Stages of project finance

In project finance, project development is the process of financing a capital-intensive project and preparing it for commercial operations. The stages of project finance starts with the origination of a project, followed by negotiation of project agreements, concluding with mobilizing of financing and successful commissioning of the facility.

Time elapsed for a major project from the award to financial closing can easily amount to one year and occasionally several years. As a rule, project development in emerging markets is more time consuming due to the absence of experience and policies. A World Bank study estimated that in developed economies, transaction costs in financing infrastructure projects were usually 3-5 percent of total project costs.

Pre-bid stage

At pre-bid stage, the sponsor of the project or the Project Company secures a conditional right from a ceding authority pursuant to a tendering process or an unsolicited proposal to build the facility.

Bidding process

A host country ceding authority may issue a call for proposals from interested private bidders, usually under well-defined procedures for the rights to build and operate a specific infrastructure facility. Multilateral banks that provide technical assistance and financing, such as the World Bank and Asian Development Bank, usually insist on a tightly defined tendering process, referred to as an international competitive bidding (ICB). Under the ICB process, evaluation and award of bids are made according to ground rules set forth at the beginning of the process and adhered to throughout the tendering process. A major drawback is that a formal solicitation can take six months to complete and sometimes much longer.

Alternatively, a private entity may under their own initiative submit an unsolicited proposal to a ceding authority proposing a specific project. If the project is of interest to the authority, The Two parties directly negotiate the terms of a license or concession without undergoing a formal tender. This is more common when the proposed project contains important innovations - a new type of projection, or a new solution to a known problem, or new ways of defining performance standards. For developers, unsolicited proposals are usually less costly to prepare and provide more scope to participate in defining the technical and commercial outlines of the project.

Chile's concession system allows the government to offer a bid premium to good IDeaS in unsolicited proposals. The proprietary concept is then made the central feature of a competitive tender that is open to everyone that has the technical and financial ability to implement the project. In the Philippines, when a ceding authority receives an innovative unsolicited proposal, it announces the broad nature of the proposal, then gives potential competitors 90 days to come forward with an alternative cheaper proposal.

The cost of preparing bids can be prohibitively large relative to the contract amount. For example, competitive bidding for small water utilities, each supply just a few thousand customers, might not justify the transaction costs. One option is to pool municipalities and have them auction a single, large concession. A second option is to restrict the number of bidders through a short-listing procedure. A third option still is to have consumers share the costs of bid preparation. In the United Kingdom, for example, sharing of bid costs is allowed under the private finance initiative (up to 50 percent) and has been used for Eurotunnel and Athens International Airport.

In emerging economies, it is common for project developers to engage a local advocate or partner to assist in the bidding process.

Feasibility study

Technical feasibility studies are conducted to consider the appropriateness of the facility's design relative to the needs to be serviced; capacity and phasing; cost under current or projected market conditions at one or more sites; construction schedule; and price, availability and transportation requirements of major inputs. Additional factors include the potential for unanticipated delays as well as the facility's operating characteristics, including useful life, reliability, efficiency, required maintenance, and vulnerability of its technology to innovation. A preliminary technical feasibility study has a margin of error of plus or minus 30 percent while a very complex project could have a large margin of error.

The feasibility study focuses on "hard" construction costs, and does not usually include financing costs or development (transaction) costs. Determining whether the project is finance-able is a difficult call, however, during the pre-bid stage. The project agreements have not yet been negotiated, the project cost is not pinned down, and the interaction between costs and revenues is not yet fully tested.

Contract negotiation stage

The project participants negotiate and formalize agreements defining the technical, economic, and commercial outlines of the project. The risk sharing provisions of the documents are usually structured in such a way as to remove risk from the project vehicle and allocate it to someone else in a better position to absorb it.

The sponsor is not able to approach the financial markets until the end of the contract negotiation stage of project development.

By the end of the contract negotiation stage, the sponsor will have developed fairly sophisticated and accurate models that portray the economic and financial feasibility of a project under a variety of scenarios and assumptions.

Project agreements

The sponsor will structure the project vehicle in such a way as to insulate itself from the risk and liabilities inh* Site purchase or lease agreement

• Engineering, procurement and construction (EPC) contract
• 　operations and maintenance (O&M) agreement
• input supply contract

In an emerging market country, some of these documents are entered into with the central government or its agencies. Documents such as the EPC, O&M and input supply are generally executed with appropriate private service providers.

As each counterparty to the project agreement will buttress the sponsor's credit in one way or another, it is necessary for each of the counterparties to be creditworthy in its own right.

Securing revenue

If the project is completed on schedule and within budget, its economic and financial viability will depend primarily on the marketability of the project's output. In the absence of an off-take agreement, the sponsor may commission a market study of projected demand over the expected life of the project. The study must confirm that, under a reasonable set of economic assumptions, demand will be sufficient to absorb the planned output of the project at a price sufficient to recover full cost of production, enable the project to service debt, and provide an acceptable rate of return to equity investors.

The study is prepared by independent consultants and generally includes a review of competing products and their relative cost of production; an analysis of the expected life cycle for project output; and an assessment of the potential impact of technological obsolescence. If the project is to operate within a regulated industry, the impact of potential regulatory decisions on production levels and prices - and ultimately the profitability of the project - must be considered.

Projects having a single product whose price may vary widely, such as a mine, are particularly vulnerable to changes in demand, and need to hedge against product price risk. Equally important, in projects whose success or failure rests on the price of one raw material input, there is a need to hedge the price of that material under the terms of an input supply agreement.

Environmental and social impact assessment

The sponsor may also need to finalize and file for public disclosure an environmental and social impact assessment.

Often the environmental and social standards of multilateral banks, such as the World Bank, exceed those of the host country.

Financial model

A financial model will be produced that reflects the provisions made and reached at in the project agreements, which also contain reasonably accurate assumptions with regard to cost financing. The developer will focus on the level of projected distributions, their pace and timing, and the acceptability of the project's resulting internal rate of return (IRR). The financial model often considers, through sensitivity analyses, any weakness that may result from construction delays, cost overruns, adverse regulation, inefficiency of the facility relative to existing and projected competition, interest rate fluctuations, unavailability of extractive reserves or major project inputs, and major unanticipated inflation or volatility in foreign exchange rates.

Money-raising stage

The money-raising stage begins once all project agreements are initialed and ends at the time the facility is build and commissioned. At this stage, the sponsor mobilizes the required financing and supervises the management organization, construction, and successful commissioning of the facility.

Until financial closing is reached, the sponsor is responsible for all development costs.

Sources of finance

All sources of private debt in the capital and credit markets are at least theoretically available to projects located in industrialized countries as well as developing countries that are rated investment grade. In contrast, only multilateral, bilateral and export credit agency debt are available to projects located in middle- and low-income developing countries that are not investment grade.

If export credit agency financing is available in certain countries at attractive rates, purchasing equipment for the project from suppliers located in one of those countries can reduce the project's cost of funds. Often, however, a trade off is made in respect of the quality of the equipment that can be procured.

Trade offs between corporate hurdle rate requirements, transaction fees and interest rates will materialize among financing alternatives. The length of the construction period will also affect decisions related to the types of lenders approached.

Long-term lenders may finance the installation, supply, erection, and commissioning of the facility as well as an agreed number of years during operation. Short-term loans are provided by one set of lenders to finance construction of the facility up through its commissioning, and are then "taken out" by long-term lenders. The construction lenders could be the sponsor or banks; the long-term finance could be provided through banks or project bonds.

Finance-ability

The project must generate enough cash flow so as to give lenders a margin of safety with respect to its debt service obligations. Lenders will want to satisfy themselves that:

• projected revenues, operating expenses, debt service and distributions are consistent with project agreements;
• realistic estimates of future project revenues are sufficient to cover operating expenses and repay project debt with an acceptable margin of safety.

Debt sculpting

Often a sponsor will provide short-term financing for construction. Following commissioning of the facility, the project arranges long-term financing partly on the basis of contractual arrangements that exist for the sale of project output. The project will then repay its borrowings from the sponsor out of the proceeds of long-term financing. The sponsor may subsequently be able to negotiate somewhat longer door-to-door tenors or higher leverage, resulting in lower interest rates and enhanced project returns during the operating period.

A sponsor's ability to increase financial leverage or tenor depends very much on the host country involved, robustness of the project, the length of the construction period, and the state of the international markets at the time lending is negotiated.

Door-to-door tenor of the project debt cannot exceed the expected useful economic life of the project, defined by the lenders as the start of the concession or licensing period to its conclusion, or the economic life of the plant and equipment components that make up the facility, whichever ends first.

A project's financing plan usually seeks to match the maturity of the various debt funds raised with the project's ability to generate cash to repay those funds. Matching will tend to minimize the aggregate cost of financing.

Debt-to-equity ratio

In general, the lowest cost of capital will be achieved when debt is maximized as a percentage of total capitalization and the amortization schedule for the project debt is matched, as closely as the financial markets will permit, to the cash flows of the project.

Lenders normally require that the sponsors, or outside equity investors, invest a certain amount of equity in the project prior to the initial drawdown of any debt funds. Remaining equity is contributed pari passu with the full lenders' commitment. These requirements assure lenders that the project's equity investors have a substantial financial commitment to the project from its earliest stages.

The appropriate project debt-to-equity ratio depends very much on the strength of the off-take agreement. A strong off-take agreement will permit the sponsor to achieve a debt-equity ratio as high as 3. In contrast, the absence of an off-take could result in a ratio of 1.5 or lower.

Depending on the maximum feasible debt-equity ratio and the sponsor's ability to contribute equity to the project, it may be necessary to arrange for outside equity or quasi-equity investors. To complement sponsor's equity, it is generally beneficial to recruit either third-party equity or subordinated debt into a financing plan as the cost is often below the sponsor's own threshold return requirement. Hence, by layering into the financial plan third-party equity, or quasi-equity, the weighted average cost of funds is reduced.

Construction

Usually the sponsor does not begin construction until financing is secured.

Once construction begins, draws from loan commitments usually match the schedule of construction expenditures. Matching minimizes warehousing of excess funds and/or short-term bridge financing.

References

• M. Fouzul Kabir Khan and Robert J. Parra, Financing Large Projects: Using Project Finance Techniques and Practices (Prentice Hall: Singapore, 2003).