Wednesday, September 10, 2008

Infrastructure funds

Project finance is the financing of long-term infrastructure and industrial projects based upon a complex financial structure where project debt and equity are used to finance the project. Usually, a project financing scheme involves a number of equity investors, known as sponsors, as well as a syndicate of banks which provide loans to the operation. The loans are most commonly non-recourse loans, which are secured by the project itself and paid entirely from its cash flow, rather than from the general assets or creditworthiness of the project sponsors, a decision in part supported by financial modeling. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets, and are able to assume control of a project if the project company has difficulties complying with the loan terms.

Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of a project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound. Project finance is often more complicated than alternative financing methods. Traditionally, project financing has been most commonly used in the mining, transportation, telecommunication and public utility industries. More recently, particularly in the world , project financing principles have been applied to quasi-privatizations of publicly-held infrastructure (e.g., hospitals, light rail, , Harbor , Water Supply , Power Pkant, etc.) under so-called public-private partnerships (PPP).

Risk identification and allocation is a key component of project finance. A project may be subject to a number of technical, environmental, economic and political risks, particularly in developing countries and emerging markets. Financial institutions and project sponsors may conclude that the risks inherent in project development and operation are unacceptable (unfinanceable). To cope with these risks, project sponsors in these industries (such as power plants or railway lines) are generally completed by a number of specialist companies operating in a contractual network with each other that allocates risk in a way that allows financing to take place.

The various patterns of implementation are sometimes referred to as "project delivery methods." The financing of these projects must also be distributed among multiple parties, so as to distribute the risk associated with the project while simultaneously ensuring profits for each party involved.

A riskier or more expensive project may require limited recourse financing secured by a surety from sponsors. A complex project finance scheme may incorporate corporate finance, securitization, options, insurance provisions or other further measures to mitigate risk.

Project finance shares many characteristics with maritime finance and aircraft finance; however, the latter two are more specialized fields.The main challenges of financing large-scale projects.Projects like power plants, toll roads or airports share a number of characteristics that make their financing particularly challenging.

First, they require large indivisible investments in a single-purpose asset. In most industrial sectors where project finance is used, such as oil and gas and petrochemicals, over 50% of the total value of projects consists of investments exceeding $1 billion.

Second, projects usually undergo two main phases (construction and operation) characterised by quite different risks and cash flow patterns. Construction primarily involves technological and environmental risks, whereas operation is exposed to market risk (fluctuations in the prices of inputs or outputs) and political risk, among other factors. Most of the capital expenditures are concentrated in the initial construction phase, with revenues instead starting to accrue only after the project has begun operation.

Third, the success of large projects depends on the joint effort of several related parties (from the construction company to the input supplier, from the host government to the off-taker)so that coordination failures, conflicts of interest and free-riding of any project participant can have significant costs. Moreover, managers have substantial discretion in allocating the usually large free cash flows generated by the project operation, which can potentially lead to opportunistic behaviour and inefficient investments.

The key characteristics of project financing structures

A number of typical characteristics of project financing structures are designed to handle the risks illustrated above. In project finance, several long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures, are used to align incentives and deter opportunistic behaviour by any party involved in the project. The project company operates at the centre of an extensive network of contractual relationships, which attempt to allocate a variety of project risks to those parties best suited to appraise and control them:

for example, construction risk is borne by the contractor and the risk of insufficient demand for the project output by the off-taker (Graph 3). Project finance aims to strike a balance between the need for sharing the risk of sizeable investments among multiple investors and, at the same time, the importance of effectively monitoring managerial actions and ensuring a coordinated effort by all project-related parties.

Large-scale projects might be too big for any single company to finance on its own. On the other hand, widely fragmented equity or debt financing in the capital markets would help to diversify risks among a larger investors’ base, but might make it difficult to control managerial discretion in the allocation of free cash flows, avoiding wasteful expenditures. In project finance, instead, equity is held by a small number of “sponsors” and debt is usually provided by a syndicate of a limited number of banks. Concentrated debt and equity ownership enhances project monitoring by capital providers and makes it easier to enforce projectspecific governance rules for the purpose of avoiding conflicts of interest or suboptimal investments.

The use of non-recourse debt in project finance further contributes to limiting managerial discretion by tying project revenues to large debt repayments, which reduces the amount of free cash flows. Moreover, non-recourse debt and separate incorporation of the project company make it possible to achieve much higher leverage ratios than sponsors could otherwise sustain on their own balance sheets. In fact, despite some variability across sectors, the mean and median debt-to-total capitalization ratios.

for all project-financed investments in currently were around 70%. Nonrecourse debt can generally be deconsolidated, and therefore does not increase the sponsors’ on-balance sheet leverage or cost of funding. From the perspective of the sponsors, non-recourse debt can also reduce the potential for risk contamination. In fact, even if the project were to fail, this would not jeopardise the financial integrity of the sponsors’ core businesses. One drawback of non-recourse debt, however, is that it exposes lenders to project-specific risks that are difficult to diversify. In order to cope with the asset specificity of credit risk in project finance, lenders are making increasing use of innovative risk-sharing structures, alternative sources of credit protection and new capital market instruments to broaden the investors’ base.

Hybrid structures between project and corporate finance are being developed, where lenders do not have recourse to the sponsors, but the idiosyncratic risks specific to individual projects are diversified away by financing a portfolio of assets as opposed to single ventures. Public-private partnerships are becoming more and more common as hybrid structures, with private financiers taking on construction and operating risks while host governments cover market risks.

There is also increasing interest in various forms of credit protection. These include explicit or implicit political risk guarantees,6 credit derivatives and new insurance products against macroeconomic risks such as currency devaluations. Likewise, the use of real options in project finance has been growing across various industries.7 Examples include: refineries changing the mix of outputs among heating oil, diesel, unleaded gasoline and petrochemicals depending on their individual sale prices; real estate developers focusing on multipurpose buildings that can be easily reconfigured to benefit from changes in real estate prices.

Finally, in order to share the risk of project financing among a larger pool of participants, banks have recently started to securitise project loans, thereby creating a new asset class for institutional investors. Collateralised debt obligations as well as open-ended funds have been launched to attract higher liquidity to project finance.

The term structure of credit spreads in project finance

The specific risks involved in funding large-scale projects and the key characteristics of project financing structures illustrated in the previous sections (in particular high leverage and non-recourse debt) have important implications for the term structure of credit spreads for this asset class.

First, based on the widely used framework for pricing risky debt originally proposed by Merton (1974), we should expect to observe a hump-shaped term structure of credit spreads for highly leveraged obligors. In this approach, the default risk underlying credit spreads is primarily driven by two components:
(1) the degree of firm indebtedness or leverage and
(2) the uncertainty about the value of the firm’s assets at maturity.

Given Merton’ s assumption of decreasing leverage ratios over time, postponing the maturity date reduces the probability that the value of the assets will be below the default boundary when repayment is due. On the other hand, a longer maturity also increases the uncertainty about the future value of the firm’s assets. For obligors that already start with low leverage levels, this second component dominates, so that the observed term structure is monotonically upward-sloping.

For highly leveraged obligors, instead, the increase in default risk due to higher asset volatility will be strongly felt by debt holders at short maturities, but as maturity further increases, the first component will rapidly take over, thanks to the greater margin for risk reduction due to declining leverage. This leads to a hump-shaped term structure of credit spreads for highly leveraged obligors.

Second, despite the extensive network of security arrangements, the credit risk of non-recourse debt remains ultimately tied to the timing of project cash flows. In fact, projects which are financially viable in the long run might face cash shortages in the short term. Ceteris paribus, obtaining credit at longer maturities implies smaller amortising debt repayments due in the early stages of the project. This would help to relax the project company’s liquidity constraints, thus reducing the risk of default. As a consequence, longterm project finance loans should be perceived as being less risky than shorterterm credits.

Third, the credit risk of non-recourse debt might be affected not only by the timing but also by the uncertainty of project cash flows and how the latter evolves over the project’s advancement stages. In fact, successful completion of the construction and setup phases can significantly reduce residual sources of uncertainty for a project’s financial viability. Arguably, extending loan maturities for any additional year after the scheduled time for the project to be completely operational might drive up ex ante risk premia but only at a decreasing rate.

Finally, the term structure of credit spreads observed in project finance is likely to be affected by the higher exposure of large infrastructure projects to political risk and by the availability of political risk insurance for long-term project finance loans. While long maturities and political risk represent in principle separate sources of uncertainty, commercial lenders are often willing to commit for longer maturities in emerging economies only if they obtain explicit or implicit guarantees from multilateral development banks or export credit agencies. As political risk guarantees are most often associated with longer maturities, lenders should not necessarily perceive political-risk-insured long-term loans as being riskier than uninsured short-term loans, ceteris paribus

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