this plan commonly carry 13 CU IDOL SELF LEARNING MATERIAL (SLM)

Emerging Market Risk and Political Risk. To insure the project against these risks, the project also has to pay expensive premiums • Risk Allocation: Under this financial plan, some of the risks associated with the project is shifted towards the lender. Therefore, sponsors prefer to avail this financing scheme since it helps them mitigate some of the risk. On the other hand, lenders can receive better credit margin with Project Financing. • Multiple Participants Applicable: As Project Financing often concerns a large- scale project, it is possible to allocate numerous parties in the project to take care of its various aspects. This helps in the seamless operation of the entire process. • Asset Ownership is Decided at the Completion of Project: The Special Purpose Vehicle is responsible to overview the proceedings of the project while monitoring the assets related to the project. Once the project is completed, the project ownership goes to the concerned entity as determined by the terms of the loan. • Zero or Limited Recourse Financing Solution: Since the borrower does not have ownership of the project until its completion, the lenders do not have to waste time or resources evaluating the assets and credibility of the borrower. Instead, the lender can focus on the feasibility of the project. The financial services company can opt for limited recourse from the sponsors if it deduces that the project might not be able to generate enough cash flow to repay the loan after completion. • Loan Repayment with Project Cash Flow: According to the terms of the loan in Project Financing, the excess cash flow received by the project should be used to pay off the outstanding debt received by the borrower. As the debt is gradually paid off, this will reduce the risk exposure of financial services company. • Better Tax Treatment: If Project Financing is implemented, the project and/or the sponsors can receive the benefit of better tax treatment. Therefore, this structured financing solution is preferred by sponsors to receive funds for long-term projects. • Sponsor Credit Has No Impact on Project: While this long-term financing plan maximises the leverage of a project, it also ensures that the credit standings of the sponsor has no negative impact on the project. Due to this reason, the credit risk of the project is often better than the credit standings of the sponsor. 1.10 WHAT ARE THE VARIOUS STAGES OF PROJECT FINANCING? Pre-Financing Stage • Identification of the Project Plan - This process includes identifying the strategic plan of the project and analysing whether its plausible or not. In order to ensure that the project plan is in line with the goals of the financial services company, it is crucial for the lender to perform this step. 14 CU IDOL SELF LEARNING MATERIAL (SLM)

• Recognising and Minimising the Risk - Risk management is one of the key steps that should be focused on before the project financing venture begins. Before investing, the lender has every right to check if the project has enough available resources to avoid any future risks. • Checking Project Feasibility - Before a lender decides to invest on a project, it is important to check if the concerned project is financially and technically feasible by analysing all the associated factors. Financing Stage Being the most crucial part of Project Financing, this step is further sub- categorised into the following: • Arrangement of Finances - In order to take care of the finances related to the project, the sponsor needs to acquire equity or loan from a financial services organisation whose goals are aligned to that of the project • Loan or Equity Negotiation - During this step, the borrower and lender negotiate the loan amount and come to a unanimous decision regarding the same. • Documentation and Verification - In this step, the terms of the loan are mutually decided and documented keeping the policies of the project in mind. • Payment - Once the loan documentation is done, the borrower receives the funds as agreed previously to carry out the operations of the project. Post-Financing Stage • Timely Project Monitoring - As the project commences, it is the job of the project manager to monitor the project at regular intervals. • Project Closure - This step signifies the end of the project. • Loan Repayment - After the project has ended, it is imperative to keep track of the cash flow from its operations as these funds will be, then, utilised to repay the loan taken to finance the project. 1.11 TYPES OF SPONSORS IN PROJECT FINANCING In order to determine the objective of the project and the risks related to it, it is important to know the type of sponsor associated with the project. Broadly categorised, there are four types of project sponsors involved in a Project Financing venture: • Industrial sponsor - These types of sponsors are usually aligned to an upstream or downstream business in some way. • Public sponsor - The main motive of these sponsors is public service and are usually associated with the government or a municipal corporation. 15 CU IDOL SELF LEARNING MATERIAL (SLM)

• Contractual sponsor - The sponsors who are a key player in the development and running of plants are Contractual sponsors. • Financial sponsor - These types of sponsors often partake in project finance initiatives and invest in deals with a sizeable amount of return. 1.12 PROJECT STRUCTURE AND PARTICIPANTS In developing a deterministic financial model it is essential to think about the architecture of a spreadsheet before you begin to enter data, write any spreadsheet formulas, or make any valuations. This notion of coming up with the model structure applies to virtually any analysis in finance, economics, or, for that matter, science and engineering. It involves carefully organizing the model inputs, understanding mathematical calculations that derive key outputs, and effectively presenting outputs. The general design of a financial model involves deciding how to organize the inputs from various information sources in a structured manner, how to formulate the mechanical calculations in a transparent way that is easy to audit and understand, and finally how to present the outputs for purposes of risk assessment and valuation. Other than these basic elements of structuring the inputs, calculations, and outputs of a model, subjects that should be considered in laying out the architecture of a model include programming of time lines, considering methods for verifying model accuracy, and the setting up of alternative scenarios for risk analysis. Much of the process of developing an effective model is understanding the starting point of the model, putting things in a sensible order, and letting the model flow in a natural manner from the inputs to the outputs. One of the most influential and lasting ideas in finance arose from the work of Franco Modigliani and Merton Miller in 1958, who suggested that the focus of valuation should be on aggregate free cash flow rather than the way the cash flow is split up between alternative investors. If you still believe in the theory developed by Modigliani and Miller that debt and other forms of financing do not make any difference in the way real-world investments are made, or that debt does not influence valuation, then you could end all of your financial models after computing earnings before interest, taxes, depreciation, and amortization (EBITDA), capital expenditures, working capital changes, and taxes on operating earnings. EBITDA, capital expenditures, and working capital changes are the components of the typical definition of free cash flow. There is no need to worry much about the financial structure of a model and create an income statement or compute earnings per share (EPS), equity cash flow, debt service coverage, or a balance sheet. The idea coming from Miller and Modigliani that is essential in any financial model is that you should begin with EBITDA and then evaluate what is needed to generate EBITDA before paying money to investors. Capital expenditures are necessary to generate EBITDA and working capital changes adjust the EBITDA to reflect essential cash flow. Taxes should also be paid before any money is paid to investors. Although calculating prices, demand, operating cost structure, and the amount paid for 16 CU IDOL SELF LEARNING MATERIAL (SLM)

new capital equipment to generate EBITDA—the drivers of unleveraged free cash flow— is surely the most important aspect of any model, almost all of the valuation techniques discussed later on in this book require analysis of financing items as well as free cash flow. When financing is explicitly considered, financial models may concentrate on earnings after interest and/or debt and equity cash flows and/or financial ratios such as debt/ EBITDA that include balance sheet items. As valuation of debt and equity does depend on financing, much of the discussion of financial models in this chapter considers the financial structure of a company or project financed investment and the distribution of free cash flow to debt investors and equity investors. Notwithstanding the importance of debt analysis to many valuation problems, the structure of virtually any financial model should conform to the ideas of Merton Miller in that your thinking must begin with what the company really does and the free cash flow available to investors. The financing section of a model is then just about separating that cash flow into various different buckets. The layout and ordering of financing calculations and inputs in a deterministic financial model depend to a large extent on the type of investment being assessed. Most financial models can be classified into six general categories—corporate models, project finance models, acquisition models, merger integration, and financial institution and real estate models. Because of different data sources and alternative valuation techniques, the layout is somewhat different for each of these model types. The valuation techniques, data sources, and outputs of the different model types can be summarized as follows: • Corporate model. The distinguishing feature of this first and most common model type is that a corporation has a history and it is assumed to last indefinitely (although virtually all companies will end up either in bankruptcy or eventually be purchased). This means that valuation of a corporation can only be a snapshot in time that begins with some historical analysis and ends with some kind of terminal value assumption. The terminal value calculation is necessary because it is not reasonable to make detailed forecasts of cash flow items for the indefinite life of the corporation, which would require forecasts for 30 to 500 years into the future. An important objective in corporate models is often the projection of earnings per share since this is the number that drives valuation by investment analysts. Return on investment and return on equity are also critical outputs of a model that measure the performance of the management of a corporation. • Project finance model. The second type of model, for a project finance transaction, differs from a standard corporate model because the investment is characterized by alternative time phases that have different risks; by the fact that no history on cash flows exists for the investment (no matter how many times a similar new combined cycle plant is built, you don’t know how it will work until you switch it on); by the defined lifetime of a project; and by the isolation and 17 CU IDOL SELF LEARNING MATERIAL (SLM)

quantification of detailed and particular risks. Rather than spending time on studying history as in corporate finance, project finance analysis involves evaluating consulting studies and engineering reports such as traffic studies, price forecasts, and marketing analyses. The project finance models focus on cash flows accruing to equity holders and lenders rather than earnings or balance sheet items, and projections in a project finance model generally cover the entire defined lifetime of the project. Rather than evaluating return on investment, the key outputs of a project finance model are generally the internal rate of return (IRR) that accrues to equity holders or is computed on the basis of free cash flow (project IRR). • Acquisition model. The third type of model, an acquisition or leveraged buyout (LBO) model, measures the returns earned by different types of investors in a transaction. This type of model is built from the amount of consideration paid for the equity of the acquired company, the holding period of the investment, and the assumed exit price, as well as the manner in which the acquisition is financed. To compute equity returns, acquisition models measure the way in which alternative financing sources are repaid, and ultimately compute the IRR earned by equity investors as in project finance models. The information base of evaluating an acquisition is the historical financial statements of a company as in corporate finance models along with management strategy after the transaction. • Merger model. An integrated consolidation model computes earnings per share and credit quality measures both on a stand-alone basis and on a consolidated basis before and after two companies merge. This type of financial model considers the specific financing and accounting of the transaction as well as cost savings or synergies generated by the transaction. An application of such an integrated merger model is to evaluate how The Structure of Alternative much can be paid for a company along with how the transaction will be financed so that earnings dilution will be avoided and bond ratings can be maintained. • Financial institution model. The financial model of a bank, insurance company, or other financial institution cannot begin with pre-tax cash flow and EBITDA, as with all of the other models. Instead, the model begins with items like loan balances and deposit amounts. Each balance sheet account is used to compute profit loss items such as interest income, fees, or interest expense. Cash flow depends on the increase in loans and deposits where the remaining net cash flow after loan increases and provision of new deposits goes either to temporary securities or other liabilities. A financial institution model should include a target equity to-asset ratio that is used to compute net new equity issues. When valuing the financial institution, equity cash flow is the basis of the analysis and terminal 18 CU IDOL SELF LEARNING MATERIAL (SLM)

value is generally computed from a derived market-to-book ratio or a price/earnings (P/E) ratio. • Real estate model. A real estate model is a cousin of project finance models but also has some elements similar to corporate finance analysis and poses some unique modelling challenges. Rather than concentrating on a single investment, a group of multiple investments in a portfolio are often combined together in real estate analysis. A mixed development model may include various alternative residential properties with different construction start and finish dates as well as alternative office, commercial, and shopping mall properties. Real estate models must be able to evaluate cash flows that are produced at different time periods without a clearly defined construction and operation period. Further, the models must be able to quantify the effects of different holding period strategies analogous to terminal valuation analysis in corporate models as well as alternative tax treatments. The six different model types have many principles and programming techniques in common. They each should have structured time lines, need to be segregated into modules beginning with layout of operating and financing assumptions, require audit and verification procedures, have a starting point, must not contain bad programming practices, and should be structured so as to facilitate effective risk analysis. Except for the financial institution model, all of the financial models should begin by evaluating pre-tax cash flow from revenues, operating expenses, and capital expenditures and then work through free cash flow after depreciation tax shields and working capital investment. After free cash flow is derived, the financing for all of the model types is computed in a separate module and in any financial model, the balance sheets should compile closing balances from previously defined 20 Financial Modelling Structure and Design accounts in various sections of the model. However, each model structure contains unique complexities in terms of incorporating history, computing financing, and constructing valuation 1.13 PARTIES TO A PROJECT FINANCING As we saw in the previous section, there are several parties in a project financing. Here is a list, albeit non-exhaustive, of the most usual ones. Project Company The project company is the legal entity that will own, develop, construct, operate and maintain the project. The project company is generally an SPV created in the project host country and therefore subject to the laws of that country (unless appropriate ‘commissions’ can be paid so that key government officials can grant ‘exceptions’ to the project). The SPV will be controlled by its equity owners. The control mechanism may be 19 CU IDOL SELF LEARNING MATERIAL (SLM)

defined in a charter, a joint venture agreement or partnership agreement and may also be subject to local laws. Its only activity will be to own and operate the project. Sponsor The project sponsor is the entity that manages the project. The sponsor generally becomes equity owner of the SPV and will receive any profit either via equity ownership (dividend streams) or management contracts (fees). The project sponsor generally brings management, operational, and technical experience to the project. The project sponsor may be required to provide guarantees to cover certain liabilities or risks of the project. This is not so much for security purposes but rather to ensure that the sponsor is appropriately incentivized as to the project’s success. Borrower The borrowing entity might or might not be the SPV. This depends on the structure of the financing and of the operation of the project (which will themselves be determined by a host of factors such as tax, exchange controls, the availability of security and the enforceability of claims in the host country). A project may in fact have several ‘borrowers’, for example, the construction company, the operating company, suppliers of raw materials to the project and purchasers (off-takers) of the project’s production. Financial adviser The project sponsor may retain the services of a commercial or merchant bank to provide financial advisory services to the sponsor. The financial adviser theoretically will be familiar with the project host country and be able to advise on local legal requirements and transaction structures to ensure that the loan documentation and financial structure are properly assembled. A financial consultant can also advise on how to arrange the financing of the project, taking into consideration streaming cash flows, creation of shell offshore companies, tax avoidance, currency speculation, desirable locales for the project and capital required. Consultants can add the imprimatur of legality to the creation of such convoluted structures and provide help with accounting issues relating to the above other issues, such as the expected cost of the project, interest rates, inflation rates, the projected economics of operations and the anticipated cash flow. The financial adviser finally can assist in the preparation of the information memorandum regarding the proposed project. As the name suggests, the information memorandum provides information on the project, and is presented in glowing positive terms as an inducement for banks to participate in the financing, and achieve a successful syndication (despite disclaimers stating to the contrary that the memorandum is not a recommendation to participate in the facility and no responsibility can be taken for the accuracy of the information provided therein). The lenders 20 CU IDOL SELF LEARNING MATERIAL (SLM)

The large size of projects being financed often requires the syndication of the financing. For example, the Eurotunnel project financing involved some 220 banks. The syndicated loan, which is treated in a separate book in this series, exists because often any one lender individually does not have the balance sheet availability due to capitalization requirements to provide the entire project loan. Other reasons may be that it wishes to limit its risk exposure in the financing or diversify its lending portfolio and avoid risk concentration. The solution is to arrange a loan where there are several lenders forwarding funds under a single loan agreement. Such a group of lenders is often called a syndicate. A syndicate of banks might be chosen from as wide a range of countries as possible to discourage the host government from taking action to expropriate or otherwise interfere with the project and thus jeopardize its economic relations with those countries. The syndicate can also include banks from the host country, especially when there are restrictions on foreign banks taking security in the country. There are various categories of lenders in loan syndication, typically: • The arranger the bank that arranges the syndication is called the arranging bank or lead manager. The bank typically negotiates the term sheet with the borrower as well as the credit and security documentation. • The managers the managing bank is typically a title meant to distinguish the bank from mere participants. In other words, the bank may take a large portion of the loan and syndicate it, thus assuming some of the underwriting risk. Managers can therefore broaden the geographic scope of the syndication. This role is reflected in the title which then features in the facility tombstones and any other publicity relating to the facility. • The facility agent exists to administer the administrative details of the loan on behalf of the syndicate. The facility agent is not responsible for the credit decisions of the lenders in entering into the transaction. The agent bank is responsible for mechanistic aspects of the loan such as coordinating drawdowns, repayments, and communications between the parties to the finance documentation, such as serving notices and disseminating information. The Facility Agent also monitors covenant compliance and, when necessary, polls the bank group members in situations where a vote is needed (such as whether to declare a default or perfect security arrangements) and communicates these decisions to the borrower. • Technical/engineering bank as the name implies monitors the technical progress and performance of the project and liaise with the project engineers and independent experts. As such, the bank is responsible for identifying technical (engineering) events of default. • Account bank the account bank is the bank through which all project cash flows pass and are monitored, collected, and disbursed. 21 CU IDOL SELF LEARNING MATERIAL (SLM)

• Insurance bank the insurance bank undertakes negotiations in connection with project insurances, to ensure that the lender’s position is fully covered in terms of project insurance. • The security trustee exists where there are different groups of lenders or other creditors interested in the security and the coordination of their interests will call for the appointment of an independent trust company as security trustee. The interrelationships of participating banks in a bank syndicate often appears post- syndication in a ‘tombstone’, which is a form of advertising for the successful syndicating bank. Technical Adviser Technical experts advise the project sponsor and lenders on technical matters about which the sponsor and lenders have limited knowledge (oil, mining, fuel, environmental). Such experts typically prepare reports, such as feasibility reports, for the project sponsor and lenders, and may monitor the progress of the project, possibly acting as the arbiter in the event of disagreements between the sponsors and the lenders over the satisfaction of the performance covenants and tests stipulated in the finance documents. Lawyers The international nature and complexity of project financing necessitates the retention of experienced international law firms. Project finance lawyers provide legal experience with specific experience of project finance structures, experience with the underlying industry and knowledge of project contracts, debt and equity documents, credit enhancement and international transactions. Project finance lawyers provide advice on all aspects of a project, including laws and regulations; permits; organization of project entities; negotiating and drafting of project construction, operation, sale and supply contracts; negotiating and drafting of debt and equity documents; bankruptcy; tax; and similar matters. It is advisable to involve the lawyers at an early stage to ensure that the structure of the financing is properly conceived from the outset and is tax-efficient. Local lawyers in the host country of the project are also necessary in opining on various local legal matters in connection with the project financing. They are particularly useful with respect to assessing the enforceability of claims on project assets located in the host country. Equity Investors These may be lenders or project sponsors who do not expect to have an active management role as the project goes on stream. In the case of lenders, they are putting equity alongside their debt as a way to obtain an enhanced return if the project is successful. In most cases, the equity investment is combined with agreements that allow the equity investor to sell its equity to the project owner if the equity investor wishes to get out. Third party investors normally look to invest in a project on a much longer time scale 22 CU IDOL SELF LEARNING MATERIAL (SLM)

than a contractor who in most cases will want to sell out once the construction has reached completion. Many third party investors are development or equity funds, which diversify their portfolios by investing in a number of projects. They may seek to manage the project by appointing members of their own organizations to the board of the project company. Construction Company Since most project financings are infrastructural, the contractor is typically one of the key players in the construction period. Construction can be either of the EPC or ‘turnkey’ variety. EPC, or engineer, procure, and construct, is when the construction company builds the facility as per an already designated specification. Turnkey, on the other hand, is when the contractor designs, engineers, procures and constructs the facility, assuming all responsibility for on-time completion. In both cases, it is important that the construction company selected has a track record of successful project management and completion. In many large projects, consortia of constructors may become involved either for sheer economies of scale or for political reasons. In such cases, lenders prefer members of the consortia to undertake joint and several liability since the risk of failure of performance is the total responsibility of each member of the consortium. Most projects are structured on the basis that only one turnkey or EPC contractor will be employed. The various designers, contractors and subcontractors participating in the project will therefore be under the overall control of the project manager. This enables the coordination and streamlining of reporting lines. Regulatory Agencies Projects naturally are subject to local laws and regulations. These may include environmental, zoning, permits and taxes. Publicly owned projects also will be subject to various procurement and public contract laws. It is important to ensure that a project has received all the requisite permissions and licences before committing financial resources. In many markets, such ‘roadblocks’ may require extensive and time-consuming preparation for applying for the requisite government permission followed by indeterminate waiting. Another possibility is the lobbying of local political figures or the payment of large ‘commissions’ to persons in the host country’s government which may or may not have the clout to obtain the requisite approval. For example, a Mercedes 600 SLC given to an individual in the host country’s government may accelerate the requisite permission for an oil rig to enter or leave the state’s territorial waters. Then again, it may not. Therefore, ‘caveat emptor’ or in this case, ‘know your prince’. Export Credit Agencies Export credit agencies (ECAs) promote trade or other interests of an organizing country. They are generally nationalistic in purpose and nationalistic and political in operation. Funding of bilateral agencies generally comes from their organizing governments. 23 CU IDOL SELF LEARNING MATERIAL (SLM)

Government-supported export financing includes pre-export working capital, short term export receivables financing and long term financing. ECAs play important roles in infrastructure and other projects in emerging markets by stimulating international trade. They normally provide low cost financing arrangements to local manufacturers who wish to transport their technology to foreign lands. ECAs also provide political risk insurance to projects. This has an effect of ‘validating’ the project as lenders believe that foreign governments are reluctant to curry disfavour by defaulting on facilities granted by a foreign bilateral agency. United States Export–Import Bank The Export–Import Bank of the United States (Ex–Im Bank) is the official export credit agency of the United States. Ex-Im Bank’s mission is to assist in financing the export of US goods and services to international markets. Ex–Im Bank enables US companies – large and small – to turn export opportunities into real sales that help to maintain and create US jobs and contribute to a stronger national economy. 1.14 OVERVIEW OF PROJECT FINANCE 19 Ex–Im Bank does not compete with private sector lenders but provides export financing products that fill gaps in trade financing. It assumes credit and country risks that the private sector is unable or unwilling to accept. It also helps to level the playing field for US exporters by matching the financing that other governments provide to their exporters. Ex–Im Bank provides working capital guarantees (pre-export financing), export credit insurance (post-export financing) and loan guarantees and direct loans (buyer financing). No transaction is too large or too small. On average, 85% of its transactions directly benefit US small businesses. 1.15 FINANCING SOURCES USED IN PROJECT FINANCING Just as financial instruments range from debt to equity and hybrids such as mezzanine finance, project finance can raise capital from a range of sources. Raising financing depends on the nature and structure of the project financing being proposed. Lender and investor interest will vary depending on these goals and risks related to the financing. Commercial lenders seek projects with predictable political and economic risks. Multilateral institutions, on the other hand, will be less concerned with commercial lending criteria and will look towards projects that ostensibly satisfy not only purely commercial criteria. In assembling a project financing, all available financing sources should be evaluated. This would include equipment suppliers with access to export financing; multilateral agencies; bilateral agencies, which may provide financing or guarantees; the International Finance Corporation or regional development banks that have 24 CU IDOL SELF LEARNING MATERIAL (SLM)

the ability to mobilize commercial funds; specialized funds; institutional lenders and equity investors; and commercial banks, both domestic and international. Equity Equity is often raised in the stock markets and from specialized funds. Equity, as it is well known, is more expensive than debt financing. Domestic capital markets provide access to significant amounts of funds for infrastructure projects, although capital markets in developing countries may lack the depth to fund large transactions. In such cases, the international capital markets can also provide access to significant amounts of funds for infrastructure projects. However, this is generally limited to transactions whose sponsors are large, multinational companies. Access to international capital markets by companies in developing countries is generally limited, due to their low name visibility in the international financial markets. Developmental Loan A development loan is debt financing provided during a project’s developmental period to a sponsor with insufficient resources to pursue development of a project. The developmental lender is typically a lender with significant project experience. Developmental lenders, who fund the project sponsor at a very risky stage of the project, desire some equity rewards for the risk taken. Hence, it is not unusual for the developmental lender to secure rights to provide permanent financing for the project as part of the development financing arrangement. Developmental loans are typically advanced to the project sponsor on a periodic basis, based on a budget prepared to cover the development stage of the project. The developmental lender will typically require liens on all project assets including project contracts. Repayment of the loan is typically from proceeds of construction financing. Developmental loans are extremely risky for the lender since there is no assurance that the project can be developed. These loans are also risky because the value of the collateral is totally dependent on the ability to complete the project. That value can reduce to nothing at any point. Subordinated Loans Subordinated loans, also called mezzanine financing or quasi-equity, are senior to equity capital but junior to senior debt and secured debt. Subordinated debt usually has the advantage of being fixed rate, long term, unsecured and may be considered as equity by senior lenders for purposes of computing debt to equity ratios. Subordinated debt can sometimes be used advantageously for advances required by investors, sponsors or guarantors to cover construction cost over-runs or other payments necessary to maintain debt to equity ratios or other guaranteed payments. Senior Debt 25 CU IDOL SELF LEARNING MATERIAL (SLM)

Commercial banks and institutional lenders are an obvious choice for financing needs. Commercial banks tend to limit their commitments to 5–10 with floating interest rates based on LIBOR or US prime rate. Fixed interest rate loans for 5- to 10-year maturities or longer are sometimes available. Commercial bank loans for large projects are typically arranged as syndicated bank loans. The senior debt of a project financing usually constitutes the largest portion of the financing and is usually the first debt to be placed. Generally the senior debt will be more than 50% of the total financing. Senior debt is debt that is not subordinated to any other liability, in other words, the first to be paid out if the company or project is placed under liquidation. Senior debt falls into two categories: unsecured and secured loans. Unsecured Loans Unsecured loans basically depend on the borrower’s general creditworthiness, as opposed to a perfected security arrangement. Unsecured loans will usually contain a negative pledge of assets to prohibit the liquid and valuable assets of the company from being pledged to a third party ahead of the unsecured lender. The loan agreement may include ratio covenants and provisions calculated to trigger a security agreement, should the borrower’s financial condition begin to deteriorate. An unsecured loan agreement may also contain negative covenants which limit investments and other kinds of loans, leases debt obligations of the borrower. The loan agreement may also include affirmative covenants which are things that the company has to do: e.g. ensure that the business will be properly managed, proper books and records will be kept, financial information will be furnished, insurance coverage kept in force, and the business operated according to law. Large unsecured loans are available only to the most creditworthy companies with long histories of commercially successful operation and good relationships with their lenders. Since projects tend to be new enterprises with no operating histories, projects rely upon the reputations of their sponsors, owners, and managers for standing in the financial community. Secured Loans Secured loans are loans where the assets securing the loan have value as collateral, which means that such assets are marketable and can readily be converted into cash. In a fully secured loan, the value of the asset securing the debt equals or exceeds the amount borrowed. The reputation and standing of the project managers and sponsors, and the probable success of the project, all enter into the lending decision. The lending, however, also relies on the value of the collateral as a secondary source of repayment. The security interest is regarded by lenders as protection of loan repayment in the unlikely event the loan is not repaid in the ordinary course of business. Because of the security interest, a secured loan is superior since it ranks ahead of unsecured debt. In the event of financial difficulties, the secured creditor in control of key assets of a project is in a position to 26 CU IDOL SELF LEARNING MATERIAL (SLM)

demand that its debt service, payments of interest and principal continue, even if this means that unsecured creditors may be left with nothing. The enforceability of security interests requires a practical word of caution. Inexperienced lenders sometimes confuse the right to realize security with the ability to realize it. It is important to distinguish between the two since the ability to enforce a right can come up against technical and practical difficulties of doing so – especially in the case of seizing properties located in countries with underdeveloped legal systems. Syndicated Loans As we noted, project finance typically occurs in two phases: construction and operation. In some circumstances, the construction and operation phases are governed by separate agreements: • The construction phase begins when the lender disburses funds for the construction of the project (as per the construction agreement, contingent on the submission of appropriate drawdown requests with supporting documentation such as completion certificates). Since there is no operating revenue during this stage, interest is typically capitalized. • The operations phase begins when the construction is complete. The lending banks will advance funds (as per the terms in the loan agreement), typically on the first day of commercial operations. Since the project is now ostensibly generating a cash flow, payments of interest and principle can begin. The loan amortization schedule will have been drafted beforehand based on the cash flow projections, actual payments will of course depend on the actual cash flow generated. To account for minor variations in cash flow generation, the lenders may extend a working capital line of credit. Major shortfalls may lead to the loan facility being restructured. A syndicated loan is a loan that is provided to the borrower by two or more banks, known as participants, which is governed by a single loan agreement. The loan is arranged and structured by an arranger and managed by an agent. The arranger and the agent may also be participants. Each participant provides a defined percentage of the loan, and receives the same percentage of repayments. The syndicated lending market is international by nature – that is to say, many of the borrowers and projects being financed are international – taking place in Europe, Eastern Europe, Africa, the Middle East, etc. Furthermore, in order to place these large loans (e.g. up to several hundred million dollars) in the market, sometimes several banks are needed to participate in these loans. The factors which account for the size and spectacular growth of this market are several: • The market is international rather than being confined to a particular country, and new debt issues can avoid a great deal of national regulation which may involve 27 CU IDOL SELF LEARNING MATERIAL (SLM)

onerous registration requirements. This can lead to a significant reduction in the cost of the issue. • The international syndicated lending market has evolved a very fast, efficient and flexible distribution network which can place deals in large volumes and for the most part can ensure that they are launched successfully and in an orderly fashion. • This is because syndicated loans are managed, underwritten and sold by syndicates. These syndicates are dominated by the London based Swiss, American, European, and Japanese banks which have access to large client bases. • The international marketplace gives borrowers access to a greater number and diversity of investors than would be possible within their own marketplace. This ability to tap different sources of finance can reduce overall interest costs. • The most important European banking markets are based in the UK. The effect of London being the UK’s capital (capitol) city should not be overestimated. The large volume of activities, the variety and innovation of banking products, the large number of people employed in the UK banking industry is significantly influenced by the strength of the London trading and capital market activities. The syndicated loan market was initially developed in London by a relatively small number of merchant banks which had small balance sheets but large and important customers. It would not have been possible for these merchant banks to provide the full amounts of loans needed by their customers and so other banks were asked to provide parts of the loans on the same terms and conditions, with the merchant bank taking a fee to arrange the loan and administer it once it was drawn. In today’s terms, the merchant bank was acting as arranger and agent. During the 1960s many North American and other foreign banks opened branches in London, attracted by the growth of the new Eurodollar market. These new branches could gain assets quickly and easily by participating in syndicated loans to borrowers with which they would not otherwise have had a relationship. The American and Japanese banks in particular began targeting large companies with the specific intention of arranging syndicated loans in order to maximize their fee income. In recent years in the London market, the part played by Japanese banks as arrangers has lessened and some of the UK clearing banks have become increasingly active. Today the syndicated loan market is a major part of the operations of banks throughout the world, with major centres in London, New York and Hong Kong. They are typically used to finance large projects such as the Jorf Lasfar Power Station in Morocco – one of the largest syndicated loans. World Bank group financing sources Multilateral institutions such as the World Bank provide funds to infrastructure development projects worldwide according to criteria which may change over time. While such financial support is limited, any involvement by these institutions is helpful to a project as it serves to ‘validate’ it in the eyes of 28 CU IDOL SELF LEARNING MATERIAL (SLM)

banks which may be invited to participate in a parallel syndicated loan facility. Some of the World Bank’s financing programmes are: • Loan Programme Loans are generally made to member countries to finance specific projects. Eligibility is conditioned on a showing that the borrower is unable to secure a loan for the project from any other source on reasonable terms. It is therefore generally considered as the lender of last resort. Also, a showing must be made that the project is technically and economically feasible, and that the loan can be repaid. • Guarantee Programme The World Bank also provides guarantees. After the debt crisis of the 1980s, and the decrease in commercial loans in developing countries, guarantee programmes were established to improve access to financing sources. The World Bank Partial Risk Guarantee Program provides private sector lenders with limited protection against risks of sovereign non-performance and against certain force majeure risks. • Indirect support World Bank involvement in a project can be extremely important, even though the financial commitment is small, as it basically confirms that the loan has met the World Bank’s lending and financial analysis criteria and therefore validates it in the eyes of commercial banks. A World Bank involvement therefore can affect the availability of funds from other, non-World Bank affiliated sources. Export Credit Agencies Export credit agencies use three methods to provide funds to an importing entity: • Direct lending This is the simplest structure whereby the loan is conditioned upon the purchase of goods or services from businesses in the organizing country. • Financial intermediary loans Here, the export–import bank lends funds to a financial intermediary, such as a commercial bank, that in turn loans the funds to the importing entity. • Interest rate equalization Under an interest rate equalization, a commercial lender provides a loan to the importing entity at below market interest rates, and in turn receives compensation from the export–import bank for the difference between the below-market rate and the commercial rate. Bonds In recent years, the use of the bond market as a vehicle for obtaining debt funds has increased. Bond financings are similar to commercial loan structure, except that the lenders are investors purchasing the borrower’s bonds in a private placement or through the public debt market. The bond holders are represented by a trustee that acts as the agent and representative of the bondholders. Bond purchasers are generally the most 29 CU IDOL SELF LEARNING MATERIAL (SLM)

conservative source of financing for a project. The main bond markets are in Germany, Japan, the United Kingdom and the United States. Advantages of Bonds Financing via bonds offers several advantages: • Large and liquid market the public debt market provides project sponsors with access to a large and liquid market. In contrast, limited bank and institutional funds are available for international projects. • Longer term of debt the public debt market tolerates a longer average life for debt than does the private debt market. Commercial banks and some institutional investors have regulatory or internal restrictions on long term lending. • Less onerous terms: Terms of public debt deals are less onerous and contain fewer restrictive covenants than do private debt deals. Disadvantages of Bonds • Regulatory oversight Public market deals in the USA require lengthy SEC registration processes. • Ratings Credit ratings are necessary. These are time-consuming to obtain and affect the structuring and risk allocation in project contracts. • Consents to changes to underlying project are difficult Amendments, changes, or restructurings of a project are extremely difficult to negotiate and complete because of the passive nature of the investment. • Excess liquidity Bond issues yield all the proceeds at once, while in a bank deal, funds are only drawn as needed during construction (although commitment fees are typically levied on undrawn funds). The company must therefore manage this excess liquidity to best effect. • Expensive transaction costs Transaction costs are very high for accessing the public debt markets. Consequently, transactions of less than $100 million cannot generally access this market. 1.16 OVERVIEW OF PROJECT FINANCE 41 1.16.1 Investment Funds Investment funds mobilize private sector funds for investment in infrastructure projects. These specialized funds may be sponsored by governments or the private sector and include: • Asset funds or income funds; 30 CU IDOL SELF LEARNING MATERIAL (SLM)

• Investment management companies and venture capital providers; • Money market funds. 1.16.2 Institutional Lenders Institutional lenders include life insurance companies, pension plans, profit-sharing plans and charitable foundations. These entities can be a substantial source of funding, particularly in the United States. 1.16.3 Leasing Companies Leasing companies, which use tax benefits associated with equipment ownership, can offer attractively priced leases for equipment, contributing to the overall pool of financing. 1.16.4 Vendor financing of equipment Many equipment manufacturers have financing programmes to encourage the sale of their machinery and equipment. Credit terms and criteria may therefore be relatively competitive. 1.16.5 Contractors Contractors are rarely able to participate significantly in the long term financing of large projects due to the relatively modest size of their balance sheet. However, they can provide support via fixed price contracts (e.g. building a project facility without cost overruns). Contractors can also assist their clients by providing advice on the financing of projects, since they have had considerable expertise in dealing with lenders, potential sponsors and various government agencies. They may also be able to suggest structures and methods for project financing based on their previous experience in similar projects. 1.16.6 Sponsors Sometimes, a direct loan or advance by a sponsor is the only way in which the project can be financed. Such direct loans may also be necessary as a result of cost over-runs or other contingent liabilities that the sponsor has assumed. A loan is preferable to a capital contribution, since it is more easily repaid. Sponsor loans can be at lower than market rates, moreover, some sponsors prefer to lend directly to a project rather than to guarantee a loan, because they view the credit exposure as being the same, but prefer to earn interest on their exposure. 1.16.7 Supplier financing A supplier seeking a market for a product or a by-product which it produces is sometimes willing to subsidise construction, or guarantee debt of a facility that will use that product. This might, for example, be a steel plant that would use natural gas in the Middle East. The list of possible suppliers varies with each project. In such cases, a loan is made to the supplier, and the supplier quotes financing terms to the purchaser. Supplier credits usually 31 CU IDOL SELF LEARNING MATERIAL (SLM)

require the supplier to assume some of the financing risk, although in practical terms, the supplier’s profit margin may exceed the risk assumed. 1.16.8 Host government The host government can also be a direct or indirect source of financing. • Direct sources are when the government loans funds to the project company. • Indirect sources comprise tax relief, tax holidays, waiving customs duties for project equipment, etc. There are a number of advantages to host country financing assistance in a project. These include reducing the impact of leverage; subordination; foreign exchange burden on the project sponsors. It also implies that the government support decreases political risk, which can help attract private capital. 1.17 SUMMARY • Project finance is a technique to raise funds for huge projects, majorly for infrastructure projects in both developed and developing countries. This facility is majorly availed by capital intensive industries. • Project finance is predominantly used in the fields of energy, oil, mining, infrastructure, highways and telecommunication projects. This route is mainly availed for the purpose of long term lending. • Project financing is advantages for the companies because the debt is treated off the balance sheet and avoids several restrictive covenants that exist in other forms of funding. • Project finance is majorly granted by syndicate of banks who come together and provide financial assistance in the global level. • Project financing is highly complex as it involves multitude of stake holders and various mathematical models are used to validate the viability of projects before finds are sanctioned for any projects. 1.18 KEYWORDS • EBIDTA-Earnings Before Interest, Taxes, Depreciation and Amortization • EPS-Earnings per share • LIBOR-London Interbank Offer Rate • Ex-Im- Export Import • SPV-Special Purpose Vehicle 32 CU IDOL SELF LEARNING MATERIAL (SLM)

1.19 LEARNING ACTIVITY 1. Make a detailed model Application to a Financial Institution to fund your new project costing around Rs 50 Crores based on the understanding you have gained from the above study material ________________________________________________________________________ ________________________________________________________________________ 1.20 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What are the uses of Project Finance? 2. What do you mean by Non recourse/Limited recourse? 3. Does project finance have any disadvantage? 4. Explain a typical project finance transaction. 5. What are the two phases of project financing? Long Questions 6. What are the various stages of project financing? 7. Write short notes on sponsors. 8. Who are the parties in project financing? 9. What are the major sources of project financing? 10. What is unsecured loan? B. Multiple Choice Questions 1. Tax relief is an ___________ source of funding a. Direct b. Indirect c. Loaded d. Supplier 2. Which of the following is a disadvantage of the Bonds? a. Large and liquid market b. Longer term of debt c. Less onerous terms d. Expensive transaction costs 3. IRR refers to 33 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Investor rate of return b. Institutional rate of return c. Internal rate of return d. Indirect rate of return 4. Contractual; sponsor plays a major role in \\ a. Aligning business b. Development and running of plants c. Investing in deals with sizeable return d. Coordinating with government 5. Project closure is a part of a. Financing stage b. Post financing stage c. Pre financing stage d. Evaluation stage Answer 1-b, 2-d, 3-c, 4-b, 5-b 1.21 REFERENCES Text Books: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press • Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 34 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 2- INVESTMENT CONSULTANTS 35 Structure 2.0 Learning Objectives 2.1 Introduction 2.2 Understanding Investment Consultants 2.3 Sponsors/ Shareholders 2.4 Third-Party Equity Investors 2.5 Banks 2.6 Facility Agent 2.7 Technical Bank 2.8 Insurance Bank/ Account Bank 2.9 Multilateral and Export Credit Agencies 2.10 Construction Company 2.11 Operators 2.12 Experts 2.13 Host Government 2.14 Suppliers 2.15Purchasers 2.16 Insurers 2.17 Summary 2.18 Keywords 2.19 Learning Activity 2.20 Unit End Questions 2.21 References 2.0 LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain who is an Investment Consultant CU IDOL SELF LEARNING MATERIAL (SLM)

• Who are the various types of Investment Consultants in the market • State the role of shareholders, third party equity investors • Analyse the role of multilateral and export credit agencies 2.1 INTRODUCTION An investment consultant refers to a professional who provides investors with investment products, advice, and/or planning. Investment consultants do in-depth work on formulating investment strategies for clients, helping them fulfil their needs and reach their financial goals. Investment consultants have experience in many different facets of the financial world, and may work for a bank, investment firm, or on their own. They are normally educated in a financial field, must have experience in the financial services industry, and must be licensed in order to work. 2.2 UNDERSTANDING INVESTMENT CONSULTANTS An investment consultant works with clients to form an investment strategy. Clients may be individuals or businesses—small businesses to larger corporations. The investment consultant is responsible to review the client's financial situation and come up with a plan to meet their goals. Some of their duties include actively monitoring the client's investments and working with them as their financial objectives change over time. Because of the nature of their work, many investment consultants develop a long-term working relationship with their clients. These financial professionals work in a variety of settings including banks, asset management firms, private investment companies, or they may work independently. They provide an important service to their clients, helping them organize their finances and improve their financial situation. Many investment consultants are often experienced in tax and estate planning, asset allocation, risk management, educational and retirement planning. Becoming an investment consultant requires a college degree and work experience. Some of the important skills an investment consultant needs is problem solving, math, and the ability to communicate. This last skill is important because consultants may need to explain complex financial ideas to their clients. Investment consultants receive remuneration through charging fees and/or commission, and may also receive a set salary. Payscale.com reported the average annual salary for an investment consultant was $67,984, which translated to $21.99 an hour. The closest occupation to an investment consultant under the U.S. Bureau of Labour Statistics is a personal financial advisor. The median pay for a personal financial advisor in 2018 was 36 CU IDOL SELF LEARNING MATERIAL (SLM)

$42.73 per hour or $88,890 per year. The job market for personal financial advisors was expected to grow 15%t from 2016 to 2026. 2.3 SPONSORS/SHAREHOLDERS The project sponsors are those companies, agencies or individuals who promote a project, and bring together the various parties and obtain the necessary permits and consents necessary to get the project under way. As has been noted in, often they (or one of their associated companies) are involved in some particular aspect of the project. This might be the construction, operation and maintenance, purchase of the services output from the project or ownership of land related to the project. They are invariably investors in the equity of the project company and may be debt providers or guarantors of specific aspects of the project company’s performance. Some of the different ways in which the sponsors/shareholders invest in a project are explained in the below chapters. The support provided by project sponsors varies from project to project and includes the giving of comfort letters, cash injection commitments, both pre- and post-completion, as well as the provision of completion support through guarantees and the like. Support is also likely to extend to providing management and technical assistance to the project company. 2.4 THIRD-PARTY EQUITY INVESTORS These are investors in a project who invest alongside the sponsors. Unlike the sponsors, however, these investors are looking at the project purely in terms of a return on their investments for the benefit of their own shareholders. Apart from providing their equity, the investors generally will not participate in the project in the sense of providing services to the project or being involved in the construction or operating activities. Third-party investors typically will be looking to invest in a project on a much longer time frame than, say, a typical contractor sponsor, who will in most cases want to sell out once the construction has been completed. Many third-party investors are development or equity funds set up for the purposes of investing in a wide range of projects and they are starting to become a valuable source of capital for projects. Typically, they will require some involvement at board level to monitor their investment. 2.5 BANKS The sheer scale of many projects dictates that they cannot be financed by a single lender and, therefore, syndicates of lenders are formed in a great many of the cases for the 37 CU IDOL SELF LEARNING MATERIAL (SLM)

purpose of financing projects. In a project with an international dimension, the group of lenders may come from a wide variety of countries, perhaps following their customers who are involved in some way in the project. It will almost certainly be the case that there will be banks from the host country participating in the financing. This is as much for the benefit of the foreign lenders as from a desire to be involved on the part of the local lenders. As with the involvement of local sponsors, the foreign lenders will usually take some comfort from the involvement of local lenders. As is usually the case in large syndicated loans, the project loan will be arranged by a smaller group of arranging banks (which may also underwrite all or a portion of the loan). Often the arranging banks are the original signatories to the loan agreement with the syndication of the loan taking place at a later date. In such cases the arranging banks implicitly take the risk that they will be able to sell down the loan at a later stage. However, participating in project financings is a very specialised area of international finance and the actual participants tend to be restricted to those banks that have the capability of assessing and measuring project risks. This is not to say that banks not having these skills do not participate in project financings, but for these banks the risks are greater as they must also rely on the judgement of the more experienced banks. The complexity of most project financings necessitates that the arrangers are large banks with experience in this market, often having dedicated departments of specialists. For the smaller banks with an appetite for this kind of lending, however, there is usually no shortage of opportunities to participate in loans arranged by the larger banks. 2.6 FACILITY AGENT As with most syndicated loans, one of the lenders will be appointed facility agent for the purposes of administering the loan on behalf of the syndicate. This role tends to assume an even greater significance in project financings as inevitably there are more administration matters that need undertaking. Usually, however, the role of the facility agent will be limited to administrative and mechanical matters as the facility agent will not want to assume legal liabilities towards the lenders in connection with the project. The documentation will, therefore, establish that the facility agent will act in accordance with the instructions of the appropriate majority (usually 66 2/3 per cent) of the syndicate who will vote and approve the various decisions that need to be taken throughout the life of a project. The documentation, however, may reserve for the facility agent some relatively minor discretions in order to avoid delays for routine consents and approvals. 38 CU IDOL SELF LEARNING MATERIAL (SLM)

2.7 TECHNICAL BANK In many project financings a distinction is drawn between the facility agent (who deals with the more routine day-to-day tasks under the loan agreement) and a bank appointed as technical bank, which will deal with the more technical aspects of the project loan. In such cases it would be the technical bank that would be responsible for preparing (or perhaps reviewing) the banking cases and calculating the cover ratios . The technical bank would also be responsible for monitoring the progress of the project generally on behalf of the lenders and liaising with the external independent engineers or technical advisers representing the lenders. It will almost always be the case that the technical bank will be selected for its special ability to understand and evaluate the technical aspects of the project on behalf of the syndicate. As with the facility agent, the technical bank will be concerned to ensure that it is adequately protected in the documentation and will be seeking to minimise any individual responsibility to the syndicate for its role as technical bank. 2.8 INSURANCE BANK/ACCOUNT BANK In some of the larger project financings additional roles are often created for individual lenders, sometimes for no other reason than to give each of the arranging banks a meaningful individual role in the project financing. Two of these additional roles are as insurance bank and as account bank. The insurance bank, as the title suggests, will be the lender that will undertake the negotiations in connection with the project insurances on behalf of the lenders. It will liaise with an insurance adviser representing the lenders and its job will be to ensure that the project insurances are completed and documented in a satisfactory manner and that the lenders’ interests are observed. The account bank will be the lender through which all the project cash flows flow. There will usually be a disbursement account to monitor disbursements to the borrower and a proceeds account into which all project receipts will be paid. Frequently, however, there will be a number of other project accounts to deal with specific categories of project receipts (e.g. insurances, liquidated damages, shareholder payments, maintenance reserves, debt service reserves). 2.9 MULTILATERAL AND EXPORT CREDIT AGENCIES Many projects are co-financed by the World Bank or its private sector lending arm, the International Finance Corporation (IFC), or by regional development agencies, for instance the European Bank for Reconstruction and Development (EBRD), the African Development Bank or the Asian Development Bank. 39 CU IDOL SELF LEARNING MATERIAL (SLM)

These multilateral agencies are able to enhance the bankability of a project by providing international commercial banks with a degree of protection against a variety of political risks. Such risks include the failure of host governments to make agreed payments or to provide foreign exchange and failure of the host government to grant necessary regulatory approvals or to ensure the performance of certain participants in a project. Export credit agencies also play a very important role in the financing of infrastructure and other projects in emerging markets. As their name suggests, the role of the agencies is to assist exporters by providing subsidised finance either to the exporter direct or to importers (through buyer credits). Details of the various multilateral agencies and ECAs and a description of the type of financing support they each provide in relation to projects are set out later. 2.10 CONSTRUCTION COMPANY In an infrastructure project the contractor will, during the construction period at least, be one of the key project parties. Commonly, it will be employed directly by the project company to design, procure, construct and commission the project facility assuming full responsibility for the on-time completion of the project facilities usually referred to as the “turnkey” model. The risks associated with the construction phase are discussed in more detail below. The contractor will usually be a company well known in its field and with a track record for constructing similar facilities, ideally in the same part of the world. In some large infrastructure projects a consortium of contractors is used. In other cases an international contractor will join forces with a local contractor. In each of these cases one of the issues that will be of concern to both the project company and the lenders is whether the contractors in the joint venture will assume joint and several liability or only several liability under the construction contract. This may be dictated by the legal structure of the joint venture itself (e.g. whether it is an unincorporated association or a true partnership). Lenders, for obvious reasons, will usually prefer joint and several liability. Although most projects are structured on the basis that there will be one turnkey contractor, some projects are structured on the basis that a number of companies are employed by the project company to carry out various aspects of the design, construction and procurement process which are carried out under the overall project management of either the project company or a project manager. This is not a structure favoured by lenders as it can lead to gaps in responsibilities for design and construction. Lenders will also usually prefer that the project company divests itself of responsibility for project management and that this is assumed by a creditworthy entity against whom recourse may be had if necessary. 40 CU IDOL SELF LEARNING MATERIAL (SLM)

2.11 OPERATOR In most infrastructure projects, where the project vehicle itself is not operating (or maintaining) the project facility, a separate company will be appointed as operator once the project facility has achieved completion. This company will be responsible for ensuring that the day-to-day operation and maintenance of the project is undertaken in accordance with pre-agreed parameters and guidelines. It will usually be a company with experience in facilities management (depending upon the particular project) and may be a company based in the host country. Sometimes one of the sponsors will be the operator as this will often be the principal reason why that sponsor was prepared to invest in the project. As with the contractor, the lenders will be concerned as to the selection of the operator. They will want to ensure that the operator not only has a strong balance sheet but also has a track record of operating similar types of projects successfully. The contractor and operator are not usually the same company as very different skills are involved. However, both play a key role in ensuring the success of a project. 2.12 EXPERTS These are the expert consultancies and professional firms appointed by the lenders to advise them on certain technical aspects of the project. (The sponsors will frequently also have their own consultants/professionals to advise them.) The areas where lenders typically seek external specialist advice are on the technical/engineering aspects of projects as well as insurances and environmental matters. Lenders will also frequently turn to advisers to assist them in assessing market/demand risk in connection with the project. Each of these consultancies/professional firms will be chosen for its expertise in the particular area and will be retained to provide an initial assessment prior to financial close and, thereafter, on a periodic basis. An important point to note is that these consultancies/professional firms are appointed by (and therefore answerable to) the lenders and not the borrower or the sponsors. However, the cost of these consultants/professional firms will be a cost for the project company to assume and this can be a cause of friction. It is usual, therefore, for a fairly detailed work scope to be agreed in advance between the lenders, the expert and the sponsors. 2.13 HOST GOVERNMENT As the name suggests this is the government in whose country the project is being undertaken. The role of the host government in any particular project will vary from project to project and in some developing countries the host government may be required 41 CU IDOL SELF LEARNING MATERIAL (SLM)

to enter into a government support agreement. At a minimum, the host government is likely to be involved in the issuance of consents and permits both at the outset of the project and on a periodic basis throughout the duration of the project. In other cases, the host government (or an agency of the host government) may actually be the purchaser or offtaker of products produced by the project and in some cases a shareholder in the project company (although not usually directly but through government agencies or government controlled companies). It is usually the case that the host government will be expected to play a greater role in project financing (whether in providing support, services or otherwise) in the lesser developed and emerging countries. Whatever the actual level of involvement the host government of a particular country plays in project financings, its general attitude and approach towards foreign financed projects will be crucial in attracting foreign investment. If there has been any history of less than even-handed treatment of foreign investors or generally of changing the rules, this may act as a serious block on the ability to finance projects in that country on limited recourse terms. 2.14 SUPPLIERS These are the companies that are supplying essential goods and/or services in connection with a particular project. In a power project, for example, the fuel supplier for the project will be one of the key parties. In other projects, a particular supplier may be supplying equipment and/or services required during either the construction or the operating phase of the project. Both the contractor and the operator would also fall under this category. Many of the comments made with respect to the contractor and the operator will also apply to the suppliers. However, it is not always the case that the suppliers (and for that matter the purchasers) are as closely tied into a project structure as, say, the contractor and operator. The lenders may not therefore be in a position to dictate security terms to them to the same extent. Where there is no long-term supplier of essential goods and/or services to a project, both the lenders and the project company are necessarily taking the risk that those supplies will be available to the project in sufficient amounts and quality, and at reasonable prices. 2.15 PURCHASERS In many projects where the project’s output is not being sold to the general public, the project company will contract in advance with an identified purchaser to purchase the project’s output on a long-term basis. For example, in a gas project there may be a long- term gas offtake contract with a gas purchaser. Likewise in a power project the 42 CU IDOL SELF LEARNING MATERIAL (SLM)

purchaser/offtaker may be the national energy authority that has agreed to purchase the power from the plant. However, it is not always the case that there is an agreed offtaker. In some projects (such as oil projects) there will be no pre-agreed long-term offtake contract; rather the products will be sold on the open market and to this extent the banks will take the market risk. In some projects essential supplies to the project (such as fuel) and the project’s output (e.g. electricity) are purchased by the project company or, as the case may be, sold on “take-or-pay” terms. In other words the purchaser is required to pay for what it has agreed to purchase whether or not it actually takes delivery. 2.16 INSURERS Insurers play a crucial role in most projects. If there is a major catastrophe or casualty affecting the project then both the sponsors and the lenders will be looking to the insurers to cover them against loss. In a great many cases, if there was no insurance cover on a total loss of a facility then the sponsors and lenders would lose everything. Lenders in particular, therefore, pay close attention not only to the cover provided but also to who is providing that cover. Most lenders will want to see cover provided by large international insurance companies and will be reluctant to accept local insurance companies from emerging market countries. In some industries (e.g. the oil industry) some of the very large companies have set up their own offshore captive insurance companies, either for their own account or on a syndicate basis with other large companies. This is, in effect, a form of self-insurance and lenders will want to scrutinise such arrangements carefully to ensure that they are not exposed to any hidden risks. In other cases, insurance cover for particular risks either may not be available or may be available only at prohibitive premiums or from insurers of insufficient substance or repute. In such cases the lenders will want to see that alternative arrangements are made to protect their interests in the event of a major catastrophe or casualty. OTHER PARTIES There will be other parties such as financial advisers, rating agencies, local/regional authorities, accountants, lawyers and other professionals that have a role to play in many projects to add to the complexity. Add to this the fact that very often each of these parties will have its own separate legal and tax advisers and it can be seen that the task of legal coordination of these projects can (and frequently is) a difficult, time-consuming and expensive process. This makes effective project management an essential and key part of the success of the implementation of a project. 43 CU IDOL SELF LEARNING MATERIAL (SLM)

2.17 SUMMARY • Investment consultants are those professionals who assist the investors with all market intelligence along with supporting verifiable metrics. Investment consultants have experience in many different facets of the financial world, and may work for a bank, investment firm, or on their own. • An investment consultant works with clients to form an investment strategy. Some of their duties include actively monitoring the client's investments and working with them as their financial objectives change over time. • These financial professionals work in a variety of settings including banks, asset management firms, private investment companies, or they may work independently. Many investment consultants are often experienced in tax and estate planning, asset allocation, risk management, educational and retirement planning. • The project sponsors are those companies, agencies or individuals who promote a project, and bring together the various parties and obtain the necessary permits and consents necessary to get the project under way. They are invariably investors in the equity of the project company and may be debt providers or guarantors of specific aspects of the project company’s performance. • The support provided by project sponsors varies from project to project and includes the giving of comfort letters, cash injection commitments, both pre- and post-completion, as well as the provision of completion support through guarantees and the like. • Third Party Equity Investors are investors in a project who invest alongside the sponsors. Unlike the sponsors, however, these investors are looking at the project purely in terms of a return on their investments for the benefit of their own shareholders. . • The complexity of most project financings necessitates that the arrangers are large banks with experience in this market, often having dedicated departments of specialists. • The Technical bank, which will deal with the more technical aspects of any project loan they would be responsible for preparing the banking cases and calculating the cover ratios . The technical bank would also be responsible for monitoring the progress of the project generally on behalf of the lenders and liaising with the external independent engineers or technical advisers representing the lenders. • Many projects are co-financed by the World Bank or its private sector lending arm, the International Finance Corporation (IFC), or by regional development agencies, for instance the European Bank for Reconstruction and Development (EBRD), the African Development Bank or the Asian Development Bank. 44 CU IDOL SELF LEARNING MATERIAL (SLM)

• In an infrastructure project the contractor will, during the construction period be one of the key project parties. Commonly, it will be employed directly by the project company to design, procure, construct and commission the project facility assuming full responsibility for the on-time completion of the project facilities usually referred to as the “turnkey” model. 2.18 KEYWORDS • IFC-International Finance Corporation • EBRD-European Bank for Reconstruction and Development 2.19 LEARNING ACTIVITY 1. Prepare a Model Project Finance Report indicating the usage of Investment Consultants, Sponsors, Third Party Equity Investors, Banks etc. ________________________________________________________________________ ________________________________________________________________________ 2.20 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Who is an investment consultant? 2. What is the role of multilateral and export credit agencies? 3. Write short note on Host Government 4. Who is project sponsor? 5. Illustrate the role of third party equity investors. Long Questions 1. Differentiate facility agent and technical bank. 2. What do you mean by account bank? 3. Who are the operators and experts? 4. Explain in detail all the investment consultants. B. Multiple Choice Questions 1. Investment consultants receive their remuneration through a. Fees and commission b. Government payment 45 CU IDOL SELF LEARNING MATERIAL (SLM)

c. Interest rate d. None of these 2. Project sponsors are those companies who a. Investors b. Syndicates of lenders c. Promote a project by bringing together various parties d. Does contract work on infrastructure 3.Turnkey Projects are those projects in which a. Single Agency takes care of overall project construction activity. b. Technical Banks execute the Project. c. Only Financial part is taken care. d. None of these 4. More importance is given to Project Insurance to cover any unexpected losses by a. Lenders b. Sponsors. c. Suppliers d. None of these 5. Host Government is the government in whose country the Project is undertaken. a. True b. False c. Partly correct d. None of the above Answers 1-a, 2- c, 3 – a; 4 – a; 5 – a. 2.21 REFERENCES Text Books: • Edward Yescombe, Principles of Project Finance, Yecombe Consulting Ltd., Academic Press 46 CU IDOL SELF LEARNING MATERIAL (SLM)

• Michael Rees, Principles of Financial Modelling: Model Design and Best Practices Using Excel and VBA , The Wiley Finance Series) Reference Books: • Edward Bodmer, Corporate and project finance modelling, Wiley Finance Series 47 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 3 PROJECT RISK AND MITIGANTS Structure 3.0 Learning Objectives 3.1 Identification and Allocation of Risks 3.2 Categories of Project Risks 3.2.1 Construction/ Completion Risks 3.2.2 Operating Risks 3.2.3 Market Risk 3.2.4 Political Risks 3.2.5 Reserve/ Production Risks 3.2.6 Counter Party Risks 3.2.7 Legal and Structural Risks 3.3 Summary 3.4 Keywords 3.5 Learning Activity 3.6 Unit End Questions 3.7 References 3.0 LEARNING OBJECTIVES After studying this unit, you will be able to: • Describe identification and allocation of risk • List various categories of project risks • Understand different categories of project risks 3.1 IDENTIFICATION AND ALLOCATION OF RISKS The essence of any project financing is the identification of all key risks associated with the project and the apportionment of those risks among the various parties participating in the project. Without a detailed analysis of these project risks at the outset the parties will not have a clear understanding of what obligations and liabilities they may be assuming in connection with the project and, therefore, will not be in a position to consider appropriate risk mitigation exercises at the appropriate time. Considerable delays can occur and expense can be incurred, should problems arise when the project is under way and arguments ensue as to who is responsible. Thus, from the sponsor’s point of view, it will be particularly concerned to ensure that it has identified and understood all the risks that they will be assuming in connection with the project. It will want to be certain that it is are able to manage and monitor these risks 48 CU IDOL SELF LEARNING MATERIAL (SLM)

effectively and, where they are not able to do so, either to pass them on to another party involved in the project that is better able to manage any particular risks (perhaps a supplier, contractor or purchaser of products) or, where this is not possible for any reason, perhaps to find some other way of managing the risk such as by taking out insurance or, more radically, altering the structure of the project to extinguish the risk or at least reduce it. From the lenders’ perspective, they will have similar concerns. Additionally, they will have the following concerns: • in assuming any risks associated with a particular project, they will need to be satisfied that there are no regulatory constraints imposed on them by any of the authorities that regulate their activities or pursuant to laws applicable to them • they may have to report non-credit risks assumed by them in connection with their activities to their regulatory authorities • Generally speaking, the more risk that lenders are is expected to assume in connection with a project, the greater the reward in terms of interest and fees they will expect to receive from the project. The task of identifying and analysing risks in any project is not one that can be left to any one party or its advisers. Rather, it is likely to involve the project parties themselves, accountants, lawyers, engineers and other experts who will all need to give their input and advice on the risks involved and how they might be managed. Only once the risks have been identified can the principal parties (the sponsors and the banks) decide who should bear which risks and on what terms and at what price. Ground Rules There are some ground rules that should be observed by the parties involved in a project when determining which party should assume a particular risk: • A detailed risk analysis should be undertaken at an early stage • Risk allocation should be undertaken prior to detailed work on the project documentation • As a general rule, a particular risk should be assumed by the party best able to manage and control that risk, e.g. the risk of cost overruns or delay on a construction project is best managed by the main contractor; in a power project, the power purchaser (if a state entity) is in a better position than others to assume the risks associated with a grid failure and consequent electricity supply problems for any reason • Risks should not be “parked” with the project company, especially where the project company is a special purpose vehicle. The point here is that, where there is a disagreement between say, the fuel supplier and a power purchaser in a power 49 CU IDOL SELF LEARNING MATERIAL (SLM)

project over which party should assume a particular risk, there may be a temptation to park the risk in question with the project company. However, this is simply storing up problems for the future as the project company will rarely be in a position to manage or control that risk, let alone pay for it. 3.2 CATEGORIES OF PROJECT RISKS The following is a list of some of the key project risks encountered in different types of projects. Of course, not all of these risks will necessarily be encountered in each project, but it is likely that most participants in projects will need to consider one or more of these risks and decide by whom these risks are to be assumed and how. It has already been seen earlier that, once these risks have been identified, it is through the various contractual arrangements between the parties, and insurance, that these risks are, for the most part, apportioned and assumed. 3.2.1 Construction/Completion Risk In any infrastructure project involving a construction element, this is likely to be one of the key risks. Will the project be built on time, on budget and in accordance with the applicable specifications and performance criteria? In assessing these risks, the lenders in particular will be looking at the overall contract structure, the identity of the parties involved and factors such as whether the technology involved is proven. The key areas likely to be of concern to the lenders are: • Type of contract: is the construction contract a “turnkey” contract with a prime contractor or are the design and works being undertaken by a series of consultants and contractors with project management being undertaken by the project company? Lenders have a strong preference for turnkey arrangements as this avoids gaps appearing in the contract structure and disputes between the contractors as to where particular responsibilities lie • Price: lenders have a clear preference for fixed-price lump sum contracts. They will wish to be confident that the facility can be completed within the funding which has been committed and that cost overruns are the responsibility of the contractor. If there are to be any changes to the contract price, then the lenders will want to have a say on this particularly if this is as a result of changes to specifications on the part of the project company 50 CU IDOL SELF LEARNING MATERIAL (SLM)