Introduction

Project Finance is an attractive financing alternative where project sponsors can shed risks to the bank or capital debt markets. To the owner/parent, the non-recourse aspect is prized since it allows that company or group to go on to develop other projects, to become a serial developer.

A knowledge of the risks and the structures to handle them are paramount in getting the best deal for both sides. This book provides a risk system which can be applied to any project in any industry sector, indeed the financing of any venture. It also outlines each structuring solution that would be acceptable to the Project Financiers.

By the time one traverses to the Glossary and Index at the end, some 214 Case Examples will have been provided for the 172 structures and risk mitigants that can be considered to address the 16 risks in the Project-Finance business.

• Early Greek merchants who funded vessel-specific expeditions have been cited as among the first.

· In 1554, the first known French Concession (a precursor to Build Own Transfer - “BOT”) was granted for a French canal¹. (See Exhibit 1) The concessionaire must self-finance without support from the public authority granting the concession. One of the key conditions was a non-discriminatory tariff – and to keep up with new canal technology!

· In the 1800’s railways came into vogue, usually funded via bonds or share/stock offerings.

· Modern Project Financing is often thought to have originated with production payment financing in the Texas oilfields in the 1930’s. A driller would fund the well-drilling costs in exchange for a share in future oil proceeds. In West Texas, it was hard to ‘miss’ striking oil every time! At that time, a Dallas bank granted a non-recourse loan to develop an oil & gas property to be repaid from the cashflows from those wells.

· Resources transactions, especially mining and oil & gas, led the way in the 1960’s mainly driven by US banks. Their techniques were ‘imported’ into Europe in the late 1970’s for a string of large Project Financings for North Sea offshore oil.²

· The risk-shedding character of Project Finance has now been adapted to portfolio financings, privatisations, and mergers and acquisitions (“M&A”) across a wide range of industry sectors.

A funding structure that relies on future cashflow from a specific development as the primary source of repayment with that development’s assets, rights, and interests legally held as collateral security.

This is in contrast with conventional corporate lending where the lenders look to the balance sheet and total business and financial resources of a borrower as the source of repayment.

Project Financing is an option granted by the financier exercisable when an entity demonstrates that it can generate cashflows in accordance with long-term cashflow forecasts. Upon exercise of the option, the balance sheet of the entity’s parent(s) or sponsor company(s) balance sheet is no longer available for debt service. The assets, rights, and interests of the development are usually structured into a special-purpose project vehicle (“SPV”) and are legally secured to the financiers as collateral.

Prior to satisfying the options conditions, it is the usual practice for the financiers

(b) to be able to rely on other financial or contractual resources to repay that funding [if the project fails to be completed]; and

The conversion to the Project-Finance status occurs following satisfaction of a Completion Test designed to demonstrate the cashflow-generation performance of the project.

If the project entity is already generating sufficient cashflows – such as in a privatisation or acquisition – then this pre-option architecture is redundant. The principle remains the same -- immediate reliance on the enterprise’s cashflows as the primary repayment source, holding the project as [legal] collateral.

2) A Project Financier does not expect the debt to be repaid from the project assets or collateral.

» It is not asset-based financial engineering, such as real estate/property, where a future refinancing is specifically structured as an exit for the investor and is the intended means of repayment of the debt.

Further discussion on the conflicting definitions of Project Finance is given in Appendix 2 of the Book.

As will be evident later (in the Book), Project Finance is a highly structural tool since, after the option exercise, the lenders/bond investors wish to have strong control over the continuing operations (cashflow generation) backed up by full entitlement to that enterprise (legal collateral over all of the project’s assets, rights, and interests) in the event of a default. The usual organization is a ‘spider’ diagram showing a web of contracts, ownership, and advisory relationships as shown in Exhibit 2.

Off-balance-sheet finance was a common objective of early Project Financings where deferred income (as in a production payment) or lease obligations were not recorded on the balance sheet as senior debt. International accounting standards have now moved just about every obligation and indebtedness onto the balance sheet, if not formally requiring a statement in the notes to the company’s accounts. Not every country has yet moved to adopt these standards. The expectation though is that they will (have to) over the next few years.

So what can be done to get the deal off-balance-sheet? There is no special Project Finance tool available.

The preponderance of joint ventures and consortia undertaking project developments makes it relatively easy to hold a party’s interest to 50% or less in the SPV, thereby enabling the project debt to be deconsolidated. Only the investment in the SPV is booked on that party’s balance sheet.

Case Example: In the Colowyo Project Financing in Wyoming, the project company was owned 50:50 by W R Grace and Hanna. In addition to the Project Finance debt not appearing on these company’s balance sheets, the bank also did not include the debt in its legal-lending limit established for both companies.

Case Example: Shell (50%) and Pemex (50%) established Deer Park Refining LP, as shown in Exhibit 3. It is a variant of a cost-corporation SPV. Recourse for the $550-million rated 144A project-note issuers was limited by ceilings on refinery margin stabilisation ($200m) and standby credit lines ($150m).⁴

Two equal equity stakeholders can agree together to deconsolidate above or behind the SPV or to enter into arrangements to fund each other yet keep their interests at 50:50 (or lower percentage) to achieve deconsolidation of the debt off each balance sheet.

Case Example: Secondary deconsolidation was done in the £661-million Barking project in the UK. Here Thames Power Limited (”TPL”) is a 51% shareholder in the incorporated SPV, Barking Power Limited (“BPL”). TPL’s shareholding is split 50:50 between BICC (who owns one of the TCC companies) and CUPG (a Canadian Utilities company which is providing management and technical services to a 100% - owned TPL operating subsidiary Thames Power Services Limited – “TPS”). (see Exhibit 4). During construction CUPG has voting control of TPL and during operations TPL has control of BPL. But right above TPL, its shareholders have deconsolidated their interest.

Some developers continue to spin off portfolios of project interests to lower their holdings (to 50% or below). These portfolio entities are designed to stand on their own (balance sheet) full to the brim with Project Financings with the objective of keeping that debt pool off the parent’s accounts and therefore, hopefully, not affecting the parent company’s rating. This also provides a mechanism for a developer like Enron or Edison Mission to roll out one project after another and thereby use Project Financing as an overt development tool.

Another financial tool to take project debt off balance sheet is defeasance, a cash offset. (as will be discussed in Chapter 8, Structures)

Case Example: Possibly the most aggressive example of defeasance is the Transurban City Link electronic tollroad financing in Melbourne, Australia. Two of the seven debt facilities (totalling A$1,249 million - approx. US$825 million) are “secured by cash collateral equal to the amount of the loan which is set off against the loan liability.”⁵

Variations on defeasance are frequent for cross-border transactions. The target is perennially tax structuring, not just the balance-sheet treatment, and often is packaged with leasing.

So although off-balance-sheet used to be de riguer for Project Financings, it is no longer the driving force.

A sponsor company seeks to take full advantage of the option to remove its balance sheet at the launch of the true Project-Finance phase of the financing – after completion. This option is able to be exercised once a cashflow demonstration test has been satisfied – the Completion Test. After completion – the same as for an existing project -- the key recourse is, as before, to the project cashflows collateralised by its pool of assets, rights, and interests.

Pre-completion -- with cash outflows for construction and start-up/commissioning -- has to be the structured and funded somehow. Inevitably the financier requires financial support either fully to a creditworthy sponsor or financial guarantor or to the turnkey construction contract (“TCC”). Completion, as we will see in Chapter 19, Completion Risk, is buttressed by all manner of financial props, contingent supports, warranties, bonding, and the like.

Rarely will the Project Financier allow the option (to non-recourse) to be granted prior to completion. In the few occasions when financiers have accepted Completion Risk fully, such as in MIM’s $345million Oaky Creek Project Financing in Queensland, Australia, bankers have been stuck with forced rescheduling when output and markets failed to generate the expected cashflows.⁶

One needs to be clear about what “non-recourse” means. To the Project Financier, this means that repayments originate from the projects cashflows, and not the parent companies. But the Project Financier does not want the parent or sponsor to withdraw its people or entrepreneurship from the deal and will seek contractual recourse to ensure continuation of that commitment and ownership.

The option conditions embedded in the Completion Test is often the most negotiated facet of a Project-Finance transaction.

• Some project developers put up a project development case which is more difficult to satisfy than is expected in reality. Once the option test conditions are agreed and documented, the sponsor unveils the ‘real’ project which can then easily beat the agreed Completion-Test performance criteria and allows the switch to non-recourse to occur earlier.

• Some other sponsors always present a higher capital expenditure (“capex”) requirement and a longer development timetable, knowing full well that they can better both parameters (with the project built under budget and ahead of time).

Some Project Financiers, most notably the institutional private-placement market, prefer to avoid this gamesmanship and hassle by waiting to do the Project Financing after completion. This also serves to simplify the documentation.

Many financial limitations may be agreed within a Project Financing whereby recourse is constrained in three main ways:

3. Event, where satisfaction of some event or trigger occurs (perhaps exceeding a financial hurdle in some way).

Case Example: Limited-recourse architecture was built into the SmarTone cellular telephone Project Financing in Hong Kong. Besides the original US$90-million Project Financing -- to roll out the cell stations and market the system -- an additional US$30 million (Amount) was held as cash collateral which could be accessed, if needed, for up to 18 months after completion (Time) should subscriber cashflows be insufficient. To the Project Financier, this cashflow deficiency pool had the first two elements of limited recourse.

Case Example: This can be contrasted to the 30-year, US$375 million Sydney Harbour Tunnel in Australia. Here, if the cashflows from the tunnel tolls are insufficient for debt service, then any cashflow deficiency is made up from the New South Wales state treasury – unlimited recourse and thus , by reduction, not a Project Financing in the first place.

Although Project Financing moves to non-recourse post completion, three instances remain which may spring recourse back to the original sponsor/parent.⁷ These are:

2. Misrepresentation, where incorrect or inadequate, disclosure or statements have been made or omitted; and

3. Willful negligence, where any ordinary concept of diligence and stewardship has been deliberately abandoned or worse.

Some other recourse events are common such as the SPV owners being subject to recourse (to their balance sheets) for increased interest withholding taxes above an agreed threshold. These 'springing' structures will be identified in each Risk Chapter later.

Entrepreneurs, small companies, and cash-starved governments can see dozens of high-leverage Project Financings in the press as evidence of the money pot in the hands of the Project Financiers. Other developers seek to optimise this success by Project Financing one development, then another.

Many new projects exceed the capital resources of the developer(s). Sometimes the number of projects being developed concurrently can stretch the budget of even the biggest corporate. Mega-projects can be outside the reach of even the largest corporations or even governments and are ready targets for structuring a Projects-Finance deal.

Case Example: For the Griffin transaction, the company’s net worth was approximately US$3 million. It required US$28 million to finance a major expansion of operations to satisfy a take-if-delivered contract to its main customer. By way of 100%-debt deal -- lease, working capital, and local currency -- under a Project-Finance umbrella, the requisite moneys were provided to meet the contract delivery timetables.

Case Example: AES is the world’s largest global power company. It owns or has an interest in 120 power plants with a capacity of 43,000MW (in 16 countries at last count).⁸ With eight plants under construction and more than 70 projects totally 35,000MW under consideration in 70 countries,⁹ it seeks to finance/refinance its developments with as much Project Financing as it can get and in the process deals with 75 banks.⁸

The ability to transfer risk to the financier is at the heart of the Project-Finance process. Companies with significant Market Risk, cyclical operating conditions, or price challenges eagerly isolate those risks, on the financiers’ behalf, into the SPV.

Even large companies facing Political Risks change their tune to pipe in the Project Financier as a way to get Political-Risk cover on the debt side of the project. Roughly half of all Project Financings are to secure Political Risk coverage.

Case Examples: Shell arranged Project Finance for its Sarawak, Malaysia, production with a particular desire to cover currency inconvertibility.¹⁰ Angola’s military enclave, Cabinda, has seen the oil majors continue a string of large export-finance transactions, again in part to cover the incipient political risk over the last decade.¹¹ Cabinda has a permanent, 9,000-strong army protection unit.

The intention with most Project Financings is to create and finance a discrete entity, the SPV, as a way to control and limit the parent/sponsors' financial risk and exposure. The discipline to sequester a deal in this way provides a useful negotiating framework with suppliers, offtakers, and governments. There is no mistaking where the buck stops or who is mitigating what risk.

For some Project Financings, the goal may be to specifically quarantine the project from other group activities. This can apply in both directions. The financiers may wish to protect the SPV from other corporate activities. In this way, a well-structured Project-Finance deal may be much more secure and bullet proof than an amorphous group-credit transaction.

The developer, on the other hand, may seek to ensure that in the event of project failure, the debt does not bounce back onto its balance sheet.

Case Example: When Freeport Minerals’ nickel mine was expropriated in Cuba, Freeport stood aside from the banks who had Political Risk cover. Freeport went on to develop the Greenvale nickel mine/plant in Queensland, Australia, which collapsed after oil-price Operating: Cost pressures. Again the banks (and Germany’s KfW) took the loss of $326 million and Freeport continued with its other projects and subsequent merger, unaffected by two major Project Finance failures in a row in the same sector.

• Small companies or weak ‘credits’ may have a new project which is substantially better than themselves. The new project or acquisition may be able to attract much more funding on better terms and conditions than the weak sponsor.

• Project supports from take-or-pay contracts, strong offtake, or through investment/linkage to a strong consumer may be more ‘bankable’ than anything the sponsor may be able to achieve.

Some Project Financings are established to hide the enterprise from the parent's business activity to endeavour to protect the parent's rating. As referenced earlier, some developers package up project bundles as a self-sustaining project-financed SPV which can gather their own rating (hopefully not influencing the parent company's rating).

Case Example: Edison Mission Energy Funding Corp (S&P BBB, Moody’s Baa1) raised $450 million in senior, unsecured notes for four California power plants. It’s 50% owner, Edison Mission Energy, meanwhile operates 22 US and 27 international power plants with a combined $5 billion balance sheet of equity, bank lines, but only $200 million in rated senior-unsecured notes.

However, mature ratings aren't easily hoodwinked and are accustomed to digging through to subordinated and quasi-debt deals.

Securitised transactions are developing whereby project cashflows are being pooled into an payment or lease class which is then dedicated towards debt service. The usual credit enhancement is some cash/collateral (10-15% of the total debt) sitting beside a secure stream of receivables. Sometimes a monetisation (securitisation of gross revenue) is employed to enhance the solidity of payments.

Example: The £228 million Train Finance 1 plc for British Rail’s is for the rolling stock lease component for the privatised UK rail operators.¹² The underlying 8-10 year leases are 80% guaranteed by Her Majesty’s Government, so it is a hybrid sovereign/project deal. (See Exhibit 3). The use of leasing is a direct clue to the asset-driven character of a deal.

Case Example: Calpine, a well-known deployer of Project Financing, has established a portfolio of four merchant-power plants in four states of the USA. The idea is to pool these diverse cashflows into a $1-billion revolver to use to build other plants.¹³ This is a hybrid corporate/Project-Finance transaction adapting a cash-sweep variation onto a monetisation.

Case Example: Large oil companies such as Argentina’s YPF or Mexico’s Pemex have issued notes repayable out of oil receivables (under a ‘good’ contract). This isn’t Project Financing per se, more a corporate transaction dealing with sales from a non-specific portfolio of revenue generators, akin to a commercial-paper issue.¹⁴

Many regard Project Finance as a tool to achieve high gearing/leverage and long repayment terms. Therefore, it will automatically enhance the rate of return calculations, however calculated. In most instances the return should be able to be doubled -- always given adequate cashflow coverage of debt service (via the DSCR).

Many governments like to use IRR thresholds to curb windfall/excess profits, especially in privatisations or for granting new concession contracts. e.g. BOT/BOO and, of course, keep the returns to the private sector at politically acceptable/defensible levels. Thankfully, most of these IRR regimes have not contemplated the boost from high-debt leverage achievable in Project Financing.

Where a company board has established an internal IRR hurdle (for all its projects), then a smart board will realise that different projects attract different leverage. In almost every case, Project Finance, if viable, will boost the return above the board's hurdle rate.

Large projects are often undertaken by a consortium of entities, such as participants who provide:

Due to the highly structured nature of a Project Financing, a horizontal as well as vertical discipline is naturally achieved. Each consortium member is, in a sense, protected from, yet supported by the other. Project Financing might may be particularly useful where significant conflicts of interest exist with some consortium participants.

Case Example: In the $324 million Kutubu unincorporated joint venture (“UJV”) for an oilfield development and pipeline, the non-government participants Project Financed the Papua New Guinea Governments 22½% interest -- to be repaid from the government's share of oil production from the project itself. Only two, smaller, minority joint venturers (and not the project’s operator, Chevron) Project Financed their 24.2% combined UJV percentage interest.¹⁵The smaller companies, big oil, and the government each gain discipline and certainty by way of the Project-Finance process.

In a Project Financing, the drawdown and repayments may be linked long-term to a particular enterprise rather than being lumped into corporate-credit facilities which are often relatively short term and subjected to regular review. Project bankers prefer progressive loan drawdown matched to certified actual project expenditures; whereas the project bond market practice is usually a one-time advance of the total amount -- although some staged drawdowns are slowly emerging. Money on deposit rarely earns the borrowing rate of interest -- labelled negative ‘carry’ or ‘arbitrage’; thus surplus cash is viewed as inefficient.

For the repayment period, a project-finance structure may be specifically hard-wired to cashflow generation. It can be very flexible.

Case Example: For Arco’s Black Thunder project in Wyoming, USA, the $120-million production payment was repaid from a maximum 60% of the net monthly operating cashflow.¹⁶

2. Security restriction are in place by lenders, the World Bank (negative pledge), bondholders, or sometimes governments; or

then Project Financing can be engineered to get around these fences in a manner which does not threaten the original intent because the new enterprise is being launched on the premise of standing alone and apart anyway.

Case Example: EZ Industries' bankers controlled its balance sheet and legal security through a trust deed. Anxious to undertake a large new project, Elura, it structured a US$130-million production payment without reference to its bankers. The Project-Finance covenants were exactly written to fall outside the trust deed shackles.

Case Example: Edison Mission Energy was set up with a kitty of US$500 million by Southern California Edison, a 100-year-old electricity utility in the USA, specifically to become an unregulated non-utility. It has consistently used Project Finance leverage to maximise its development and acquisition opportunities. It is no accident that the first entry on its web site is titled "A Leader in Project Financing"¹⁷ having closed over 40 transactions for a total of more than US$15 billion, 11 of which were non-US$ deals.

A well-structured Project Financing can be highly flexible. Banks may be able to achieve this through automatic resetting devices based on the project's performance or the sponsor's expansionist desires (while still leaning on the cashflows-first principle).

Bond structures have far fewer covenants and are thus seen as providing more (within-covenant) flexibility than banks. But attempts to reset or reschedule a bond structure will be met with the easy-to-understand human gesture of throwing hands up in the air. The management of the deal (agency/trustee) is little better than a post office. Does one use the postal service to get a home mortgage? The nature of the bond investor and his/her portfolio is essentially screen-based. The idea of handling waivers and going to bondholders meetings might mean missing a screen flicker. So it is essentially the banks that offer flexibility.

Case Example: Tejo Energia's DM1.14-billion Project Financing was arranged for a partial privatisation by the state electricity utility, Electricidade de Portugal ("EdP") under a 15-year PPA. The 12-year bank facility was specifically designed to be refinanced within six years after startup. Two years after completion the banks extended the transaction beyond the PPA life to year 19 and halved the loan margin to 80 basis points.¹⁸

The flipside to flexibility is the attitude of Project Financiers to a workout. In conventional balance-sheet lending, the task is to reshape the entity, sell this, merge that, and sack so many. In a Project-Finance bond issue, the bondholders have great difficulty getting together to agree anything. Banks, however, structured a Project Finance with an eye to its future cashflow potential anyway and always recognised that an exit by foreclosure or sale was unlikely to be sufficient to pay off the debt.

Therefore bankers are more likely to work to preserve the enterprise, including recapitalising it (read: "new loans") and re-shaping the repayment profile. The Project-Finance legal structure allows the banks to step-in to the shoes of the project to take the next steps to redressing the cashflow difficulties. As a last resort the banks will still try to bring in a new player to own, operate, and reinvigorate the venture, rather than an outright sale.

Case Example: When the Barrack group collapsed in Australia after failing to raise new equity, Chase as the lead bank to the group was caught as a senior lender, subordinated lender, and (hedging) margin lender.

However, one struggling project was Project Financed separately. A new manager was installed to restore the operation and, within a year, the entity had repaid its US$15 million loan. The rest of the Barrack group bankers wrote off more than US$100 million, in excess of half of their exposure. Their workout process included the sale of the main cashflow generator for the entire group for US$20 million!

If matters surrounding the deal are commercially sensitive, then the quarantining of the deal and deal information inside tight confidentiality restrictions is another reason to select Project Financing. If suitably warned, many banks can be excellent in this area. However, some national business cultures are 'leaky'. A private placement document is far from private since numerous 'hands' have viewed and inputted into the offering memorandum or placement document.

Case Example: IAF's private client was offered two monetisation deals as laid out in Exhibit 11.5, essentially priced the same but with more money and a longer term on offer via a US private placement vs a bank deal. Privacy was a key reason to choose the banks since if the customer of the client could get hold of the financial disclosure in the offer document, it would without doubt use that against the client in the next round of price and volume negotiations. The underlying shifts in the monetisation base also required future flexibility on amounts and term. The identity of this deal? Confidential, of course.

The Project Finance process involves a high level of due diligence (Chapter 9) and credit intensity. With the banker taking all the risks so structured without an equity return, it is natural to see extensive stress testing of the Downside and Breakeven Cases. It is always raining on a banker's parade.

This effort should be welcomed, rather than endured. The Project Financier's (second) opinion might just be right.

· The blockbuster deal "Everyone is/must be in this deal." The result ? Eurotunnel.

· The pioneering deal, "This deal will set the pace." Many times it is better to be second or third. Like SmarTone (see later).

· The me-too deal. "We're getting left behind. Everyone else is doing these deals". There are so many deals without any proper FX cover done in the late 1990s in Asia, there is not sufficient space to list the examples.

· The tombstone/market image deal. "We must have our name on it. It's a prestige client/deal". Need one mention Iridium?

· The relationship deal. Sponsor: "You must do this [tough] deal otherwise we'll reduce your other business with us." Bank: “We must be seen as the lead/top tier to retain/build our relationship.” Project Finance is not a relationship 'product'. The whole idea is to set the deal loose from the ‘relationship’ as soon as the option conditions are satisfied.

A great advantage for Project Financing is its simple maths which are given in Chapter 5. The valuation measures such as IRR can be ignored from a structuring viewpoint. Derivatives can be added later, after the basic structure building blocks are in place.

Although a project Finance spreadsheet can be pretty fancy, the deal can be structured without regard to a balance sheet or accounting Sources & Applications. Over-reliance on accounting ratios is one of the shortcomings experienced in the business. (see Exhibit 3.18) The concentration on cash is sufficient discipline for the mathematics.

The leaders in the long-term Project-Finance stakes have been bond issues which can stretch to the 30-year-plus time zone. Bankers are also accustomed to structuring their longest-term exposures as Project-Finance credits.

Case Example: Petrozuata, a Venezuelan semi-crude export-oil project burst, through the national term for a bond issue, which was 12-years maximum, by issuing some 25-year paper. It's US$1-billion 144A bond issue was rated higher then Venezuela to boot. (read: "pierced the sovereign ceiling")

Because of the highly structured nature in many project deals – the natural result of risk allocation – the complexity and often cumbersome documentation is seen as the primary barrier.

Large companies frown on the perceived extra cost and complexity of Project Financing, preferring to use the collective corporate capital pool for the necessary development monies. Some company treasurers also fear the reverse leverage that might spring from increased interest rates in a highly-geared structure while others fear the controls of the classical Project Finance covenants that banks, especially, seek.

As will be explained in Chapter 5, Project Finance margins are not priced for risk. (This will disappoint the derivatives desk.) Instead the structure is adjusted to cover and balance the risks. The structures are complex and the adjustments and tradeoffs are four-dimensional.

Project Finance pricing -- the spread or margin -- is very cheap given the risks assumed. To use economist's jargon, it is inefficient intermediation. The market for a well-structured deal remains very competitive so pricing spreads have always been low. A choice of Project Finance will not devolve to a pricing comparison.

Case Example: BHP selected Project Finance for its Ok Tedi development, diagrammed in Exhibit 21.7, since the margin was lower than what it could achieve on-balance-sheet.

Case Example: The Petropower project was able to raise 18-year debt on a Project-Finance basis for a Chilean project in a well-crafted structure shown in Exhibit 19.6. At 1.7% over the equivalent US treasuries, if one knocks of 0.25% to equate to LIBOR and take off a further 1-1.5% to 'price' Chilean political risk, then the treasury staff can celebrate a practically free Project-Finance deal for this cogen/refinery transaction.

Whenever the author is asked "What is the cost of your [Project-Finance] money?" thoughts of tonight's dinner intervene and the meeting is mentally ended. If the borrower can only appreciate a cut-price deal, they can go to another barber shop for shaving. Project Finance is inexpensive when evaluating risk, flexibility, and the other many advantages listed above. The choice more than not devolves to whether money can be raised at all. It is the availability of [structured] money vs not getting the money.

Project Financing is hard to execute quickly. The various stages are outlined in Chapter 1 and nine months to one year is a handy estimate for a deal already well prepared and presented. The shortest is around three months where a small group of experienced players are dealing with a wholly (pre)packaged, simple, straightforward deal with known and trusted developers.

The longest period for a project seen by the author was 25 years, mostly the effort to get government onside. The Hubco project is (in)famous for its 10-year, 3-Information Memoranda roller-coaster ride for a large political-risk package for Pakistan. If time is truly of the essence, then Project Finance has great difficulty as a financing ingredient to the deal.

The Project Finance structure is designed to control the risks. The tight packaging of Project Finance structures and documentation can create the appearance that the bankers are running the business. Inevitably, this spills over into controls over operations; special reporting; regular independent engineering reviews and (re)certification; constraints on security, permission to do anything new; regular waiver/compliance 'negotiations'; and incessant lunches with visiting firefighters. (read:" bank syndicate members"). Here, the private placement and bond markets are far less restrictive.

Case Example: In the first Kutubu US$324 million Project Finance for two minority UJV borrowers, the author tallied the number of items covenanted -- positive, negative, and reporting -- and the total was 287. If the companies' treasurers felt they were working as the bank's back office, they would have some justification.

Case Example: For US$107 million Hero Asia transaction, a 144A bond issue for two Chinese power-plant developments, there are essentially three covenants:

1. No further indebtedness

2. Do not merge, consolidate, or sell yourself.

3. Honour your contracts.

Case Example: In the Cooljarloo integrated project development, an A$320-million dual-currency Project Financing was structured together with a US$250-million Euronote facility with Put Option. The documents had 30 pages of "thou shalt nots" with 450 commandments in all.¹⁷ Faced with a 40% cashflow reduction (below projected levels at loan signing two years earlier), the bankers had great difficulties in agreeing anything, with the smallest banks being the greatest nuisance. (read: "please take me out")

Needless to say, the Company could barely move as it had incessantly to negotiate waivers for just about everything, as well as face pressure to reprice the deal (upwards).

Insurances are seen as a secondary structure in many aspects of Project Finance. While expensive, it may be the only backstop available for many risks. A comprehensive program is fully laid out and priced in Appendix 3.

A balance between insurance costs need to be made against the amount of money raised. All sorts of credit-enhancements can also be achieved by insurances such as delay-in-startup (“DIS”) insurance, monoline wraps, and the like.

Case Example: A professional partnership offered a combined-cycle, three-machine power plant package. The LDs would be expected to be substantial, around US$500,000 per partner, and could only be accepted within a Project-Finance deal if backed up by a substantial DIS insurance package to backstop these LD commitments. All parties recognised the need for DIS and negotiated accordingly.

As may be evident in Exhibit 2, the lawyers/solicitors are off to the side in their own box. They love Project Finance since all the other 18 participants need a lawyer! It seems when looking at a stack of Project-Finance documents that the lawyers must be paid by the word since there are so many.

A standard structure would be hard to implement for less than US$500,000 in legal bills, and a US$1 million bill or more is commonplace. Part of the problem is that the bankers abdicate the drafting to the lawyers as soon as the term sheet is signed. Since most lawyers are untrained in risk structuring -- "That's a commercial matter" -- it is no wonder that the deals see plenty of wall paper. The five most terrifying words the author has experienced are:-"Leave it to the lawyers".

Active participation in drafting and document scope setting is actually welcomed by smart Project Finance lawyers who enjoy the change from a word-processed, plain-vanilla corporate deal.

Case Example: The Project-Finance lawyer followed previous transaction styles in that most boring of clauses, the notices clause. "Please send by [methods] to the SPV borrower, Attention: Treasurer." The addition of these words:- "and to another party nominated in writing" permitted a Project Financing to proceed since non-receipt of such notices to the bank was deemed a fatal flaw -- irremediable defaults could creep in to topple the security structure.

For the lenders, the deal represents a long-term commitment with many opportunities to go wrong and no easy way out except to book a loss/provision and run. The structure is built as robustly as possible, but when it comes to litigation, court systems will inevitably tend to 'defend' the borrower from the 'oppressive' lender with no one covering the interest bill during this talkfest and interminable delays.

Project Financiers try to bolster the structure with belts-and-braces security and covenants as much as possible. That doesn't prevent a slick litigation lawyer finding many delaying tactics all courtesy of 'Central Court No.2'. The bankruptcy costs (agency costs) can be very high in a workout as much from the delay as from the many professional teams that may need to be mobilised -- engineers, lawyers, accountants. The margins and payments in a project Financing are usually woefully insufficient to fund any serious workout.

Large companies are fond of saying:- "Look, Project Financing is of no use to us with its attendant controls and complexities. We have to stand behind every deal we do, especially to honour concession agreements in 'risky' countries". (read: "We have a continuing business elsewhere; a tarnished reputation from abandoning a deal would compromise our relations with governments and other financiers.")

The operative word here is "abandoning". From an earlier point, Project Financiers work very hard to avoid abandonment in any workout. If a company like Shell cannot "take a walk", then Project Finance should not be selected.

Most properly-structured Project Financings are genuine in their quarantining of recourse and the stand-alone nature of the debt. The party who seems to open more back-door recourse is government! The seven most terrifying words for a credit committee must be:- "The sponsor will back this deal anyway." (read: "bail-out").

Case Example: A major Canadian company, Rio Algom, structured a US$120 million Project Financing for a Nova-Scotia development. Bank of America may have realised that it had a problem when it was only able to sell down US$10 million of the deal to Rio's main Canadian relationship banks. Several months after startup, the project defaulted on a loan repayment. The banks eventually had to foreclose and sell the deal--to whom? Rio Algom, for US$70 million..

Project-Finance packaging appeals as a means to attract high leverage; often to get the resulting debt off balance sheet; to quarantine the project and its financing; and as a means to instil discipline with its associated powers and protections across the various parties in a project venture.

Project Financing can represent a meaningful skill in packaging an enterprise to operate on a stand-alone basis to repay a debt, however funded. There are more than 100 structures that can be employed to mitigate the many risks reviewed in this first edition.

Advantages are many and the disadvantages controllable or avoidable. To succeed, the risk trade-offs need to be woven into a workable yet flexible set of arrangements which can be structured to survive the stresses of the future.

The reader is invited to explore the risks in no particular order but to first examine the cashflow mechanisms and general structures that are available, perhaps then to investigate due diligence and finessing sector protocols.

1. Fillet, M., “BOT Contracts -- The Critical Ingredients of the French Model,” Project Finance International (“PFI”), Issue 74, June 8, 1995, pp 33-38.

2. Sarmet, M., “Credit Lyonnais -- International Project Financing,” Banque, No. 392, February 1980.

3. Tinsley, C.R., Practical Introduction to Project Finance, Five Workbooks, Introduction and Glossary, Euromoney Self-Study Solutions, London, 1996.

4. Davis, H.A., "Deer Park Refining Limited Partnership," Project Finance: Practical Case Studies, Euromoney Books, 1996, pp.155-158.

6. Anon, “Second Thoughts about Project Risks”, The Banker, September 1982, pp 109-112.

7. Tinsley, C.R., “Risk Trade-Off,” 2^nd Mineral Economics Symposium, CIM, Vancouver, Canada, November 21-23, 1982.

10. Tinsley, C.R., “Handling Political Risk,” Pacific Rim 90 Congress, Vol. III, The AusIMM, Surfers Paradise, Queensland, Australia, May 6-12, 1990, pp 427-431.

11. Bell, J., “UBS’s Angolan Success,” Euromoney’s Project and Trade Finance, January 1997, p 36.

13. PFI, “Calpine in Construction Deal,” Issue 173, July 14, 1999, pp 33-34.

14. IADB,“YPF Structured Export Notes Private Placement,” www.iadb.org/sds/utility.cfm/151/ENGLISH/pub/47

15. Tinsley, C.R., “Structuring Risk in Project Finance: The Case of the Kutubu Petroleum Development, PNG”, UN-ESCAP Interregional Seminar on Applied Finance for Natural Resources, Bangkok, Thailand, December 9, 1991, pp 163-180.

16. Casper College Production Payment Foundation Inc., Financing Proposal Memorandum, September 1, 1977.

19. Reynolds, D.G., "The Tiwest Project: Living with Uncertainty," 16^th Annual AMPLA Conference, Surfers’ Paradise, Queensland, Australia, July 22-25, 1992.

INTRODUCTION - Advanced Project Financing: Structuring Risk

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