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Project financing is an innovative and timely financing technique that has been used on many high profile corporate projects including Euro Disneyland and Eurotunnel. Employing a carefully engineered financing mix, it has long been used to fund large scale natural resource projects, from pipelines and refineries to electric generating facilities and hydroelectric projects. Increasingly, project financing is emerging as the preferred alternative to conventional methods of financing infrastructure and other large scale projects worldwide.
Project financing discipline includes understanding the rationale for project financing, how to prepare the financial plan, assess the risks, design the financing mix and raise the funds. In addition, one must understand the cogent analyses of why some projects have succeeded and why some have failed. A knowledge base is required regarding the design of contractual arrangements to support project financing; issues for the host government legislative provisions, public/private infrastructure partnerships, public/private financing structures; credit requirements of lenders, and how to determine the projects borrowing capacity; how to prepare cash flow projections and use them to measure expected rates of returns; tax and accounting considerations; and analytical techniques to validate the projects feasibility.
Project Finance is finance for a particular project, such as a mine, toll road, railway, pipeline, power station, ship, hospital or prison, which is repaid from the cash flow of that project. Project Finance is different from traditional forms of finance because the financier principally looks to the assets and revenue of the project in order to secure and service the loan. In contrast to an ordinary borrowing situation, in a project financing the financier usually has little or no recourse to the non -project assets of the borrower or the sponsors of the project. In this situation, the credit risk associate with the borrower is not as important as in an ordinary loan transaction; what is most important is the identification, analysis, allocation and management of every risk associated with the project.
The purpose of this paper is to explain in a brief and general way, the manner in which risks are approached by financiers in a project finance transaction. Such risk minimisation lies at the heart of project finance.
In a no recourse or limited recourse project financing, the risks for a financier are great. Since the loan can only be repaid when the project is operational, if a major part of the project fails, the financiers are likely to lose a substantial amount of money. The assets that remain are usually highly specialised and possibly in a remote location. If saleable, they may have little value outside the project. Therefore, it is not surprising that financiers, and their advisors, go to substantial efforts to ensure that the risks associated with the project are reduced or eliminated as far as possible. It is also not surprising that because of the risks involved, the cost of such finance is generally higher and it is more time consuming for such finance to be provided.
Risk Minimization Process:
Financiers are concerned with minimizing the dangers of any events which could have a negative impact on the financial performance of the project, in particular, events which could result in: (1) the project not being completed on time or on budget; (2) the project not operating at its full capacity (3) the project failing to generate sufficient revenue to service the debt (4) the project prematurely coming to an end.
The minimisation of such risks involves a three step process. The first step requires the identification and analysis of all the risks that may bear upon the project. The second step is the allocation of those risks among the parties. The last step involves the creation of mechanisms to manage the risks.
If a risk to the financiers cannot be minimized, the financiers will need to build it into the interest rate margin for the loan.
STEP 1- Risk Identification and analysis
The project sponsors will usually prepare a feasibility study eg: as to the construction and operation of a mine or pipeline. The financiers will carefully review the study and may engage independent expert consultants to supplement it. The matters of particular focus will be whether the costs of the project have been properly assessed and whether the cash –flow streams from the project are properly calculated. Some risks are analysed using financial models to determine the project’s cash-flow and hence the ability of the project to meet repayment schedules. Different scenarios will be examined by adjusting economic variables such as inflation, interest rates, exchange rates and prices for the inputs and output of the project. Various classes of risk that may be identified in a project financing will be discussed below.
STEP 2- Risk allocation
Once the risk are identified and analysed, they are allocated by the parties through negotiation of the contractual framework. Ideally a risk should be allocated to the party who is the most appropriate to bear it and who has the financial capacity to bear it.it has been observed that financiers attempt to allocate uncontrollable risks widely and to ensure that each party has an interest in fixing such risks. Generally, commercial risk are sought to be allocated to the private sector and political risks to the state sector.
STEP 3- Risk management
Risks must be also managed in order to minimise the possibility of the risk event occurring and to minimise its consequences if it does occur. Financiers need to ensure that the greater the risks that they bear, the more informed they are and the greater their control over the project. Since they take security over the entire project and the must be prepared to step in and take it over if the borrower defaults. This requires the financiers to be involved in and monitor the project closely. Such risk management is facilitated by imposing reporting obligations on the borrower and controls over project account. Such measures may lead to tension between the flexibility desired by borrower and risk management mechanisms required by the financier
This paper only gives a brief overview of the common risks and methods of risk minimisation employed by financiers in project finance transactions. As stated previously , each project financing is different . Each project gives rise to its own unique risks and hence poses its own unique challenges. In every case, the parties – and those advising them-need to act creatively to meet those challenges and to effectively and efficiently minimise the risks embodied in the project in order to ensure that the project financing will be a success.
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