28-01-2011, 04:58 PM
[attachment=8522]
Aditya Agarwal
Sandeep Kaul
Fuqua School of Business
Contents
The MM Proposition
What is a Project?
What is Project Finance?
Project Structure
Financing choices
Real World Cases
Project Finance: Valuation Issues
The MM Proposition
The MM Proposition
“The Capital Structure is irrelevant as long as the firm’s investment decisions are taken as given”
Then why do corporations:
Set up independent companies to undertake mega projects and incur substantial transaction costs, e.g. Motorola-Iridium.
Finance these companies with over 70% debt inspite of the projects typically having substantial risks and minimal tax shields, e.g. Iridium: very high technology risk and 15% marginal tax rate.
What is a project?
High operating margins.
Low to medium return on capital.
Limited Life.
Significant free cash flows.
Few diversification opportunities. Asset specificity.
What is a project?
Projects have unique risks:
Symmetric risks:
Demand, price.
Input/supply.
Currency, interest rate, inflation.
Reserve (stock) or throughput (flow).
Asymmetric downside risks:
Environmental.
Creeping expropriation.
Binary risks
Technology failure.
Direct expropriation.
Counterparty failure
Force majeure
Regulatory risk
What does a Project need?
Customized capital structure/asset specific governance systems to minimize cash flow volatility and maximize firm value.
What is Project Finance?
Project Finance involves a corporate sponsor investing in and owning a single purpose, industrial asset through a legally independent entity financed with non-recourse debt.
Project Finance – An Overview
Outstanding Statistics
Over $220bn of capital expenditure using project finance in 2001
$68bn in US capital expenditure
Smaller than the $434bn corporate bonds market, $354bn asset backed securities market and $242bn leasing market, but larger than the $38bn IPO and $38bn Venture capital market
Some major deals:
$4bn Chad-Cameroon pipeline project
$6bn Iridium global satellite project
$1.4bn aluminum smelter in Mozambique
€900m A2 Road project in Poland
Project Structure
Structure highlights
Comparison with other Financing Vehicles
Disadvantages
Motivations
Alternative approach to Risk Mitigation
Structure Highlights
Independent, single purpose company formed to build and operate the project.
Extensive contracting
As many as 15 parties in upto 1000 contracts.
Contracts govern inputs, off take, construction and operation.
Government contracts/concessions: one off or operate-transfer.
Ancillary contracts include financial hedges, insurance for Force Majeure, etc.
Highly concentrated equity and debt ownership
One to three equity sponsors.
Syndicate of banks and/or financial institutions provide credit.
Governing Board comprised of mainly affiliated directors from sponsoring firms.
Extremely high debt levels
Mean debt of 70% and as high as nearly 100%.
Balance capital provided by sponsors in the form of equity or quasi equity (subordinated debt).
Debt is non-recourse to the sponsors.
Debt service depends exclusively on project revenues.
Has higher spreads than corporate debt.
Disadvantages of Project Financing
Takes longer to structure than equivalent size corporate finance.
Higher transaction costs due to creation of an independent entity. Can be up to 60bp
Project debt is substantially more expensive (50-400 basis points) due to its non-recourse nature.
Extensive contracting restricts managerial decision making.
Project finance requires greater disclosure of proprietary information and strategic deals.
Motivations: Agency Costs
Problems:
High levels of free cash flow due to few investment opportunities. Possible managerial mismanagement through wasteful expenditures and sub optimal investments.
Structural solutions:
Traditional monitoring mechanisms such as takeover markets, staged financing, product markets absent.
Reduce free cash flow through high debt service.
Contracting reduces discretion.
.“Cash Flow Waterfall”: Pre existing mechanism for allocation of cash flows. Covers capex, maintenance expenditures, debt service, reserve accounts, shareholder distribution.
Motivations: Agency Costs
Problems:
High levels of free cash flow due to few investment opportunities. Possible managerial mismanagement through wasteful expenditures and sub optimal investments.
Structural solutions:
Concentrated equity ownership provides critical monitoring.
Bank loans provide credit monitoring.
Separate ownership: single cash flow stream, easier monitoring.
Senior bank debt disgorges cash in early years. They also act as “trip wires” for managers.
Problems:
Opportunistic behavior by trading partners: hold up. Ex-ante reduction in expected returns.
Structural Solutions:
Vertical integration is effective in precluding opportunistic behavior but not at sharing risk (discussed later). Also, opportunities for vertical integration may be absent.
Long term contracts such as supply and off take contracts: these are more effective mechanisms than spot market transactions and long term relationships.
Why Corporate Finance cannot Deter Opportunistic Behavior ?
Do not allow joint ownership.
Direct expropriation can occur without triggering default.
Creeping expropriation is difficult to detect and highlight.
Multi lateral lenders which help mitigate sovereign risk lend only to project companies.
Non-recourse debt had tougher covenants than corporate debt and therefore enforces greater discipline.
In the absence of a corporate safety net, the incentive to generate free cash is higher.
Structural Solutions:
Non recourse debt in an independent entity allocates returns to new capital providers without any claims on the sponsor’s balance sheet. Preserves corporate debt capacity.
Motivations: Risk Contamination
Problems:
A high risk project can potentially drag a healthy corporation into distress. Short of actual failure, the risky project can increase cash flow volatility and reduce firm value. Conversely, a failing corporation can drag a healthy project along with it.
Structural Solutions:
Project financed investment exposes the corporation to losses only to the extent of its equity commitment, thereby reducing its distress costs.
Through project financing, sponsors can share project risk with other sponsors. Pooling of capital reduces each provider’s distress cost due to the relatively smaller size of the investment and therefore the overall distress costs are reduced. This is an illustration of how structuring can enhance overall firm value. Re: MM Proposition.
Financing Choice: Portfolio Theory
Combined cash flow variance (of project and sponsor) with joint financing increases with:
Relative size of the project.
Project risk.
Positive Cash flow correlation between sponsor and project.
Firm value decreases due to cost of financial distress which increases with combined variance.
Project finance is preferred when joint financing (corporate finance) results in increased combined variance.
Corporate finance is preferred when it results in lower combined variance due to diversification (co-insurance).
