A

CHAPTER 2 INTRODUCTION TO PROJECT FINANCE

Anyone who lives wilhin their means suffers from a lack of imagination. - Oscar Wilde. Irish dramatist, novelist, A poet (1 !" - #$%%& A number of financing options are available for infrastructure projecis. and for PPP projects in particular. One of the most common, and often most efficient, financing arrangement* for PPP projects is "project financing", also known as "limited recourse" or "non-recourse" financing. Project financing normall takes the form of limited recourse lending to a speciall created project vehicle which has the right to carr out the construction and operation of the project. One of the primar advantages of project financing is that it provides for off-balance sheet financing of the project which will not affect the credit of the shareholders or !be grantor, and shifts some of the project risk to the lenders in e"change for which the lenders obtain a higher margin than for normal corporate lending. #his chapter provides an introduction to project financing. 2.1 OFF-B\LANCE SHEET Project financing ma allow the shareholders $o keep financing and project liabilities "off-balance sheet". Project debt held in a sufficientl minorit subsidiar is not consolidated onto the balance sheet of the respective shareholders. #his reduces the impact of the project on the cost of the shareholder$s e"isting debt and on the shareholder$s debt capacit , releasing such debt capacit for additional investments. %learl , an project structure seeking offbalance sheet treatment needs to be considered carefull under applicable law and accountanc rules. #o a certain e"tent, the grantor can also use project finance to keep project debt and liabilities off-balance sheet, taking up less fiscal space. &iscal space indicates the debt capacit of a sovereign entit and is a function of re'uirements placed on the host countr b its own laws, or b the rules applied b supra- or international bodies or market constraints, such as the !(& and the rating agencies #hose re'uirements will indicate which project lending will be treated as ot#-balancc-sbcel for the government, for e"ample the statistical office of the )uropean communities *)urostat+ in decision ,-./0O1 re'uires that such transactions must

SB
r'nan (r, ur tiwani in l)*nutnic+irr

*!+ place instruction risk on the private part *i.e. no completion guarantee from the government+, and */+ the private part must bear either availabilit or demand risk *2e. service deliver or market risk+. !t should be noted that keeping debt off-balance sheet does not reduce actual liabilities for the government and ma merel disguise government liabilities, reducing the effectiveness of government debt monitoring mechanisms. As a polic issue, the use of off-balance sheet debt should be considered carefull and protective mechanisms should be implemented accordingl ." 2.2 LIMITED RECOURSE AND SPONSOR SUPPORT -ecourse financing provides the lenders with full recourse lo the assets or cash 3ow of the shareholders for repa ment of the loan in the case of default b the project compan . 4here the project otherwise fails to provide *he lenders with the repa ments re'uired, the lenders will have recourse to the assets and revenue of the shareholders, with no limitation. One of the advantages to the shareholders of project financing is the absence, or limitation, of recourse b the lenders to the shareholders. #he project compan is generall a limited liabilit special purpose project vehicle, therefore the lenders$ recourse will be limited primaril or entirel to the project assets *including completion and performance guarantees and bonds+. 5on-recourse *sometimes, confusingl , called "limited recourse -+ financing limits the lenders$ recourse to the assets of the project at band in case of default b the project compan . 2imited recourse financing ma be structured in a variet of wa s but will usuall onl provide the tenders with recourse to the assets of the shareholders in certain specified situations, up lo a limited ma"imum amount and over a limited period, A ke 'uestion in an non-recourse financing is whether there will be circumstances in which the non-recourse nature of the borrower$s liabilit is to fall awa and the lenders are to have recourse to part or all of the shareholders$ assets. 6enerall , the t pe of breach of covenant or representation which gives rise tn this conse'uence is a deliberate breach on the part of the shareholders, and, in particular, the shareholders not using appropriate efforts to ensure thai the project is successful b . for e"ample, committing a breach of the operating or joint venture 7ec sections ,./.8 and ,.9 for further discussion of off-balance sheet financing.

8
agreement which governs the running of the project. !t should also be noted thai applicable law will restrict the e"tent to which liabilit can be limited, for e"ample liabilit for jieisonal injur or death. :ifficult 'uestions arise in relation to the obligations of the shareholders lo lake up the participation of joint venturers who drop out or default on their obligations, and, in particular, the 'uestion of when the shareholders are lo be entitled to abandon the project in the event of catastrophe or in the event that the project no longer proves economic. #hese issues will either be resolved in the drafting of the financing agreement or at law *generall through the law of tort or contract+. 4here some portion of the project involves more risk than another, recourse ma be provided to the lenders to the e"tent of that risk or until that high risk period has passed. Alternativel , *be amount of recourse allowed to the lenders ma be limited in value. #he e"tent to which some recourse is provided is commonl called "sponsor support". !n project financing, the construction phase involves particular risks for the lenders. #he value of the project against which the lenders provide financing is usuall in the operation and the pa ment stream suppotled b the concession agreement and not in the e'uipment and materials, the ph sical assets of the project. 7ince the lenders will bear more risk until construction is complete, sponsor support is sometimes provided for the period up to completion of the works, which will generall be defined in the concession agreement and marked b the issue of a certificate or *he passing of specified tests. !t ma also be provided for the period until certain financial ratios are achieved, or until the works have achieved a period of operation al a certain level. Another approach is lo provide the lenders with limited recourse to sponsor assets in the even* of certain breaches of *he financing agreements b the project compan or the shareholders. 7ponsor support ma include; - shortfall guarantees, where the banks, after enforcing all other securit rights, e"perience a shortfall< = bu -down undertakings, a promise *o prepa projec* debt to ensure specified ratios, in certain circumstances< = price guarantees, to ensure pricing of offtake< - market price purchase guarantees, lo purchase a minimum 'uantit of product al market price over a set period< - ta" loss purchases, where a shareholder agrees to purchase certain ta" losses from the project compan <

9,
,rtvalc (rcior Imtatment m - . / . . . . .

= technical support, e"tended warranties and maintenance arrangements< and = contingent e'uit or subordinated debt commitments to cover construction or cither price overruns. #he project compan will want to limit the t pe of breaches resulting in recourse lo the shareholders, such as egregious or intentional breaches of essential covenants or representations which ma alter the lenders$ risk matri". 7ponsor support ma involve the establishmenl of a fund, normall pledged or secured, which can be used, for e"ample, where there is a deficienc of funds or an increase in costs during the period of limited recourse." :ue to the limited recourse and highl leveraged nature of project financing, the majorit of project risks borne b the project compan will therefore be borne b the lenders. #his makes for e"tremal risk averse lenders. #herefore lender due diligence on a projeel will include detailed review of whether project risk allocation protects the project compan sufficientl . #his is known commonl as verif ing the project$s ""bankabilil "," 2J TAKING SECURITY #he lenders will want lo put in place as much securit for the financing as possible. 7ecurit is both $offensive" and "defensive"; offensive lo the e"tent the lenders can enforce the securit to dispose of assets and repa debt where the project fails< defensive to the e"tent that senior securit can protect !he lenders from actions b unsecured or junior credilors. %omplete control re'uires comprehensive fi"ed and floating charges *which terms differ b countr + over all projeel assets, which in common law jurisdictions ma allow the lenders to appoint a receiver to manage the business in the event of insolvenc . !f such comprehensive securit rights are not available, the lenders ma seek lo use nng-fenctng covenants in an effort to restrict other liabilities, securit over project compan shares to allow the lenders to lake over control of the compan or the creation of a special golden share that provides the lenders with control in the event of default. 7ecurit righls ma also #inslc . Practical !ntroduction to Project &inance; 7tructuring and &unding al ,> *,??>+. &or further discussion of bankabilil . tee chapter 1

01taplrr I foltvductitm to ,rv23l 4inance

@8 allow ihe lenders to take over the project rather than just sell the project assets, since the value of the projectiles in its operation and not incompleted assets. 2enders want to be prelected in !he event of insolvenc of !he project compan . #he lenders do not want to rel on !he generosit of the courls under bankruptc proceedings, and will therefore want lo appoint an administrative receiver to manage the allocation or projeel compan assets to the benefiA of its senior creditors. Bnder certain legal s stems, a lender holding securit over all project compan assets, including receivables and future receivables, can appoint such an administrative receiver, la others, !he e"tent to which lenders can lake securit over all projeel assets in the event of insolvenc or failure of the projeel compan , ma be limited and therefore sophisticated structures must be implemented to achieve the level of securit needed b project finance lenders A fi"ed charge attaches lo !he assets immediatel , and such asset can onl be disposed of subject lo thai charge. Bnder a floating charge, the asset ma be managed in !he. ordinar course of business without reference lo !he holder of the charge. #he charge does not attach to an asset until a specified evenA occurs at which point ihe charge cr stalliCes and becomes a fi"ed charge over !he relevant assets. %harges ma be registerable, which provides the lenders with additional comfort.9, #he principal lender issues in relation lo securing their lending include; - share pledge or retention *where ihe lenders can lake over ownership of shares+< = securit over all *or substantiall all+ of !he projeel assets and project agreements< D securit over insurance proceeds *as permitted+, bonds, guarantees and li'uidated damages obligations of the project participants. = collateral agreements and direct undertakings between ihe lenders and the parties to the more significant projeel agreement< * standb e'uit or debt< 2ender rights lo run ihe project rather than just sell offthe used will re'uire consideration of the applicable legal s stem and 115 treatment of securit and insolvenc . -ights over project compan shares ma achieve the desired securit , but ma also involve the lenders taking on project risk ( 7ee also section E ,1 for runner discussion of securit rights.

91
,mar (ector lirvatmm m litfnutrramrr

= legal rights and receivables *in particular !he revenue stream+ of the project compan < = bank accountF including retention and reserve accounts< = sponsor support undertakings< = guarantees from parent companies for their subsidiaries< = government guarantees< = default, cross-default and step-in rights so as to give the lenders ma"imum control over Ghe possible termination, and cure, of an default related to an of ihe project documents, and v comprehensive insurances either as co-insureds or assignable to the lenders. #he nature of the securit taken over projeel assets will depend on ihe provisions of the applicable law and negotiations between !he lenders and Ghe project compan . #he securit rights sought b lenders also include practical control mechanisms, such as reserve discretions *where the projeel compan is limited in the discretion that it can e"ercise without lender approval+. 2enders will also have *rigger events, which allow lenders additional rights and powers in !he event of their occurrence. #he lenders ma want lo have rights, through the projeel compan , against persons other than the project compan and the projeel sponsors, such as; = !he offtake purchasers or projeel users, through for e"ample "take-or-pa " arrangements, or "through-put" agreements in the case of a pipeline or similar project, to guarantee the purchase of a given amount of production or a given amount of use of *he project< = the input suppliers, through for e"ample "pui or pa " agreements, to suppl a given amount of input, such as fuel or raw materials, at a set price< = the operator, lo guarantee proper operation of the projeel, for e"ample so as to produce a set output per unit of input< = the construction contractor, to provide completion guarantees and performance securities ensuring the project meels the performance criteria specified in !he construction contract< and

5hopitr 2 IHBOAHMHI *> ,roftti 4mancr

- the insurers, lo provide compensation for certain evenls which mighl have an impact on the performance and production of the project. #hese rights against third parlies will be set out contractuall , including under direct agreements. An immediate issue is whether the t pe of securit provided is recognised or even legal in the sile countr . (atters of priorit of rights and registration of securit must be considered, as well as ihe levels of fees, stamp dut , adrninistrative costs and an subse'uent dela s which are commonl incurred. &or e"ample, in man countries there is no concept of the general floating charge, an instrument used often for Bnited Hingdom-based project financings." 7ince the t pes of securit provided will often relate to either real propert in the host countr or moveable properl found within the territor of !he host countr , the hosl countr $s legal s stem will generall appl to !he ownership, seiCure and securit over such propert . !nsolvenc and bankruptc laws ma abo restrict the enforceabilit of securit righls. #he project compan ma be a wholl -owned subsidiar of a shell compan which in turn is owned b !he shareholders. #his can permit shareholder issues to be addressed in a more favourable jurisdiction for providing lender securit , voting righls and management arrangements. :espite the comprehensive securit structure to be pul in pace b !he lenders. 11 should be noted that the grantor and or the government will retain reversion righls in those assets needed to provide public services, in order to ensure thai no suspension or degradation of public services would result from termination or e"pir of the projeel. 2.4 FINANCIAL RATIOS 6iven !he importance of leverage and !he sensitivit of lenders to the securit of !he projeel revenue stream, a number of financial ratios will be ke to the anal sis of a projeel financed transaction. &inancial ratios can 'uantif man aspects of ihe projeel compan $s business and operations and are an integral part of anal Cing its financial position. &or instance, profitabilit ratios *e.g. return on e'uit + measure its rate of return, li'uidit ratios *e.g. debt service cover ratio+ measure how much " -nshton and (c5air, 0fioa6d wilh %amion- !%2 /? at @1 *(a ,??1+.

H
,ma7 (tt3r Invetrmml i lyhMMH

cash is available 10 pa down debt, and debl ratios *e.g. loan life cover ratio+ measure the projeel compan $s abilit lo repa long-term debl. :uring due diligence, before financial close, lenders will run !hese ratios using various sensitivities, for e"ample testing the financial ratios in the event construction costs increase b /0I, or revenues fall b ,0I. After financial close, !he lenders wilt use !hese ratios as part of the projeel monitoring and control functions. 4here ratios do not achieve the levels re'uired, the lenders will have a series of possible interventions rncluding blocking distributions, sweeping cash from e"isting accounts, appl ing reserve account mone lo debt service, taking control of additional righls of the borrower or its shareholders9* and other measures to ensure that ihe compan continues lo be managed in a manner focused on successful implementation of the project and earns revenues sufficient lo cover debt service. !f !hese breaches persist, eventuall , such breaches will amount to events of default permitting the lenders to accelerate, cancel outstanding loan amounts or suspended e"isting loans !t ma also permit them to increase the interest margin, re'uire compensation of the lenders for additional investigation costs and other fees and fines #he following sets out some of the main ratios of interest lo lenders. 2.4., :ebt-e'uit *:.)+ ratio A compan $s debl lo e'uit ratio is calculated as long-term debt . shareholders$ e'uit . #he lenders will prefer a lower debl-lo-e'uit ratio in order lo obtain a greater investment from the shareholders, ensure shareholder commitment to the project, increase the net value of projeel assets, and provide the lender with greater securit arising from the additional e'uit capital injection into !he projeel thus increasing the net value of project assets. 7hareholders, on the other hand, will wanA an increased debl-lo-e'uit ratio, decreasing the amount of investment the will need to suppl and, since !he return on debt contributions is fi"ed, increasing the potential return the can obtain from their e'uit contributions. #he actual agreed debl-lo-e'uit ratio will be the result of a compromise between the project compan and !he lenders, based an the overall risk to be borne b the lenders, the project risk generall , the nature of the projeel, the identit of the sponsors, ihe industrial sector and technolog involved, the value of !he projeel and the nature of the financial markets. &or (aniple, debt-lo-e'uit ratios for power 7ee section /./ and /.8 on sponsor support and taking securit

5haplir 2 Introduction to f r o * t c t 4tao23t

17 projects in developing counlries lend lo be in the order of !"2! to 7!"#!$ while other projects with higher market risks ma not e"ceed %!-%& per cent. debl. /.4./ 2oan life cover ratio *22%-+ #he LLCR is the net present value of available cash for debt service up to the maturit of *he credit facilities, divided b the principal outstanding. !t is e"pressed as a ralio representing the number of limes the cashflow *over *he scheduled life of the loan+ can repa the outstanding debt balance. #o verif Ghat the Golal outstanding debt is not al risk from a shortfall, lenders will appl a minimum LLCR lo ensure that !he total revenue available to the projeel compan over !he life of the loan is ade'uate to repa and service the total amount of debt outstanding /.1.8 :ebt service cover ratio *:7%-+ #he amount of pa ment due lo the lenders b the project compan al an given lime is called debt service, and making those pa ments is known as servicing debl. #he lenders will want lo be sure thai as and when each pa ment obligations of !he borrower arises, the borrower will have the mone available lo pa that amount. #he lenders will therefore anal se, through the projeel financial model, the ratio of lotaF amount of revenues available for debl service *e.g. :el of operating costs, insurance premia, ta"es, etc.. but before e'uit distributions+ during a period and compare this to the amount of debt service owed. #he DSCR measures !he amount of cash flow available lo meet periodic interest and principal pa ments on debt. Bnlike the LLCR$ it e"amines the project compan $s abilit to meet its debl pa ments with reference to a particular period of time, for e"ample annuall or semi-annuall , rather lhan OJ%# the life of !he loan- #his assessment can be made forward or backward looking. &igure 2., *though e"tremel simplified+ shows the cushion of revenue forecast above the amounl of debt service due from lime lo time thai is ihe DSCR.

5haplrr 2 taBmlulhii u ,ro/KI 4ino3a

/.1.1 -ate of return *-O-+ -ate of reluni *-O-+ or relura on investment *-O!+. or sometimes just return, is the ratio of mone gained or lost on an investment relative to the amount of mone invested, usuall on an annual basis. !t includes return earned on both debt and e'uit . !nternal rale of return *,--+ is the discount rale that results in a net present value *5PJ+ of Cero of revenues over the project period, which shows the annualiCed effective compounded rate of relura which can be earned on the invested capilaA *again, both debt and e'uit +. -eturn on e'uit *-O)+, on the other hand, strips out the return commilted lo debt serv icing, providing e'uit investors with a picture of their return over the period of the project Private sector shareholders will e"pect a high rale of return when the provide e'uit funding fora project. #he actual rale of relura achieved b the projeel compan can be influenced b ; = e"change rates between the local currenc and an currenc in which debl will be made available, including !he cost of e"change and an applicable or potential currenc restrictions< = the willingness of private seclor lenders, the capital markets or other interested lenders lo provide debt to the project, the interest rales and maturities available for such debt, the debl service cover ratios which the will re'uire, and other conditions which the privale seclor lenders will impose< - !he availabilit of bilateral, e"port credit, multilateral, governmental and other funding for the project< = !he leverage of debl to e'uit thai the project compan can withstand *see below the discussion of weighted average cost of capital+< and = !he la" and accounting regime applicable lo ihe project. !ncluding methods of calculating depreciation, treatment of off-balance sheet financing, and ta" treatment of interest pa ments relating to debl e"ceeding certain legislativel prescribed debl-lo-e'uit ratios. Project financing assists investors in ma"imiCing debt leverage, increasing !he debt-lo-e'uit ratio and reducing ihe weighted average cost of capilaA *4A%%+. &igure /./ shows some of the benefits of project finance as the are imbedded in the different relationships amongst project participants.

,rivait (tciar Invar-tern tn In*ramclurt

F'()*+ 2.2 C,-*-./+*'0/'.0 12 P*13+./ F'4-4.+ 1. 2ower JJA%% given high leverage on the back oi Kcure revenues

! i m lie @ recourse 5o diiTct liabilit b 6overnment or 2enders , :ebt on -balance jheet for 7PJbutofl balanot sheet rot 6overnment and 7hareholders 8 7ubie revenue stream
1.

4A%% is used ,0 measure ihe project compan $s cost of capital; !he value of its o'uit plus the cost of its debt- 4A%% is calculated b multipl ing the cost of each capital component, such as share capital, bonds and long term debt, b ils proportional weight and then adding these components together. Assuming that interest charged on debl is much lower than the returns sought b e'uit investors, increasing the amount of debl also increases e'uit return. #his is because the total amount paid b the project compan in respect of its debl and e'uit *measured b its 4A%%+ will be lower compared lo a projeel full e'uit financed thereb leaving the projeel compan with more runds for distribution and an increased -O). ll also allows investors to spread precious e'uit capital over a greater number of projects *as tolaF e'uit investment re'uired for each projeel decreases through better leverage+, allowing investors *in particular those with specialist sector e"pertise - sponsors+ lo undertake more projects, and thereb deliver more infrastructure. %onsider the following two scenarios where 7100 is invested in a project compan . !n scenario ,, the amount is invested full as e'uit with a return of ,0I. #he 4A%% would be *L100 M lfNI 7100 - 0.,. !n scenario /, !he projeel compan uses !he leverage offered b a 8;, debt lo e'uit ratio and so the 7,O0 e'uit investment is accompanied b debl of 78O0 at a cost of sa 75. #he 4A%%

5kapitr 2 tit8rooiactm9 lo ,ro2ect 4Oion :;

in scenario / would therefore be G*7,00 M ,0J.+ O *@800 M NI+@.7100 - 0.0NE. #he lower 6ACC in iccnano / lBustritei that the projeel compan will have a lower threshold or cojt in overcome before its cash flows create value for shareholders, increasing the return on e'uit investment 2$& CERTAINTY OF RE7ENUE STREAM &uture forecasts of demand, cost and regulation of the seclor in an relevant site countr will be important lo private sector investors coroidering the revenue prospects of the project. &or e"ample, the ma wish to; = review the demand profile for project offtake, in the conte"t of the e"tent to which the project compan will bear project risk and will be able lo influence demand< = e"amine demand projections and information on the historical willingness of consumers to pa tariffs and lo pa 7uch tariffs on time< - look at prospectP for growth, demographic movements, current tariffs and projections of consumer attitudes towards pa ing increased tarit#s< = where tariffs are based on indices, look al projections of the future movement of such indices and their relation lo actual costs, including operating cosls, finance costs, capital e"penditure re'uirements and other such costs< = review public, residential commercial and industriaF consumption and usage, actual and forecast, within ihe service area, and

= consider the impact of technical changes on the revenue stream, for e"ample !he installation of meters ma cause a reduction in use and therefore projeel revenues. #he projeel participants must ensure that the project has received all necessar approvals from the host government and an local authorities, and thai the government will not change ils regulation of the project$s operation in such a wa as to inhibit the project development and production plans, or !he revenue stream. #his risk is often difficult to manage in particular in countries with developing or highl volatile legal and regulator structures. #he project compan will want lo review the reasonableness of sanctions for failure to operate to *he standards re'uired, the pa ment structure for financial penalties, and an further sanctions for project compan breach. #he project

,rtvau (tcur <ottom in Infraslntca))

structure should be reasonable and fle"ible, especiall where the project in 'uestion is to continue over a long period, as tbe incentive mechanisms ma need to change to ensure efficienc as the project evolves over time. 2.% PUBLIC SECTOR SUPPORT 4here the financial viabilit of the projeel is not sufficient to attract appropriate private sector finance, or there is an opportunit lo improve value for mone , or there are project risks thai tbe investor is not well placed lo bear, the bosl government ma consider providing financial or other support of its own. #his support might be e"pressed !hrougb loans, e'uit , written guarantees, direct agreements, comfort letters, legislation or through some other contractual or moral obligation. Qoth the project compan and !he lenders will want to be covered b an such e"pression of support. #his re'uirement ma be difficult for developing countries which are seeking to decrease their national debl in order to improve their credit rating. %ertain countries refuse to provide government guarantees for project financing. Jarious solutions have been suggested lo replace a government guarantee where the lenders are not satisfied with the credit risk of a public entit and the central government refuses to provide a guarantee. #hese generall involve anolhe# entit providing a guarantee or other support, for e"ample a local bank, a development bank, a multilateral organisation or !he shareholders. Public support ma include a mi" of grants, subsidies and other financial support for the project such as. = funding direct pa ments or grants< - providing financing for the project !n the form of loans or e'uit investment< = providing guarantees, including guarantees of debt, e"change rales, convertibilit of the local currenc , offtake purchaser obligations, other supplier obligations, tariff collection, tbe level of tariffs permitted, the level of demand for services and or termination compensation, etc.< = providing an mderrrnit against bad debts owed b stale entities< = providing tariff subsidies for consumers from whom the project compan would have difficult in collecting debts due<

5hapur 1 Iniroduclirm lo ,ro*tcl 4mante

* waiving fees, costs and other pa ments which would otherwise have to be paid b the project compan to a public sector entit *eg. authorising la" holida F or a waiver of ta" liabilit +< = funding shadow tariffs and topping up tariffs to be paid b some or all consumers< and = providing capital assets or other direct in-kind investment. &ilipino Power #he following are undertakings received b investors.lenders from the Philippine 6overnment for power projects in the hue ,??0s;$ = repatriation of capital< = timel and reasonable adjustment of tariffs. $ the fulfilment b the local utilit of its obligations under the take-or-pa agreement< - availabilit of fuel, and = bu -out of the projeel b the utilit in certain specified situations. #here have been a variet of difficulties related to these undertakings, in particular as governments change, but their presence was critical to projeel viabilit . #he projeel compan will want lo ensure that the grantor is capable of fulfilling ils obligations and that those obligations can be enforced against tbe host government where it does not fulfil them. #he host government must first have !he legal and constitutional right lo undertake such obligations. Obligations undertaken without legal right are ultra vires and generall considered lo be void and unenforceable.$$ #he projeel compan will also want lo ensure that the obligations undertaken b the hosl govemmenl are feasible and reasonable, G$lacing obligations on ihe host government which il will not be able lo perform ma cause the entire project lo " 7alcedo, #he &ulure of &inancing Power Projects in ihe Philippines" P&, al ,/1 */ @ur ,??N, $" &or further discussion of ulna vires see section R " i
,

,romt (ector !6IHII = t I2,84

fail. &inall , ihe projeel compan will warn the right lo enforce the obligations placed on the host government, which will include access to an appropriate dispute resolution mechanism and the abilit to enforce an judgment or award against the host government. 4here !he government has in place a robusl fiscal risk rnanagernenl mechanism. !he projeel compan can lake greater comfort in !he support offered b ihe government. 2.7 THE PROJECT PROCESS &inancing arrangements for PPP projects follow a rough iwo step progression. &irst, funding is provided b the lenders and !he shareholders during !he construction phase, which will include up-front fees, development costs, design and construction. #he lenders will advance funding progressivel during ihe construction phase, putting procedures in place before drawdowns of financing are permitted to ensure ihal the funds will be spent in an effective and efficient manner so as to encourage timel completion. Progress pa ments will usuall be linked to milestones and verified b an independent e"pert acting for the lenders and possibl tbe granlor. :uring Ghis first step, tbe lenders will insist on a careful balance of e'uil and debl funding and ma re'uire recourse be ond project assets, lo ihe shareholders or some other guarantor, to cover the risk of an dela s or cost overruns which have not otherwise been transferred lo the construction contractor #he second step is final completion of construction followed b operation. %ompletion of construction includes performance tests 10 ensure that the project is capable of achieving the necessar revenue stream. Approval of final completion will release the construction contractor from certain liabilities and wilt therefore be carefull controlled b the lenders. :uring operation, once the projeel has begun to produce output, the debt is serviced solel b the project revenue stream, 2.7.1 T,+ .140/*)./'14 0/-(+ f=rring the first stage, the construction stage, the lenders provide financing progressivel as the project is designed buitt and commissioned. #he drawdowns of debl will be lied lo pa ment events or milestones, dividing this process into identifiable stages in order to provide incentives lo complete in a timel fashion and so thai the lenders can verif tbe completion of each stage before releasing more funds. #hese pa ment events or milestones will be structured lo re'uire a few large drawdowns, so as to avoid !he cost of administration of more numerous 7ee section 1.9 rbrfunher discussion of fiscal risk management

5hapur 2 lnn6m3litm to ,ro2ta 4inance

a advances. An independent e"pert will often be used lo verif the satisfaction of pa ment conditions for drawdowns. F'()*+ 2.#" P-98+4/0 D)*'4( C140/*)./'14

After construction, completion will need to be verified b the lenders before !he final drawdown can be made. #his final drawdown should be of sufficient siCe to provide an incentive for the construction contractor to ensure proper completion of the project. Part of the contract price ma also be retained until !he end of tbe defects liabilit period and tbe carr ing out of !he performance tests. !n certain cases final drawdown ma occur before completion where final pa ments are lo be made b e'uit infusion or where tbe lenders agree lo allow drawdown against a completion guarantee #he lenders will still want to maintain the construction contractor$s incentive to complete the works in a timel manner. %ompletion represents the end of certain guarantees provided b tbe construction contractor, including li'uidated damages for lale completion. !t ma also signal !he end of an lender recourse lo !he shareholders$ assets thai ma have been available to the lenders *such limited recourse ma be re'uired until completion of construction or the end of ihe first ear of operation, particularl when using untested technolog +. #herefore, the lenders will want to ensure that risks specific lo tbe completion phase, and for which such guarantees were obtained, have been properl managed and fulfilled. )"tensive testing of tbe works will therefore be re'uired

ft
,matt (ector kmmaatm at l)2ratO>5I)rr

2.7.2 T,+ 1:+*-/'14 0/-(+ #he second stage, the operation stage, finds the project on stream and operating al appropriate levels. !t is during Ghis phase lhal ihe lenders are repaid from the project revenues. #he project compan will normall be given a grace period of three lo ,/ months before repa ments begin, providing ihe project compan with a period for "ramp-up" of ihe newl completed project. F'()*+ 2.4" P-98+4/0 D)*'4( O:+*-/'14 )'uit

-epa ment can be calculated in man wa s. Q far the most common method of repa ment is in accordance with a repa ment schedule. #he amount paid can be based on e'ual monthl rates, a percentage of tbe project$s cash flow, a percentage of the project$s revenue for output or a rale per unit of output. -epa ment can also be made in une'ual amounts, based on calculations of projected income and maintenance needs, such as replacement of parts, maintenance periods *during which income ma be decreased+ and peak.off-peak periods.

5hapter 2 tntrvditclivn io ,iarci 4mata

##w flow of fiindmg for a PPP project will look umething hfcc this< F'()*+ 2.&" F)1;'4( 21* - PPP P*13+./

/0
Shaiftiolm Lender Equity i. ?.'? I huckifi Return on
l rr rili !

"e#$ Scr %&Haooii ' (ra )

A
*ro! cu +om&tuiy

<
+once,,ion (ee = T7>.= *urcha,e = Tariff %fftake *urcha,er +orurn,ctiou +on traci hfa -r.&Li Su&&ly *nct Throu.h tn&ul Sy&ct! . *rice

<
+cc,oucdon +ontrae ror 1 Su&&lier

!nput suppl ma be paid b tbe projeel compan from revenues earned or ma be paid directl b the offtake purchaser from a through-put arrangement, or some combination thereof. As can be seen above, there is generall onl one source of revenue for tbe project compan ; the offtake purchaser. #he lenders will re'uire the revenue stream into !he project compan to be funnelled through accounts which provide ihe lenders with securit over such funds and allow Ghe lenders lo control the cash flow waterfall. &igure /.> sets oul a t pical cash flow waterfall and the associated account structure. 6ross revenues *being principall the tariff from the offtake purchase agreement and an dela li'uidated damages from the construction contractor+ will be placed first into the proceeds account, with drawings permitted onl for permitted pa ments *such as operating costs and la" liabilit + and debt service. #be balance will flow into reserve accounts *ensuring the are funded to an agreed

>t
,rivait (eclor fura*meni in infrastructure

level+ io before ending up in a distribution account, from which funds can be made available for repa ment of shareholder subordinated loans and distribution lo shareholders, so long as no event of default or potential event of default persists. F'()*+ 2.%" R+?+4)+ F@1A -4;B P*13++@ A..1)4/0

-n,urance fund, a / Rcin,01cmcnl

Srfcrance TJ %ompensation U I *,r 2i D *( ran lD'mdaDDd it3Mt$ "J R V.V.T. . or -i4ca compan #hml parr liabilit -^ n t M m * ^ 56 (Tcoayincol ofde#t #he reserve accounts are meant to protect the lenders from cash flow shortages, for e"ample;" 9?, @ de<t service reserve - an amount set aside, either funded up-froal b tbe project debt or b project revenues during the operation period, to protect against future inabilit lo repa debl where the projeel pa ment stream is insufficient< On the subject o f reserve accounts, tee alto Jinter and Price. Projeta &inance; A 2egai 6uide *8rd edirion /00>+.
*

5hapter 2 Ir=ro1m=on io ,ro2ect f-0monce

'/
i* @ maintenance reserve - an amounl sci aside during ihe operation period for major maintenance and replacement costs. &or e"ample, major roamtenance costs will generall arise ever five to seven ears for thermal power projects< @ capital e6penditure reserve - an amount set aside based on a percentage of the ne"t ear$s capital e"penditure forecast *where such amounts are particularl large or the project might be short of funds+< @ reha<ilitation reserve - an amounl set aside in case of catastrophic damages< @ lai reserve - an amounl set aside to satisf projeel ta" liabilit when it comes due< and @ stand<y reserve - which ma also lake the form of a loan facilit , for an changes to be made lo the project, not foreseen al the time of financial close 7tandb reserves are sometimes used to cover specific project liabilities, such as where the projeel compan bears the risk of some part of the cosi of changes in law, granlor variations or changes in environmental regulations. Other funds received b the project compan , including insurance funds, performarice li'uidated damages from the construction contractor and third part liabilit , are paid inlo a compensation account. -estrictions on !he use of these funds will be heavil negotiated and ma depend on limitations placed on the funds received *in particular fund* roccivod from irisurijice cover+. 6enerall speaking, funds in ihe compensation account will be al located between reinstatement of an damage caused lo the project, pa ments out lo third parties, prepa ment of debl and pa ment lo !he projeel compan ." #he lenders ma re'uire an pa ment from the compensation account which is to be made lo the project compan to be funnelled into the proceeds accoun2 #he project compan ma be enlillcd lo remove mone from reserve accounts where it provides a teller of credit to support ihe amount withdrawn until those accounts are replenished. &or further discussion of !he lllocatioa of rserfcrrnanit li'uidiied damages, see secuom ,,././ and ,,1 N, and insurance funds through "head for the hills$ clauses, see section ,,.9.9.

N0
,rivate (ector Investment in Infrastrui htre

!t is often preferable for the sponsors to involve the lenders prior to bid submission so that an re'uired reserves can be included in the financial model and the bid tariff. 3owever, earl lender involvement can increase development costs.*$ 2.7.# D*-A;1A4 0.,+;)@+ Project loans ma onl be applied towards permitted uses, in particular approved capital cost of construction and interest during construction. #he lenders will restrict drawdown of debt lo amounts corresponding to completion of part of the construction works, ensuring thai debt drawn represents value added to the project compan $s asset base. #his also provides added incentive lo tbe projeel compan lo ensure compliance b the contractor with ihe construction schedule. #he drawdown schedule will identif construction milestones or another performance based schedule to ensure levels of investment correspond lo the amounl of debl to be advanced 2.7.4 R+:-98+4/ -4; : *+-:-98+4/ -epa ment of the loan will need to be compatible with !he project pa ment profile, either under the concession agreement or !he offtake purchase agreement. !nfrastructure projects are long term placements, with high up-front capital costs and long-term regular revenue streams. 2ow revenues when compared with capital cost for mosl projects means that debt repa ment can onl occur over the long term. :ebt tenors often stretch well be ond ,9 ears lo allow operating costs to remain as low as possible. -epa ments ma be made in instalments or a single amount or some combination thereof. A large single pa ment, in particular at !he end of tbe maturit of the loan, is known as a "bullet$$. 2enders lend to resist allowing set offs, under the "pa now, litigate later" principal. !n addition, allowing set off would complicate the arrangements wilh an s ndicate of banks. #he lenders will want to ensure that sufficient amounts lo service the debt are set aside in the project cash flow and thai where the cash flow is insufficient the insurances and projeel participant liabilit regimes *such as levels of li'uidated damages+ ensure pa ment of debl service in !he event of defaull and other acls or occurrences which might interrupl the projeel pa menl stream. 2enders ma seek to be protected from withholrjirig or other ta" triplications through a la" gross-up mechanism. #he lenders will want certain pa ments made to the projeel compan to be used for prepa ment of debt, for e"ample insurance proceeds resulting from &or further discussions of this issue, sec chapter ,>.

/1
destro ed or damaged assets, tenninaiiori compensalion from an offtake or concession agreement or government entit , compensation for e"propriation. performance li'uidated damages from the construction contractor or other such significant pa ments. #rie grantor and the project compan will want lo use such pa ments for reinstatement of assets or other project re'uirements. 2.7# R+2'4-4.'4( After completion of construction, once construction risk in the projeel has been significantl reduced the project compan will look to refinance project debt at a lower cost and on better terms, given tbe lower nsk premium. #he capital markets are often used as a refinancing tool after completion of tbe project, smce the bondholders prefer not to bear project completion risk, but are often able to provide fi"ed rates al a longer tenor and lower margin than commercial banks. #his refinancing process can significantl increase e'uit return, with the e"cess debl margin released and !he resultant leverage effect. 4hile wanting lo incentiviCe the projeel compan lo pursue improved financial engineering, in particular through refinancing, the grantor will want to share in the project compan $s refinancing gains, often in the form of a 90-90 split. 2.7.% R+:-98+4/ 0.,+;)@+ #he project compan will not have revenues available for debt service *repa ment on debt principal and.or interest+ until after construction completion, after commencement of operation, once revenues have ramped up sufficientl to e"ceed operating costs &or this reason, project finance generall involves a grace period during construction, up lo five ears and ma be more, during which !he project compan does not make debl service pa ments, instead interest incurred during construction *G:%s+ is rolled up and consolidated into outstanding debt. #he projeel is generall given an additional grace period of 8 - ,/ months after completion of construction lo mobiliCe operating capacit and allow revenues to ramp up to robust levels. #his period is also useful lo absorb construction dela s, an often inevitable part of an aggressive construction schedule. 4here lenders do not provide grace periods, alternate mechanisms *though often cosil + can be created through debl engineering and bridging finance. 2. TERMS OF FINANCING A PPP project will involve financing from various sources, in some combination of e'uit and debt. #he ratios of these different contributions will depend on

Ni
,nvt=e (ector Irrreirmeru i n Infras out tore

negotiations between !he lenders and !he shareholders. %ertain selected issues relevant lo !he terms of financing for a projeel financed transaction are discussed below." 2. .1 EC)'/9 .14/*'D)/'140 )'uit contributions are funds invested in tbe projeel compan which comprise ils share capilal and other shareholder funds. )'uit holds the lowest priorit of ihe contributions, therefore *he other contributors will have the right lo project assets and revenues before ihe e'uit contributors can obtain an return< or, on termination or insolvenc , an repa ment. )'uit contributions bear the highest risk and therefore potentiall receive tbe highest returns. )'uit contributors in projeel financed transactions might include the projeel participants, local investors, the host government, the grantor, other interested governments, institutional investors and bilateral or multilateral organisations. )'uit investors will want to pa in their e'uit investment as late as possible in *he construct D0 period, even wholl back-ended to save costs and improve their aggregate e'uit return. 2enders will prefer front-ended or pro rata e'uit investment lo maintain their cushion ratios on debt drawn-down. 2enders ma want a bank or third part pa ment guarantee on e'uit pa ments to be made later in *he project lo ensure the will be available al !he lime agreed. 2. .2 D+D/ .14/*'D)/'140 :ebl can be obtained !ron; man sources, including commercial lenders, institutional investors, e"port credit agencies, bilateral or multilateral organisations, rsondholders and sometimes tbe host countr government 2$nlike e'uit contributions, debt contributions have the highesl priorit amongst the invested funds We.g. senior debl must be serviced before an other pa ments are made+. -epa ment of debt is generall lied to a fi"ed or floating rale of inleresl and a programme of periodic pa ments. #he source of debl will have an importanl influence on the nature of tbe debt provided." #his section will focus on some of !he characterA slics of projeel debl., &or further discussion of negotiating and drafting the financing agreement, sec Jinier and Price *8rd edition /00>+ supra note 90 &or &urther discussion of different lenders, see 9tctioo 8.@.!. &or further discussion of meCCanine and subordinated ciehr, see wcrion /.E.8.

5htif0icr 2 Inimhtclion to ,ro2ect 4inance

7 .A.1 >he relative <enefits of different lenders 4here multilateral organisations and e"port credit agencies number amongsl the /+4;+*0$ the debt package ma D+4+2'@ from certain insulation from political risk and preferential treatment b the host government in relation to repa ment, although such lending ma be more difficult to obtain due to restrictions and re'uirements of multilateral organisations and e"port credit agencies. 7ome of these multilateral organisations also benefit from preferred creditor status, providing greater comfort to the lender group. %ommercial banks are desirable as long-term debt providers, given their fle"ibilit in renegotiating loans and reacting to new or unforeseen conditions. #his fle"ibilit ma not be available, for e"ample, from boridholders. Another 01)*.+ of :*13+./ debl is e'uipment suppliers. 7uppliers will provide financing in order to sell their e'uipment, and ma provide more aggressive terms accordingl &inance lessors pa for assets and lease Ghem back lo *he project compan 4hether or not the lessor is !he e'uipment supplier, il can provide compeliBvel priced financing, in particular lo the e"tent !he lessor can set off the cost of e'uipment against ils profils Gsince !he projeel compan will nol have profits in ihe earl ears lo benefil from this set off+. 2easing can provide additional benefits in tbe financing of infrastructure projects, in particular additional or earlier ta" allowances *in particular depreciation+, new sources of finance *such as vendor finance+, and improved securit '4/+*+0/0 where asset ownership is retained off0,1*+ in a more securit friendl jurisdiction. Qui leasing also adds comple"it lo an alread comple" structure, adding -41@,+T creditor$s interests and influence over projeel assets. &inance leases creale a ta" efficient method for a finance house to purchase a piece of e'uipment and lease it back lo tbe project compan . #be lease pa ments are e'uivalent lo debl service. %learl . !he lenders will wanl to include securit over the @+-0+; assets wiuuh !he project securit regime, and therefore finance @+001*0 will be included in !he intercreditor arrangements. A. .A.A (yndication !n s ndicated lending, each amounl advanced b one of the s ndicated banks constitutes a separate loan, with the bank$s obligations and righls being several. #he banks will not underwrite each 1/,+*0 obligations, and each bank will wanl lo
/

/&or more detailed discussions of dcvelopmeni finance instillations, see section 8 @.8 and :enton 4ilde 7apte, Public Privale Partnerships< QO#
techni'ues and projeci finance. */nd )dition, /00>+

N1
,r8vale (eclor Imwrimrm I n tofrailrwture

sue separatel and make ils own sel off arrangements. #he agenl bank for ihe s ndicate will verif conditions precedent, receive funds, calculate interest rales and make demands on the borrower on behalf of the s ndicale. Onl certain bank actions will be subject to majorit bank control, for e"ample acceleration *where !he whole amounl due under the loan becomes due and pa able immediatel +. !f one bank in the s ndicale receives more mone than it should, there will be a sharing clause thai re'uires the s ndicate banks to share funds received 7uch sharing ma create challenges in some jurisdictions, where holding funds on trusi is not enforceable. 7 ndicale members ma nol be comfortable with simple righls in contract lo claim repa ment of monies from other s ndicate members. M-*E+/ F@+A "market fle"" clause allows an unangei lo change price, structure or terms of the lending facilities in tbe face of changes in financial markets, in order lo enhance tbe prospects of a successful s ndication. #his right is generall onl provided lo arrangers taking significant underwriting risks. 7 ndicated lending generall involves a common lermsUgreemenl, to coordinate basic terms of debt, even though eacb loan will be separatel documenled. including defining the roles lo be pla ed :ifferent bank roles within a s ndicate, include; = Account bank - holds different bank accounts on behalf of the s ndicale< = 7ecurit trustee - holds securit righls for the benefil of ihe s ndicale< and = 3edging providers - provider of the, often ver profitable, hedging arrangements for the borrower. A. .A.B (hari0a financing 2arge project finance transactions provide an opportunit lo combine differem forms of finance, and given their siCe and comple"it ma re'uire a diversit of sources of funding, for e"ample !slamic *compliance with 7hari$a law+ and conventional interest based financing. One of the ke challenges of !slamic financing is that !he !slamic financing institution, possibl through a special-purpose vehicle, will own the underl ing assets, which therefore would nol be available as securit for other lenders. #he mlercredilor arrangements between

5hapter 2 tntro2lii-ttirn tir ,ro*oCi finance

>( commercial and !slamic financing institutions will need to address these challenges.$A. .A." +ank guarantee Qank guarantees form an important part of project financing, allowing counterparties immediate access to pa ment without the cosi of locking up cash. 7uch guarantees ma be "on demand" or onl pa able once the default is proven in court, adjudication or arbitration. A bank issuing a guarantee, letter of credit or performance bond will fi" the amounl and oblain a counter indemnit from the customer, possibl secured against fi"ed or floating charges or cash deposits. #he issuer will be entitled to convert the counter indemnit pa ments imo loans or demand immediale repa menl. #he issuers will enter into !he intercreditor agreement lo ensure sharing ofnghfiover project assets A. .A.! +ondfinancing Qond financing allows the borrower to access debt directl from individuals and institutions, rather than using commercial lenders as intermediaries.", , #he issuer *the borrower+ sells the bands lo tbe investors #he lead manager helps the issuer lo market !he bonds. A trustee holds rights and acts on behalf of the investors, slopping an one investor from mdcpendenll declaring a dcfaull. -ating agencies will assess !he riskiness of the project, and assign a credit rating lo the bonds which will signal to bond purchasers the attraeliveness of *he investment and !he price the should pa . Qond financing generall provides lower borrowing costs, if the credit rating for the projeel is sufficientl strong. -ating agencies ma be consulted when structuring the project to ma"imise the credit rating for tbe project. A monoltne insurer ma provide credit enhancement lo investors, also known as an "insurance wrap". #he monoline insurer has a superior credit rating *usuall AAA+, and provides some undertaking to investors using !hai superior credit rating lo reduce risk for investors, Ghereb improving the rating for the bond and reducing !he ield re'uired justif ing the cosi of !he insurance wrap. " 3assan and 2ewis, 3andbook of !slamic Qanking, */00N+ ** &or r"atner chacuu"sn of documenting a bond issue, see supra note &#.

NK
,rivate (ector <tvestmrnt In InfraDituriure

Qond financing provides a :umber of benefits inchiding lower interest rates, longer maturit and more li'uidit . #he disadvantages associated with financing through bond issues include; $ "negative carr ", bond financing is drawn all at once, up front, and therefore interest is charged on the entire amount from da one. #he borrower will have to bear the "cost of carr ", being the interest paid on the bond proceeds, from tbe date of receipt lo the dale it is used to invest in capital e"penditure. Qond holders will also nol roll up interest during construction *there will be no grace period+ re'uiring !he project compan to borrow enough lo pa interest during construction where it has no revenues during this period. Qanks will charge a commitment fee on amounts of bank debt nol et drawn, bul !bis commiuncnt fee will be substantiall less than !he cosl of can of bond financing, = less certainl in the underwriting process due lo the volatilit in the securilies market, uncertaint unless !he bonds are underwritten *which is rare+. #his said, though the pricing for a bond is nol known until the bond is issued lo the market, bond underwriters should have a good idea of actual pricing based on their pre-markefing work< = less fle"ibilit during project implementation *e.g. lo approve waivers and amendments+, given the diversit of bondholders and the difficult of gelling approval for changes< = more time and cosl, due to more e"tensive disclosure processes and the rating process< and = lack of e"port credit agenc and other support for bonds. Qond financing has seen limited usage for initial project financing, bul is commonl used for refinancing,$ once consiruction risks have been largel miligated 2. J M+<<-4'4+F0)D1*;'4-/+; .14/*'D)/'140 2ocated somewhere between e'uit and debt, meCCanine contributions are accorded lower priorit than senior debt bul higher prioril than e'uit . )"amples of meCCanine contributions are subordinated loans and preference shares. Bse of meCCanine contributions *which can also be characterised as 'uasi-e'uir + will
8

8"

7ee bo" in section /.N.9 for discussion of refinancing.

5napler A Introduction to ,ro2ect 4inance

n allow the project compan to maintain greater levels of debt to e'uit ratio in the project, although at a higher cosl than senior debt, A. .B.1 Eature of su<ordination 7ubordination involves a lender agreeing not 10 be paid until another lender to !he same borrower has been paid, whether in relation lo specific project revenues or in !he event of insolvenc . 7ubordination can be achieved either b contract or through corporate structuring *where the subordinated lender provides debl to a holding compan , which onl has access lo project revenues or assets once the lenders to the subsidiar compan have been satisfied+. %ontractual subordination ma create challenges in some jurisdictions, where subordinated lenders holding funds on lrusl for senior creditors is nol enforceable. 7enior creditors ma not be comfortable with simple rights in contract lo claim repa ment of monies paid lo ihe sur"irdinated lender that should have been paid lo ihe senior lender.A. .B.A DeCCanine financing (eCCanine contributions for projeel financed transactions can be obtained from shareholders, commercial lenders, institutional investors and bilateral and multilateral organisations. 7overeign wealth funds allow countries with superior savings rales lo e"port that capital to other parts of ibe world. #hough often criticised for lack of transparenc and the pursuit of political rather than commercial agendas, sovereign wealth funds represent significant sources of funding for infrastructure projects. 7imilarl , private e'uit funds *often called "infrastructure funds"+ can pla an important role in providing meCCanine financing to a project, taking more risk than traditional lenders, bul less than the sponsors. #he nature of intervention b a private e'uit fund will depend largel on !be nature of thai fund. 7ome bring significant infrastructure finance e"perience, and can help improve project management and cost effectiveness. Others are focused on financial investment with onl limited infrastructure e"perience. A. .B.B 4orm of meCCanine contri<utions (eCCanine contributors will be compensated for !be added risk the lake either b receiving higher interest rates on loans lhan tbe senior debt contributors anaJor b X &or more derailed discussion of subordination, see 4ood, Project &inance. 7eeisnB(iof3 and 7ubordinated :ebt */nd )dition. /00N+.

N,
,rivate (eclor Investment jn tn2rasintcture

receiving partial participation in the project profits or the capital gains achieved b project e'uit . 7haring in capital gains ma be provided b wa of a share option or convertible righl or some other "e'uit kicker" given lo tbe meCCanine contributor. A common form of meCCanine debt is associated with construction cost overruns 2enders will want lo see standb or contingenc funding available to address potential construction cost overruns, usuall in an amounl of about ,0I of the project$s overall funding, while still satisf ing the various projeel ralios if those amounts arc drawn. #herefore stand-b debt will need to be balanced wiih standb e'uit comrwrments. A. .B." Feasons for meCCanine finance #he reasons for providing sur"irdinaled debt are numerous. #he most common involves shareholders$ interests. 7hareholders ma prefer to provide subordinated debt instead of e'uit to; = benefit from ta" deductible interest pa ments, - avoid withholding ta". = avoid restrictions on some institutions nol permitted to invesi in e'uit < y allow ibe projeel compan to service ils subordinated debl when il would nol be permitted lo make distributions< = permit shareholders to obtain some securit , for e"ample lo rank senior against trade creditors< and = access easier variations and waivers of tbe terms of debt than e'uit . Qul. unlike e'uit holders, subordinalcd lenders; = do not share in profits, = do nol normall nave voting and control nghls. - ma need to provide for capital ade'uac re'uirements< and * ma be subject lo usur laws on !he amount of interest the arc allowed to charge, where e'uit would nol.

5hapter 2 introduction to ,ro2ect 4inance

N? 2. .4 C14 ;'; 14 0 :*+. +;+ 4/ %onditions precedenl *%Ps+ will be set against certain events lo prevent the lenders from being committed to providing funds before the project structure and risk allocation matri" are consistent with the lenders$ re'uirements. 7atisf ing %Ps is a comple", detail oriented process that represents a ke moment in projeel financing. #here are two ke sets of %Ps; for financial close and for each drawdown. &inancial close is the momenl the lenders agree to allow first drawdown, and therefore when the projeel moves from ihe development phase to implementation. )ach drawdown e"poses the lenders further, and therefore lenders want lo verif thai the project is still on back, Ghat ratios are still in acceptable ranges and thai an potential problems are identified earl &or this reason, man of the %Ps to financial close will be re-evalualed before each drawdown. #he following is a ver brief introduction to %Ps thai will nol differentiate between %Ps lo financial close and those for drawdown. A. .".1 5ommercial and legal arrangements Qefore the financing arrangements become effective, the lenders will want evidence that !he various project documents and commercial arrangements are in place. %onditions precedent ma include effectiveness of project documents and issue of all permits and consents *for e"ample e"change control consents+, guarantees, contract bonds, collateral warranties, sponsor support and letters of comfort re'uired b the lenders, regulator approvals obtained, evidence that corporate entities are properl formed, environmental reports, due diligence reports from law ers and technical advisers, and legal opinions on relevant commercial and legal structures. A. .".A 4inancial ratios and covenants Qefore an distribution, the lenders will want to confirm thai the borrower is not in default of the financing obligations. %onditions precedenl ma include compliance wilh the debl-lo-e'uit cover ratio, no cosl overruns, commitment of e'uit funds and an securit documents associated wilh e'uit to be provided later in the process, and thai funds available to the project compan at the lime of drawdown are sufficient for completion. A. .".B (ecurity package 2enders will want to see that !he whole of its securit package is in place, effective and enforceable. #his will include verification of asset ownership, registration of

Ya
,rrvau (trlor <rnamm a In2roitnicim

rights over assets, rights over and in bank accounts, perfection of securit *for e"ample its registration+, secured assets -*. free from encumbrances, endorsement of insurance policies, cut through and other arrangements for reinsurance, share pledges, assignment of voting and other shareholder righls, and legal opinions on securit -*T-4(.8.4@0. 2.7.& H+;('4( -4; 2)/)*+0 contracts 7ome financial risks can be shared through financial instruments known as derivatives, futures contracts or hedging. &or e"ample, e"posure lo foreign e"change risk can be miugaled b swapping currenc re'uirements wilh another market participant. )'uall other risks such -0 interest rale risk can be managed through ihe use of derivatives. #hese arrangements arc usuall managed under the common terms set oul in the !7:A master agreement.$$ 3edging arrangements will influence !be cost of debl, and the breakage costs lo be included in termination compensation 3edge counterparties, or possibl a hedging bank, will be a part to the intercreditor agreement to formaliCe ihe sharing of securit and arrangements on default. #o the e"tent that hedge counterparties benefil from project securit , in theor their hedges should also be limited recourse. 7imilarl , if hedge counterparties gel paid out if the suffer a loss when ibe close oul their hedge, then lenders will argue that the should share an windfall profits. #hese issues will be addressed in !he intercreditor arrangements. :erivatives are used in man functions in projeel finance transactions, including = interest rate swaps - lo manage movements in e"change rales lo convert variable rate debl lo fi"ed rate debt. = currenc swaps to manage movements in currenc e"change rales< and = commodit derivative- - lo fi" the price of commodities over time. #he offtake purchaser ma agree to bear mleresl rale risk, b inde"ing part of ils tariff lo cosl of debl. 3owever, such tariff adjustments lo account for interest rale fluctuations are unlikel lo be applied at !he speed al which mleresl rate fluctuations can arise, creating a rrusmaich risk 6uarantees and other credil enhancemenl mechanisms can be used lo mobiliCe fi"ed rale debt. N,,
,

!7:A is the !nternational 7waps and :erivinves Association, see www.isda.i"g. &or a discussion of some such mechanisms, see chapter N

:ktw A nurHtaen io ,ro2tci 4inanceG

II

2. .% S,-*+,1@;+* 0)::1*/ #he lenders ma wanl access lo non-projecl asse !s to protect iheir interests, where !he project does not provide sufficient protection to the lenders. 7hareholder support can lake man forms, lis purpose is lo provide ibe lenders with a guarantee or undertaking from !be shareholders *which ma need lo be supported b bank guarantee, parent compan guarantee or otherwise+ giving the lendcis either access lo further securit or comfort that tbe shareholders are committed lo !he project. #he shareholders, however, have entered min a projeel financing in order to benefit from limited liabilit and recourse. #he will not wanl lo provide further support or increase their liabilit for !he project. Other sponsor support ma include guarantees of borrower warranties *in particular those wilhin the control lo shareholders or lo be verified b them+, indemnities against environmental haCards, guarantees of cosl of materials or demand for project offtake. &or further discussion of sponsor support, see section 2.2 limiled resource and sponsor support. 2. .7 S/+:-'4 !n the case of termination of the concession agreement, ihe lenders will have securit over the project assets. , 3owever, the projeel assets are likel not lo be worth !he value of !he outstanding debt. #herefore. !he lenders often re'uire some form of righi to take over the projeel where the project compan has failed in its obligations and the grantor intends to terminale the concession agreement or the offtake purchase agreement. 7lcp-in provisions give the lenders !he right to step in to the project compan $s righls and obligations under the project documents. #be lenders will want lo ensure thai the grantor is in a position to continue wilh the projeel after step-in. 3owever, the lenders themselves will not wanl lo be involved in ihe actual step-in #he will generall mandate a "substitute entit " lo step in for them. #he step-in regime is usuall included in direct agreements between the lenders, the grantor and the projeel participants ll can involve three different levels of lender intervention in the projeel; cure righls, step-in rights and novation or substitution. As noted above, slep-in rights like securit nghls in projeel financing are generall considered lo pla i defensive, rather than an offensive, role. 7ec also section /.8 on taking securit

Y/
,r2uaie (ector trrveilmemi in infrastructure

A. .H.1 5ure righls %ure rights allow ihe lenders to cure a breach of an obligation b the project compan under one of the project documents, including in particular the concession agreement. )ach of the project participants will be re'uired to inform the lenders of a relevant breach and allow the lenders to cure that breach. 4here the lenders do nol e"ercise their nghl to cure within an established cure period, the relevant project participant ma proceed under its contractual remedies. 2enders will generall be hesitant to involve themselves in the cure of a project compan breach unless the cure is limited to the pa ment of amounts due. #he lenders ma want the opportunit to cure before having to decide whether to step in, for e"ample tbe default ma simpl re'uire the pa ment of monies, but otherwise the project compan is performing wcll. A. .H.A (tep-in rights 7tep-in rights arise where the project compan breaches one of tbe project documents and the relevant project participant chooses to terminate. #he lenders are given a chance to step in with !he projeel compan , cure !he relevant breach and put tbe project back on track. #be other project participants will be re'uired to continue their contractual relationships with the substitute entit in lieu of the project compan , although the project compan will not be released from ils obligations under the project documents. #he lenders will also be permitted lo step out where the choose lo do so, without incurring an continuing liabilities. #be project compan would remain liable both during step-in and after slep-out. 7lep-in rights will also be available for each of ibe project documents. A. .H.B Eovation A third level of step-in involves novation of all of !he project compan $s righls and obligations to a substitute entit , in which case the substitute entit , for the purposes of the project, takes over the projeel compan $s role and ihe projeel compan is removed from the project #be concession agreement, each of the other project documents and an licences or permits will need to provide for novation or be renegotiated before the lenders can successfull novate tbe projeel lo ihe substitute entit . #he various project participants ma re'uire the right to approve the substitute entit , although the should not be permitted to dela or withhold such approval unreasonabl .

5hapter A Inaoavclton to ,ro2ect 4inance

,8 2. . 6-**-4/'+0$ )4;+*/-E'4(0 -4; *+:*+0+4/-/'140 #he project compan will need to covenanl lo !he lenders thai il will not *amongst other things+ change the project plan, project contracts, capital e"penditure program or debt program without lender consent #hese are !be ke elements of the project, which the lenders will want to control to restrict changes in their underl ing nsk profile. #he lenders will wanl the project compan to provide warranties and representations concerning the financial, legal and commercial stalus of ihe projeel compan , and the construction, operation and performance of the works. #he lenders will also want the projeel compan lo provide a series of undertakings in relation lo the project documents and the project compan $s compliance with its obligations. #hese will include "reserve discretions" whereb !he project compan undertakes not to act on certain of ils righls and discretions under the project documents without lender approval or to act on nghts and discretions al !he instruction of the lenders. -epresentations and warranties generall reflect %Ps. #he arc often divided between positive and negative undertakings, though this is often simpl an issue of semantics suite a positive undertaking can generall be framed as a negative undertaking. # pical borrower undertakings include; = Positive undertakings; R %ompl with contractual obligations, in particular construction and operation in accordance with project documents< R %ompl wilh legal obbgalions. in particular in relation lo ihe land and ta"es< R -efrain from e"ercising certain rights and powers *"reserve discretions"+, e.g. arneud, assign or transfer an project contract. R 6ive access to the site and records to the lenders$ advisers and provide reports and other information< R #ake out and maintain insurances. R Bse best endeavours lo achieve completion of construe lion b !he scheduled completion date< R &ile and pa all ta"es promptl < R implement good industr practice, and

K1
,rnnar (t6lor hntsimnu m Itfrairrvtturr

R :iligentl pursue its rights under the project contracts. = 5egative uiHteriakings; R 5o other securit . R 5o other debl *or possibl no e'ual or more senior debl+< R 5o asset disposal< R 5o other business. R 5o other contracts< R 5o other distributions< and Y 5ot lo abandon tbe project. #he warranties and representations will be used b the lenders not so much as a basis for claiming damages but rather as potential events of default which permit the lenders lo suspend drawdown, terminate, demand repa ment and enforce securit . #be lenders will wanl !he project compan to repeat certain warranties and representations with each drawdown and periodicall throughout *he life of tbe loan, lo ensure continued compliance. 2. .G U0+ 12 I40)*-4.+ Although ihe projeel participants ma each provide insurance for the project, il is generall more efficient for the project compan lo provide or ensure provision of comprehensive insurance coverage for the entire project. !n this wa *he interfaces between different insurance packages, the coverage provided b different insurance providers and the overlapping of the tasks performed b the various project participants will not result in overlapping insurance or gaps in insurance coverage. #he lenders ma re'uire that insurance proceeds received b the project compan , in certain circumstances or over certain amounts and al their discretion, must be paid to ihe lenders for repa ment of debt. #he grantor and the projeel compan will want insurance proceeds alwa s lo be used for reinstatement of the works. #his is contrar to the interests of the lenders and will be a heavil negotiated issue. -estrictions imposed b insurers and at law will need to be considered in this conte"t. -e'uired insurance ma become 700 costi or unavailable. #be projeel compan will be re'uired to have in place certain insurances, under the concession agreement and the financing agreemen2 #he parties will need 10 agree how to

5ka*ucr 1 .ADD*KK. I n ,ro*til -HH

1&

manage risks thai become "uninsurable", and the definition of ibis term. &or certain risks, and in certain markets, the grantor ma agree lo be ibe insurer of last resort, effectivel stepping m to insure risk in e"change for the pa ment of the premium last paid when ihe insurance was "insurable" or some other agreed rale. 3owever, the grantor will wanl lo be sure that the increased cosl is not due to projeel compan failure or actions. Applicable law ma re'uire insurance to be obtained locall , in which case the project compan will seek to reinsure those risks inlemattonall in order lo obtain the higher-'ualit insurance protection 2ocal law ma limit the e"tern to which reinsurance can be used 2enders will likel seek cut through arrangements wilh reinsurers, to allow direct pa ment from reinsurers to the project compan and or lo !be lenders. 2. .1! I4/+*.*+;'/1* '00)+0 -4; 0+.)*'/9 /*)0/++ &inancing for the projeel is likel to come from several sources, such as commercial banks, meld lateral organisations, international financial organisations and possibl ihe capital markets, including different levels and classes of debl and e'uit . An intercreditor agreement will often be entered into b the lenders in order to address ke issues. !ntercreditor issues$* include; = Order of drawdown of funds< = %oordinating malunt of loans; = Order of allocation of debt service pa ments< = 7ubordination< = 3olding and acting on securit rights< - (anagement of drawdowns, insurance funds and technical advisers< J )"ercise of discretions< = Joting on decisions, e g variations of lendinc agreements, waiver of re'uirements, accelerate loan, enforce securit , terminate hedging arrangements< and &or more detailed discussion of intercreditor agreements, see 4ood */00N+ supra note N0.

/1 ,mtae (ector Dvcilmcnl in Infiosni6tirr

= (anagement of pa ments 7ecurit and other rights tend to be managed through trustee arrangements, with one of the lenders or a third part acting as agent for the lender group, holding and acting on securit rights 2J.11 L+-;+*0H /+.,4'.-@ -;?'0+* #he lenders normall will wish to engage a technical adviser in order to review the project and the projeel documentation in the pre-financial close phase. #hen during the concession period, particularl during construction, the lenders ma wanl their technical adviser lo advise tbe lenders on tbe progress of the project, and in particular on technical issues, rbe lenders$ technical adviser will usuall certif completion of the works and milestones or progress preceding drawdowns under the financing agreements. 2. .12 T+*8'4-/'14 .18:+40-/'14 On termination, !be projeel assels are generall transferred to the grantor, or lo some other private parr who will continue lo provide services lo the grantor. &or this reason, on termination, the grantor is re'uired lo pa an amount of mone thai compensates !he project compan for the construction of that asset !n tbeevenl of termination for project compan default, termination regimes var , bul focus primanl on some portion of !be market value of the underl ing asset, or if this is nol feasible, the reimbuiscmenl of the outstanding amounl of senior debt al the date of termination, based on lending arrangements thai have been approved b tbe grantor. #he intention is to pa for the asset transferred lo tbe grantor on termination Q siCing compensation to !he amount of senior debl *and not an e'uit or Other costs+, the shareholders are motivated to support the project compan , and !he lenders are encouraged lo lend lo the project. 7enior debl ma nol be paid oul completel in order lo incentiviCe ibe lenders lo use their best efforts lo avoid project compan default, thus, the grantor ma wanA to compensate onl a portion of senior debl. !n more risk jurisdictions ibis ma amount to G!G&5$ while in more secure jurisdictions this ma amounl to 7!-7&5 of senior debt. !n the event of teiminalion for granlor default, the project compan will generall be compensated for debt, losl profit and breakage costs. #he granlor will wanl lo consider carefull ihe definition of these different elements of compensation lo avoid the projeel compan earning e"tra profit or being reimbursed for unreasonable or unnecessar pa ments made lo third and associated parties. #ermination that arises from "no fault" termination, e g e"lended force majeure.

t0oapter 2 Introaucnoti to ,rotra 4inana

usuall results in compensator+ for debt and e'uit capital bul usuall not lost profits and onl some breakage costs. !f tbe underl ing assets are not transferred to tbe grantor, tbe nature of the underl ing loss of the projeel compan will be significantl different. %learl compensation regimes are subject to market forces and will be heavil negotiated, and therefore the above should be considered an indication onl of the termination regime thai will appl in an given project Also, an termination compensation regime must 3i within the applicable legal regime and an restrictions thai ma appl to penalties or e"cessive interest 1.G OTHER RISK ISSUES RELE7ANT TO FINANCING A number of other important issues will be ke lo the successful financing of tbe project 2.G.1 C18:@+/'14 %ompletion represents ihe end of the construction phase of the project. #he construction contractor will be liable for li'uidated damages for late completion, therefore !he definition of "completion" will have a large impact on the construction contractor$s risk. #he lenders will want lo ensure thai completion re'uires the works lo be in a condition sufficient to merit release of the construction contractor from dela li'uidated damages liabilit . #be works will therefore be subjeel lo certain technical tests and demonstration of performance capacit before completion is achieved #he project compan will want lo ensure that the criteria placed on completion can be measured objectivel as set out in the construction contract and that ihe lenders do not have the right to refuse completion owing lo their own subjective evaluation of the works. #his ma involve technical testing effectuated b independent e"perts, or b standard measures or tests with clearl ascertainable results, not unreasonabl subject lo dispute. %learl , the cost of completion will be fundamental lo !he financial viabilit of the project. #he lenders will need some mechanism lo manage !he nsk that the project compan $s cost of completion increases as compared with thai anticipated at financial close." %osl increase risk is discussed further in section 9.1.

renale (ector Inveiimera m hfrmovcmrt

A.$.A F1*.+ 8-3+)*+ -4; change in I-4 ll is important lo nole thai the financing agreements will not include force ma2eure or change in law provisions. #he obligation to repa !he loans will continue in the evenl of force ma2eure or change in law #he lenders will wanl lo review 6ir. force ma2eure and change in law provisions in Ghe projeel documents and ensure thai the are back-to-back *as tar as possible+ wilh the concession agreement. ,* 2.G.# P1@'/'.-@ *'0E As ibe market for project finance transactions has e"panded into developing countries, concerns about political risk have grown. %ommercial lenders ma be prepared lo take a degree of political risk, but in some countries the perceived political risk inhibits or even prevents the financing of projects which otherwise might be viable. 7ince the commercial insurance market can onl absorb a limited degree of true political risk, man project sponsors have turned to multilateral or e"port credit agencies to shoulder some or all of this burden. !ssues which commonl arise in relation lo such cover include; R the scope of "poBucal risk", including regulator risk and administrative risk< = whether or nol political risk includes events in more than one countr or different stales of the host countr < = !he relationship between political risk and other "normal" project risks *for e"ample completion risk+< = tbe e"tent to which a shareholder *particularl a local shareholder+ can influence events which comprise political risk< and = the conse'uences of a political risk evenl occurring and how il affects, for e"ample, shareholder obligations to achieve completion, liabilit of shareholders under indemnities provided to e"port credit agencies or the basic liabilit of the borrower. 2.G.4 E4?'*148+4/-@ *'0E )nvironmental and social laws and regulations will impose liabilities and constraints on a project #be cosl of compliance can be significant and will need lo 4orce ma2eure and change in law are discussed in further detail in chapter ,A.

5hapar 2 huroductioii -o 87IBICI 4inancr

be allocated between the project compan and the grantor. )'uall , in order to attract international lenders, in particular !ris, the project must meet minimum enva-onrncntal and social re'uirements that ma e"ceed those set out in applicable laws and regulations. #his process is made easier where local law supports similar levels of compliance. #he )'uator Principles" constitute a voluntar code of conduct originall developed h !he ,&% and a core group of commercial banks, but now recogniCed b most of the international commercial banks active in project finance. #hese banks have agreed nol to lend lo projects that do not compl wilh !he )'uator Principles. #he follow generall the !&% s siero of categoriCing projects, identif ing those that are more sensitive to environmental or social impact, and re'uiring specialist assessment where appropriate :uring project implementation, the borrower musl prepare and compl with an environmental management plan *)(P+. )nvironmental due diligence in respect of such projects and in respect of the legal regime within which the are being constructed, and an appreciation of the environmental re'uirements of public agencies which will be involved wilh the project, are crucial if the project compan and lenders are lo make a proper assessment of the risks involv ed" 2.G.& C)**+4.9 +I.,-4(+ *'0E Project finance debt is often sourced from foreign lenders, in foreign currencies, et projeel revenues are generall denominated in local currenc 4here tbe e"change rale between the currenc of revenue and the currenc of debt diverge, ihe cost of debt can increase, often dramaticall . #hough under the theor of purchasing power parit , inflation pressures on the devalued currenc will eventuall bring the foreign e"change rate back lo parit , project finance lenders are generall not prepared to wail 'uile so long *with average periods of about ,0 ears+. 4here revenues are to be earned in some currenc other lhan thai in which ihe debt is denominated the lenders will wanl to see the revenue stream is adjusted 10 compensate for an relevant change in e"change rale or devaluation. !f this is nol &or lurther discussion of environmental risk and the )'uaior Principles, see section 9.?. #his issue is discussed in lurther derail in sections 9.?.

mi ,rivate (ector Invament in 9i4mmitmre

available, the lenders will waul lo sec appropriatel robust hedging arrangements or some other mechanism lo manage currenc e"change nsk " 2.G.% I4/+*+0/ *-/+ *'0E !nterest ma be charged al a fi"ed rale, at variable rates *usuall based on the banks lending rate or an inter-bank borrowing rate plus a margin+ or a floating rate *calculated b reference to cost of short-term deposits+. #he spread or margin is e"pressed in "basis points". One basis point is onehundredth of ,I. !nter-bank borrowing rales include 2!QO- *2ondon inter-bank borrowing rate+, )B-.,QO- *in !he )B+ and 5,QO- *in 5ew Zork+. Projeel finance debt lends 10 be fi"ed rale. #his helps provide a foreseeable, or at least somewhat stable, repa ment profile over time to reduce fluctuations in ihe cost of infrastructure services !f leaders ore unable to provide fi"ed rale debl and no projeel participant is willing lo bear !he risk, hedging or some other arrangements ma need to be implemented lo manage the risk that interest rates increase lo a point that debl service becomes unaffordable lo the project- #he tension between local and foreign currenc debt is often a 'uestion of balancing fi"ed rate debl wilh foreign e"change rale nsk or local currenc debl subject lo mleresl rale nskT w 2.G.7 S1.'-@ *'0E !nfrastructure projects generall have an importanl impact on local communities and 'ualit of life, in particularl deliver of essential services like water and electricit or land intensive projects like toll roads. Project impact of societ , consumers and civil societ generall , can result in resistance from local interest groups thai can dela project implementation, increase tbe cosl of implementation and undermine project viabilit #his social r i s k $ " should be high on a lenders due diligence agenda, though il often is nol. #he lenders and projeel compan often look to the grantor to manage this risk. #he granlor in rum ma underestimate ils importance, since the social nsk paradigm for public utilities is #his issue is discussed further m section 9.1. &oreign e"change rale risk is discussed further in secucn 9.1. :elmon, "!mplementing 7ocial Polic into %ontracts for the Provision of Btilit 7ervices", in :am, Hessler and 7clareds., (aking %onnections Putting 7ocial Polic ai !he 3eart of !nfrastructure :evelopment */00N+ 7ocial risk is discussed further in section 9.,0.

11
ver investors different, ihe granlor ma nol have e" perience of 'J implied for priw*