Management Engineering - Financing complex projects

Completed notes of the course

Complete course

Financing Complex Projects 201 - 2022 Lecture Notes 1 LECTURE 1: Why infrastructures are an attractive asset for investor? Infrastructures are long term (more or less 10 years) with long economic life with stable (stability means no volatility, so forecasting more easy and precise) and predictable operating CF (financial perspective that considers only financial cash values, no D&A, no EBIT or EBITDA; we consider only CASH FLOW), with low technological risk (it9s amature market where the uncertainty on investment costs, risks etc islower; and there isnot so much new technology required). Provision of key public services. Strongly non−elastic demand (the demand in this sector isrigid, meaning that the price can increases without ashirk in the demand → retta price−quantity vertical, ifthe price increases or decreases the qremains the same). Typically the market isamonopoly or near−monopoly (one player only, and the efficiency ishigher because of that), this isalso linked with high entry barriers (huge investment, law, concessions&). The assets in this market isregulated by government because there isonly one player and the product isessential so the price can be increased by infinite (usually the price isdetermined by governments and it9s afair price for consumers and fair and stable remuneration for owner). Frequent natural hedge against inflation (if there isastrong inflation the price isadjusted and so the investment is protected; in particular in the operational phase, when the infrastructure isalready done). Low correlation with traditional asset classes. Higher return respect to government bonds (10−15−20 years term), thanks to alower interest rate. How to finance infrastructure development? Large size compared to assets in place, high risk/high return profile, high correlation with existing assets. There are two options available: • Corporate finance: the project isdeveloped into the company, the new Assets, Debt and Equity are higher because they are added with the one of the investment, so the structure of the company is changed and even its risk profile. And all the project are financed by the same entity as aportfolio of projects. • Project finance: here the starting point company create anew company (SPV =special purpose vehicle) that ishold by the investor but incorporate the new project as an external legal entity (that has only the project as Asset), so the structure of the starting company remains untouched. With SPV we can create some special rules or financial constraints (no dividend distribution for instance), in order to reduce the risk profile (different cost of capital and cost of debt), atailor made financial product that has controlled behaviours. How can Ichoose between these two? According to project developers 9characteristics and preferences, to characteristics of the project [size, sector, return/risk (if it9snot stable, there are no many banks that want to finance me)], lenders 9preferences and market conditions . 2 Project finance =industrial project financed off−balance sheet in aSPV within anetwork of contractual agreements with key counterparts. All the economic consequences are attributed to the SPV& slide 17 Infrastructure can be seen as anetwork of contracts: • Financial =sponsor for providing Equity capital and lenders to provide Debt capital to SPV (the project company). • Project/industrial =in which the SPV receives the assets to design, build and operate (TKCC; O&MA, FSA, RMSA&). Why this structure? Because the SPV isaempty entity and need input factors that have to be purchased. Operating CF >debt service isthe minimum condition, and we need to demonstrate to banks this in order to receive funds. When there are changes due to exogenous factors (government actions or regulators) the SPV ask to modify revenues (customers pay more, higher specific tariff. Modify the benefits analysis ) to guarantee the debt repayment. Because ifthe infrastructure is essential they have to avoid the bankruptcy. PROs :higher return for sponsors and shareholders, not all the data appear on BS or notes of the directors, the sponsor istotally isolate from SPV and possible negative events, easier evaluation of security interests through SPV . CONs: high transaction costs as compared to the corporate financing (cost to create the contractual structure). There are 4types of sponsor that launch aproject finance initiative: 1. Industrial sponsor =business reasons that are linked to core business and so not only for return reasons. 3 2. Contractor =plant contractor motivate to participate with asmall share. 3. Public sponsors =for the chance to realize public works for social community, working with private money and not public funds 4. Financial sponsors =the most present, they are the single goal to invest capital in ahigh profit deals. For instance: private banks or multilateral development banks, infrastructure funds, institutional investors and SWFs (sovereign wealth funds). The focus of fundraising ison renewables, telecoms and energy mainly; spread all around the world especially in EU and north America. LECTURE 2: THEORY OF PROJECT FINANCE: In one SPV usually we have only one project. The financial structure (and financing decisions) doesn9t matter in term of value creation (Modigliani and Miller theory) and the rise of project finance provides strong evidence of that. Itisnot clear why firms use project finance giving that ittakes longer and more costly; the project debt is often more expensive (50 to 400 bps) due to its non−recourse nature; the managerial flexibility and discretion are restricted due to high leverage and extensive contracting; itrequires greater disclosure of information; harder to obtain operating synergies as the project isindependent; less interest tax shields. Therefore, why? The two financing methods show major differences ifthe project isvery large with respect to the current size of the company, has an higher risk profile than the avg riskiness of the existing portfolio of assets, and ifitisrelated to the core business (limited diversification effect). → contamination risk (high potential risk for existing company, reason why company in this case prefers aproject financing). Example of risk contamination: There are 2project with different market value, size, return and risk profile (std. deviation), what isthe portfolio return and the risk profile? The portfolio has abetter result in term of return, but also the risk! And the results are more aligned with the Project B(new project), so the shareholder in project A 4 (existing) will be not so happy! And also ifwe compute the results with different correlation values (ro) the results are however worst → contamination risk of the new project on the existing assets (a default of the new also leads to default of already−existing assets). Therefore, in this situation the solution of separating the two projects can be the optimum solution to avoid contamination risk. This isnot necessarily always the best solution for creditors (creditors wealth expropriation risk due to absence of coinsurance effect → two projects together can balance the losses of one of the two). Example: 2projects → one already in place financed by debt (100 with zero coupon, all repay at the end) and one new project financed by debt (100 with zero coupon). Which isthe best financing alternative? The first figure isthe Corporate approach (where there isin the 5scenario the coinsurance effect) and the second one isthe Project one (. Slide 13 *In scenario 5we have the default of the SPV, but the company isalways able to paid dividends to shareholders, when in the corporate finance the project 1has to save the default of project 2, so the dividends for shareholders are lower. The risk pass from shareholders to debtholder, reason why in project financing the cost of debt ishigher. 5 Answers to concession; because it9s harder to stop the relationship). • BOT (Build−Operate−Transfer) =the private build afacility, and manages itfor agiven period of time. The ownership remains to the public body. • BOOT (Build−Own−Operate−Transfer) =same of BOT but here there isalso the obtaining of the ownership for the private. Funding isprovided by the private who has the right to retain the R coming from the management of the facility. The concession must be sufficiently long to enable repayment of the investment and adequate ROI. Instruments of government to find acounter party: Grants; Availability based payments [regulated revenues that have to cover Opex +Depreciation +RAB*WACC (=Return on invested capital) → tariff (€/service; service that can be volume or #of customers: the #of customer ismore stable and easier to forecast than the volume, that have avolume risk for the private player]; Credit−enhancement tools; Direct provision of debt and equity capital; Other measures. CASE STUDY LECTURE 3: PROJECT CHARACTERISTICS, RISK ANALYSIS AND RISK MANAGEMENT Introduction: In the pre -completion phase we can incur in three types of risk: planning, technology and construction 8 In order to neutralize this risks we can utilize for example turnkey construction contract (TKCC) with specific penalties: After the deadline of the completion of the infrastructure (commercial operating date =COD) there isa plant testing done by independent technical engineers that verify minimum performance std (MPS). Ifthe MPS are not met the possibilities are Liquidity, that isthe project default (SPV tries to avoid the liquidation, because it9s abankruptcy of the SPV); another possibility is