Project Finance in Developing Countries

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PROJECT FINANCE IN DEVELOPING COUNTRIES

International Finance Corporation Washington, Washin gton, D.C. D.C . 1999

 

Copyright O 1999 Internatio Inter national nal Fia nc e Corp Corporati oration on 2121 Pennsylvania Avenue, N.W. Washington, D.C. 20433, U.S.A All rights reserved

M a n u f a a d in the United States of America First pri printi nting ng A p d 1999

The International Finance Corporation (IFC), an affiliate of the World Wor ld Ba Bank, nk, p promotes romotes the eco

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nomic development development o off its i ts member countries thr through ough investment in the private ssecto ector. r. IItt is the wo world rld's 's largest multilateral organization organization providing providing financial assistan assistance ce d directly irectly in the form of loans and equi ty to private enterprises in developing cou countries. ntries.

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This volume is a product of the scaffof the International Int ernational Finance Corporation. The conclusions a and nd the judgments contained herein should not be attributed to, and do not necessarily reflect the views of, IFC IF C or its Board of Directors Directors,, or the World Bank o orr iits ts Exe Executi cutive ve Directors, o orr the countries they represent. IFC and the World Bank do not guarantee th the e accu accurac racy y of the data included in this pub lication and accept no responsibility whatsoever for any consequence of their use.

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Some sources sources cited in this volume ma may y be inf informal ormal documents that are not readily avai availabl lable e The material iin n this public publicatio ation n is copyrighte copyrighted. d. Requests fo forr permission to reproduce portions of it should be sent to Director, Corporare Planning and Financial Po Policy licy Departme Department, nt, IFC,at the address shown in the copyright notice above. IF IFC C encourage encouragess diss dissemination emination of its work and will normally give permission promptly and, when the reproduction r eproduction is for nonc noncommercial ommercial purposes, with without out ask  ing a fee. Permission to copy copy portions for clas classroo sroom m use is granted through the C Copyright opyright Clearance Center, Inc., Suite 910,222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. -

Dism buted Dismbute d by by the World Bank  IF C publicatio publications ns in pri print nt are shown in the World Bank Bank's 's annual a nnual Index o off Publicatio Publications. ns. This index All All IFC contains an alphabetical list by title; indexes of subjects,authors, countr countries, ies, and regions; and complete ordering information.Th information.The e la latest test editi edition on is avail available able free of charge &o &om m the Distribution Unit, Office of the Publisher, the World Bank, 1818 H Street, N.W N.W., ., Wa Washington, shington, D.C. 20433, U.S.A.; from Publications, Publicatio ns, the World Bank, 66 Avenue dltna, 75116 Paris, France; or at the online publications site: http:lhmyw.worldbankorg,and click on "publications. publications."" Principal authors: Priscilla Anita Ahmed, Principal Financial Financia l Offic Officer, er, IFC Corporate Planning and Financial Policy Policy Department Department;; and Xinghai Fang, formerly Poli Policy cy Analy Analyst. st. IF IFC C Corporate Planning and Financial Policy Department, and currently General Manager, Office of Group Coordination Committee, China Chin a Constructi Construction on Ban Bank. k. LI LIBR BRARY ARY O F CONGRESS CATALOGUIN CATALOGUING G IN PUBLICATION PUBLICATIONDATA DATA Ahmed, Priscilla A. Project finance in developi developing ng countries : IFCb lessons of experience / International Finance Corporation. p. cm. Lessons of arperience series ; no. no. 7) Includes bibliographical references. Principalauthors, Pri sda A. Ahmed and Xinghai Fang Fang.. ISBN 0-8213-4434-X development ent projectsFinance. 1. International Finance Corporation. 2. Economic developm Industrial Industria l developmen development t International finance. I. International Finance 3. projectsFinance. 4. Corporation. 11. Series : Lessons of experience : 7. HG3881.5.156P76 1999 332. 1 ' 5 3 6 ~ 2 1 99-21713 -

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CONTENTS

Preface Abbreviations 1

2

The Impor Importance tance of Pro Proje ject ct F Fia ia n ce

Globalization and the Rapid Growth of Project Fiance

3

IFC's Role in Project Finance

4

Miti Mitigat gating ing Major Project Ris Risks ks

5

Strengthening Streng thening Proje Project ct Security



Summary and Conclusions Appendix A: Greenfield Projects Supported by IFC through Lited- Recourse Project Financing, Fiscal 1989 98

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Appendjx B:

A Sample IFC Project Appraisal Glossary Bibliography

 

PREFACE

Project finance to developing countries surged in the decade bef before ore the Asian c r i s i s supported suppor ted by a growing reli reliance ance on market economics in many countr countries ies during thi thiss period, as well as the increasing integr integration ation of global financ financial ial markets markets.. Projec Projectt finance structuring techniques were used to attract international financing for many large-scale projects, helping to meet investment needs in infrastructure and other sectors. The financial finan cial ccris risis is that began in East Asia in mid 1997, howev however, er, ha hass b brought rought a dram dramatic atic slowdown slow down in this trend. Th Thee crisis has created str stresse essess and sstrains trains for many projects, raising concerns about the viability of some and highlighting the importance of careful structuring and risk mitigation. -

mission iiss to contri mission contribute bute to tthe he World Bank Grou Group's p's overall overall purpose of reducin reducing g poverty and improving living standards by playing a leadin leading g role in the development of a IFCH

sustainable private se sector. ctor. As pa part rt of this miss mission, ion, IF IFC C was one of the early pioneers of  project finance in developing countries 40 year yearss ago, and project finance remains an important core of IFCb activ activities ities ttoda oday. y. In just th thee past decade IF IFC, C, which has a com mitted portfolio exceeding $11 billion in loan and equity investments in more than 1,100 companies, has supported suppor ted over 230 greenfield projects in 69 developing countries -

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with limited recourse project finance. Three impor important tant principle principless gui guide de IFC's wo work rk:: th thee business principl principle, e, the catalytic princi ple, and the t he principle of spec special ial contribution contribution.. Following the busi business ness principle, IFC focuses on promoting competitive and dynamic private enterprises by taking a partnership rol rolee and by accepting the same m market arket risk as project sp sponso onsors. rs. Th Thee catalytic principle focus focuses es on the demonstration effect of individual individ ual trans transactions, actions, a key to extending the Corporation's real development role. role. T h e speci special al contribu contribution tion pri principle nciple directs I F C to complement the market and hence focus on projects and places where it can add special value. IFC's involvement with project finance finance show showss how these principles interac interactt to help bring proje projects cts to completion. IF C and othe o therr development age agencie nciess can pla play y a signifi significant cant -

role in support of project finance in countries that have a hndamendly sound framework 

 

VI

P R O J E C T

F I N A N C E

but where access access to financial markets is limited. Project finance structuring can be particu par ticularly important to t o help mitigate risk and restore restore confiden confidence ce in difticult difticultcircumstances. circumstances. This volume describes IFCk greenfield ~rojectfinance finance activities over the past decade, initially against the background of rapid growth in capital flows and project finance activities in developing markets and then in light of their subsequent recent slowdown. I t describes describes the essentials essentials and some of the t he complexiti complexities es of project structuring, for the benefit of a wider audience, to help explain the importance of "getting it right. right." Although it is still too early to tell the final outcome outcome for most projects projects affected affected by by the th e crisis, cris is, this analysis analysis highlights highlight s those features of  structuring which in IFC's experience contribute to t o more durable projects projects over over the long term. A primar primary y mess message age is the th e importance of dearly d early identifying and addressing project project risks up-front and the potential costs of complacency in dealing with critic critical al issues issues such as foreign foreig n exch exchange ange or market demand risks. In addition to strong fundamentals, projects that are conservatively tiv ely structured in financial financial terms and th that at carry strong sponsor support in terms of  technical and management strength and financial commitment

are

those projects most

likely to be successful. Although Althou gh the t he report r eport focuse focusess on transactions, underlying underly ing the discussion is the impor tancee of good policies. tanc policies. Particularly important import ant is the need for governments to provide a supportive legal and regulatory framework framewor k Project finance, which is essentially contrac contracttbased base d financing, can be successfu successfull in the t he long lo ng term only against a background of solid rules, regulations, regulat ions, and policies. policies. If, for example, judicial processes processes are are not seen as fair or transparent, transpa rent, sponsors sponsors and investors will be wary of investing even even under the t he most care care

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fully crafted contractu co ntractual al structure. In I n a supportive environment, environ ment, h howe oweve ver, r, project finance structu ring can offer a relatively structuring relatively transparent transpar ent and efficient means for countries countr ies seeki seeking ng to increase the level of ~rivate of ~rivateparticipatio partic ipation n in economic activity activity and investment. Another important import ant policy policy messa message ge running ru nning through throug h this discussion, and reinforced by by tthe he lessons of the financial cris crisis is that tha t began in 1997 in developing countries, is is the th e priority priori ty govern governments need to give to strength st rengthening ening local local financial financial markets. Many of the project project diffi -

culties suffered suffered in the wake of the t he financial crisis would perhaps have have been more manageable if a greater share of project financing had been sourced locally. Local markets need to be able to provide provide long-term debt and equity equ ity financing financ ing on a reasonably reasonably competitive basis, basis, so that projects projects without a natural nat ural foreign foreign exchange exchange risk hedge do not need to resort heavily heavily to foreign currency financing and can therefore reduce potential potentially ly signifi

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cant foreign exchang exchangee r is isk  k 

 

Project Finance in Developing Countries was written by a team from IFC$ Corporate Planning and Financial Policy Department, led by Anita Ahmed with Xinghai Fang and Tracy Rahn, under the overall direction of Di D i e e p Wag Wagle le and Nissim Ezekiel. Val Valuab uable le support was also provided by Maybelle Pacis and Donna Raimondi. Thi Thiss book, lik likee 0thers in the Lessons of Experience ser series, ies, has drawn upon a full range of operat operational ional eexpe xpe rience with proje project ct finan finance ce transactio transactions ns from across the Cor poration. It has also benefit

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ed from comments and contributions of  of staff staff from the World Bank. Data used in the report reflect IFCH operational position through June 30,1998.

Peter L. Woicke Executive Vice President International Finance Corporation

 

ABBREVIATIONS

AI U AIU BIS BO O BOT CAMENA crn

Coface CU P D/ D/E E EAP EA P EBRD EC A ECA ECGD EIA EID/MITI FD I GDP IBRD ID B IDFC IF C IMF IPP kwh kw h LAC L/C L/ C Libor MDB MD B MIGA NGOs OECD OPIC PFA PFC PPA PURPA QlB

Export Credit Agency Agency Export Credits Guarantee Department environmental impact im pact assessme assessment nt Export-Import Insurance DepartmentMinistry of International Trade and Industry (Japan) foreign direct investment gross domestic product International Bank for Reconstruction and Development Inter-American Development Bank  Infrastructure Development Development Finance Company Intern Int ernati ationa onall F i a nc e Corpor Corporati ation on International Monetary Fund independent power project kilowatt-hour Latin AmericdCaribbean letter of credit of  credit London interbank offer rate multilateral development bank  Multilateral Investment Guarantee Agency Agency nongovernmental organizations Organisationfor Organisation for Economic Co-operation and Development Overseas Over seas Private Investment Investm ent Corporation Corpora tion project proje ct funds fu nds agreement project financial completion power purchase agreement Public Utility Regulatoty RegulatotyPolicy Policy Act qualified institutional instituti onal buye buyerr Securities and Exchange Commission (U.S.)

SEC SE C Note:

American International Underwriters Bank for for International Settlements build-own-operate build-operate-transfer Central Asiamiddle EasdNorth Africa Citicorp International Trade Indemnity Compagnie Franlaise dlAssurance pour le Commerce Extirieur Cooperative Underwriting Program debtlequity environmental action plan European Bank for Reconstruction and Development

AU

dollars are U.S U.S.. dollars unless otherwise otherwi se indicat ind icated. ed.

 

THE IMPORTANCE OF PROJECT FINANCE

In the past twenty years years there has been a new wav wavee of global interest in project finance as a tool for economic investment. Project finance finance helps finance new investment by structuring the financing around the th e projec project's t's own own operating cash flow and assets, without additional sponsor guarantees. Thus the tech nique is able to alleviate alleviate investment risk and raise finance at a -

relatively relat ively low cost cost,, to t o the benefit of sponsor and investor alike. alike. Tho ugh project finance has been in use for hundreds of year Though years, s, primarily in mining and natural resource pr project ojects, s, its other pos sible applications-esp especi ecially ally for financing financi ng large greenf greenfiel ield d projects (new projects projects without any prior track record or operating history) ha have ve only recently received received serious attention. This Th is is particu larly so in developing markets, but here its application is also also broadening, as illustrated by the th e following example exampless of IFCof  IFCsupported projects: -

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In Argentina, in 1993, project finance structuring helped raise $329 milli million on to finance finance investment in the th e rehabilitation and expansion of Buenos Aires' water and sewerage services based on a new 30 year concession awarded to Aguas Argentinas.1 Th e investment, investment, financed financed with with IFC I FC support, support, has helped helped improve water quality and service to a city of more than 6  million milli on people people.. At that th at time, private private sector partidpation in a water concession concession in a developing country was was an untested untest ed idea, -

and there was was virtually no precede p recedent nt for a private compan company, y, operating in such an enviro environment, nment, raising raisin g substantial substa ntial resources resources in international capital markets. markets. In Hungary, in 1994, projec projectt finance structuring helped helped finance a 15 year concession to develop, install, and operate a -

 

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P R O j E C T

F I N A N C E

nationwide digital digita l cellular network. The Th e $185 million joint venture project was an important part of the government's privatization and liberalization program. Because of  att racting ting commercial commercial financing at that tha t time, time, the project relied heavily heavily on difliculty attrac

$109 million in debt and equity finan financing cing from from I FC and the U.S. Overseas Private Investment Corporation (OPIC). In China, in 1997, Plantation Timber Products (Hubei) Ltd. launched a $57 million greenfield project to install ins tall modern mode rn medium-density fiberboard plants in interior China, using timber plantations developed developed over over the past decade, decade, to support China's fast-growing construction constructionindu industry. stry. As part par t of the limited recourse financing financing for the th e project, IFC helped arrange $26 million in syndicated loans, loans, at a time when foreign commercial banks remained cautious about project fiancing in China's interior -

provinces. I n Mozambique, Mozambique, in 1998, project finance structuring helped establish a $1.3 b i i o n greenfield aluminum alumin um smelter. MOZAL, the largest private sector sector project in the t he country to t o date, is expected to generate significant benefits benefits in employme employment, nt, export earnings, and infrastructure development. IFC fostered the project by serving as legal coordinator and preparing an independent, detailed analysis of economic results resul ts and environmental and developmental impacts. impacts. IFC I FC also supported the project proj ect with wit h $120 million in senior and subordinated loans for its own account. Th e change change in attitude toward toward project project finance finance can be attributed to t o a number number of fac

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tors, a prime one being tha thatt most countries today rely rely on market mechanisms mechanisms to guide their economic activity and on the t he private sector to t o supply supply investment. Greater focus on the private sector has necessitated necessitated major regulatory reforms, which in turn have have created new markets in areas previously the preserve of government activity. In one illustration, illustra tion, for example, example, provided by John Joh n D. F i ne r t y in Pro Proje jecct Financing:AssetBased FinancialEngineering, when the United States passed the Public Utility Regulatory Regulat ory Policy Policy Act (PURPA) in 1978 and established es tablished a private private market for electric power, pow er, it provided a strong model for the growth of project financing financing in many other industrial industri al countries.2 Similarly Similarly,, recent large-scale privatizations privatizations in developing countries countrie s aimed at strengthening strength ening economic growth and a nd stimulating stimul ating private sector sector investment investme nt have have given &her impetus to project finance structuring. Governments have also been will ing to provide provide incenti incentives ves to encourage private invest investors ors into new sectors. Th e surge in -

project finance was was particularly strong in 1996 and 1997, stimulated by large flows of  international capital. In 1997 the number of project finance deals worldwide (green field and expansion projects) exceeded 600, many of of them in developing countries, and their value topped $236 biiion (table (table 1.1), although this dropped back to about $111 billion in 1998. -

 

THE

I M P O R T A N C E

OF

P R O J EC T

3

F I N A N C E

Some market observe observers rs are questioning the prudence of this expanded use of project finance, financ e, espec especially ially in the wake of th thee Ea East st Asia financial cri crisis sis th that at beg began an in mid 1997 and the t he dramatic deterioration that ensued in a number of the major developing developing mar kets. In short sh ort order, many large projects underta undertaken ken in tthe he previo previous us few years were no longer economically or financially feasible. Contractual arrangements proved to be sh+in somee cas som cases es,, un unenfor enforceab ceable le-and many projec projects, ts, with hinds hindsight, ight, had fa failed iled adequately to address potential poten tial risks (i (including ncluding foreign excha exchange nge ri risks sks). ). Private lenders and inves investors tors w were ere much les lesss willing to ssuppo upport rt projects facing a dete deteriorat riorating ing po policy licy or market environment than public sector promoters would ha have ve been. In a few countries these problems were exacerbated by public criticism criticism of government suppo support rt giv given en to proj ects, and by allegations of corrup corruption tion in th thee awarding of initial contracts. -

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In IFC$ experience, howe however ver,, project finance remains a valuable tool. Alt Althoug hough h many projects projects ar aree under serious strain in the aftermath of the East Asia crisi crisis, s, project finance offers offers a means for inves investors, tors, creditors, and other unrelated parties tto o come together to t o share the costs, rrisk isks, s, and benefits of new investment in an economical economically ly efficient and fair manner. As the emphasis on corporate governance increases, the con tractually based approach of project finance can also help ensure greater transparency.

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4

PROJECT

F I N A N C E

Despite the t he financial crisis crisis that began in mid 1997, the inv investment estment needs in many developing develop ing markets remain remain enormous. e normous. Meeting these needs is essential to development, -

not only in the th e more ttra ra tional sectors such as energy but also in nontraditional areas such as school and hospital h ospital construction. For most countries, this will mean a continu

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ing reliance on privat privatee sector expertis expertisee and finance to meet demand. Once On ce growth and a nd investment resume, project project finance tech techniques niques are likely likely to be an even more important means of sharing risks and of helping these projects projects get off the ground --particularly in some markets and sectors that may be considered more risky for some time to come. As the experience of the crisis has demonstrated, individual projects are not a substitute for economy-wide regulatory reform designed design ed tto o improve competitiveness and effi di ciency, or for the development of local financial markets in support of local invest -

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ment. But in tthe he aappropriate ppropriate framewo framework, rk, proj project ect finance can provide a strong and trans parent structure for projects, projects, and through carefu carefull attention to potential risks it can help increase increa se new investment investmen t and improv improvee economic growth.

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BASICS OF PROJECT FINANCING

As already noted, project finance is tailored to meet the needs of a specific project. Repayment of the financing relies on the cash flow and the assets of the project itself. T h e risks risks (and returns) returns) are borne not by the sponsor alone but by differ different ent types of  investors (equity holders, debt providers, quasi equity investors). Because risks are shared, one criterion of a project's suitability for financing is whether it is able to stand alone as a distinct legal and economic entity. Project assets, project related con-

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tracts, and project cash flows need to be separated from those of the sponsor. There are two basic types of project finance: nonrecourse project finance and a nd limitedrecoursee project finance. recours Nonrecourseproject finance is an arrangement under which investors and creditors

financing the project project do not have any direct re recou course rse to the sponsors, as might tradition guarantees). es). Althoug h creditors' security will ally be be expected (fo (forr example example,, through thr ough loan guarante include inclu de the assets being financed, lenders rely on the o operat perating ing cash flow flow generate generated d from

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those assets for repayment. Before it can attract financing, then, the project must be care

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fully struc structured tured and provide provide comfort tto o its financiers that tha t iitt is economically economically,, technically, technically, and environmentally feasible, and that it is capable of servicing debt and generating financial financ ial returns commensurate commensurate with its risk profde. Limited-recourseprq'ectjnance permits creditors and invest investors ors some rec recourse ourse to the

sponsors. sponsor s. Th This is frequently takes the form of a precompletion guarantee during a project's construction period, or other assura assurances nces of some form of suppo support rt for the project. project. Creditors and investors, however, still look to the success of the project as their primary

 

T H E

IMPORTANCE

OF

P R O J E C T

5

F I N A N C E

source sour ce of repayment. I n most develop developing ing market projec projects ts and in other proj projects ects with sig

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nificant construction constr uction risk, proje project ct finance is generally of tthe he limited recourse type. -

D i r e n c e from corporate lending. Tradition Traditional al finan finance ce is cor corporate porate finance finance,, wh where ere tthe he primary source source of repaymen repaymentt for investors and creditors is the sponsor sponsoring ing c com ompan pany, y, backed back ed by its entir entire e balance sheet, no nott th the e project alone. Although creditors will usually still seek to assure themselves of the economic viabiity of the t he project b being eing financed, so

th that at it is not a drai drain n on tthe he corpo corporate rate spo sponso nsor's r's existing pool of a asse ssets, ts, an important influence on their credit decisio decision n is the over overall all strengt strength h of th the e sponsor's balance sheet as well as as busi business ness reputation. Depending on this sstrength, trength, creditors will still retain a sig

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nificant level level of comfort in be being ing repaid even if the individual proje project ct fails. In corporate finance, if a project fa fails, ils, its llenders enders do not nece necessari ssarily ly suf suffer fer,, as long as the company owning the project remains financially viable. In project fmance, if the project fails, investors and creditors can expect significant losses.

Project finance benefits benefits primarily sectors or industries in which projects can be struc tured as a separate entity, entity, apart from their sponsors. A case in point would be a stand

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alone production plant, which can be ass asses essed sed in accounting and financial terms sepa

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rately from the sponsor's other activities. Generally, such projects tend to be relatively

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large, larg e, beca because use of the time and other transaction costs iinv nvolv olved ed in struct structuring, uring, and to include considerab considerable le capital equipment tthat hat needs long term financing. financing. I n the financial -

sector, by contras contrast, t, the large volu volume me of finance tthat hat flo flows ws directly to developing cou coun n

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tries'' financial instituti tries institutions ons has continued to be of the corporate lending kind. Traditionally, in developing countries at least, project finance techniques have shown up main mainly ly in the mining and oil and gas gas sector sectors. s. Projects there depend on large scale -

foreign currency currency financing and are particularly suited tto o project finance be becaus cause e their output has a global market and is priced in hard currency. Since market risk greatly affects affe cts the potenti potential al outcome of most projects, pro project ject finance tends to be more applicable in industries where the reven revenue ue streams can be defined and fairly eas easily ily secured. In recent years, private sector infrastructure projects under long term govern -

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ment concession agreements with power purchase agreements (PPAs) that assure a purchaser purch aser of tthe he project's out output put hav have e also been able to at attract tract majo majorr project finance flows. Regulatory reform and a growing body of project finance experience continue to expand the situations in which project finance structuring makes sense, for example, for merchant power power plants ttha hatt hav have e no PPA but sell into a national po power wer g grid rid at prevailing market prices. In IFC's experience, project finance is applicable over a fairly broad range of  nonfinancial sectors, including manufacturin and service projects such as privately

g

 

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P R O J E C T F I N A N C E

financed hospitals (wherever projects can stand on their own and where the risks can be clearly identified up front). Although the risk -sharing attributes of a project finance arrangement make it particularly suitable for large projects requiring hun dreds of millions of dollars in financing, IFC's experience inclu including ding textile, shrimp shrim p

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farming, and hotel hot el proje project ctss also also shows th that at the approach can be employed succes successsfully in smaller projects in a variety of industries. Indeed, Indeed , tha t hatt experience suggests suggests project finance could help attract private funding to a wider range of activities in many developing markets. markets.

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BRINGING PRIVAT PRIVATE E FLOWS TO T O DEVELOPING MARKETS

Most project finance deals of the past two decades have been concluded in industrial countries, but the technique has also played a signiticant role in some developing markets. In 1997 19 97 and 1998 1 998 combined flows flows of this kind to developing developing country projects projects totaled about $183 biiio bi iion, n, or slightly slightly more more than half the total project project finance fl flow owss recorded worldwide (figure 1.1). For developing markets, project finance holds out the hope that a well-structured, economically viable viable project will attract long-term financing even if the project dwarfs its sponsors' own resources resources or entails risks they ar alone. Wi With th such a are e unable to bear alone. mechanism for sharing the costs, risks, and rewards of a project among a number of  unrelated parties, parties, a privatization or infrastructure improvement program program will have a greater chance of raising the volume of funds it requires.

 

THE

IMPORTANCE

OF

P ROJEC T

F I NANCE

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As a result, it is now standard practice for large and complex projects in the major developing markets to employ project finance techniques. The total volume of project finance transactions concluded in 1996 and 1997 before the financial crisis (an esti mated 954 projects costing $215 b i i o n ) would have been hard to imagine a decade ago. T h e number of active ago. active participants in these markets also increased increased as many inter national institutions (investment banks, banks, commercial banks, institutional instituti onal investors, and others) moved quickly to build up their project finance expertise. Th e financial financialand and economic crisi crisiss that tha t began in mid-1997 in East Asia, the site of  much recent growth, and spread to t o other o ther countries since then th en has ha s dramatically slowed slowed market evolutio evolution. n. The estimated number of projects projects in developing developing markets fell in 1998 to 140 for an amount of $60 of $60 bi io n. The Th e financ financial ial ca capa paci city ty and willingness of many banks in these countries and of other ot her potential potent ial invest investors ors to support sup port large projects projects have have also also been eroded. As a result, sponsors in crisis countries, both private and public, have canceled or deferred defer red numerous major major projects. projects.T h e ones sti still ll under implementation, particularly those financed during the past few years, have come under increased stress in the face of  reduced reduc ed market demand for their t heir output outp ut or related sponsor problems. problems. Wi th the prospects prospects for economic growth slowing slowing worldwide worldwide,, sponsors sponsors in other countries and regions are also structuring projects more conservatively It is not yet clear how prolonged these diiculties will be. When Wh en the growth of o f new productive productive investment picks picks up again, again, however, proje project ct financing is likely to increase, increase, particularly in countries where perceptions of risk remain high and investors could be expected to turn to structuring structuring techniques to help alleviate these risks. ADVANTAGES OF PROJECT FINANCE -

In the appropriate approp riate circumstances, project project finance has two important impo rtant advantage advantagess over over tra ditional dition al corporate finance: finance: it can (1)increase the availability of finance; and (2) reduce reduce the overall overall risk for major project participants, bringing bringi ng it down to t o an acceptabl acceptablee level level.. For a sponsor, a compelling reason to consider using project finance is that the risks of the th e new pro project ject will remain separate from its existing business. Th Then en if the project, project, large or small, were to fail, this would not jeopardize the financial integrity of the th e corporate sponsor's core businesses. Proper structuring will also protect the sponsor's capital base and debt capacity and usually allow the new project to be financed without requiring as much sponsor equity as as in traditional corporate finance. finance. Thus Thu s the t he technique enables a sponsor to t o increase increase leverag leveragee and expand its overall overall bu~iness.~ By allocating the risks and the th e financing needs of the project among amo ng a group of inter -

ested parties or sponsors, sponsors, project finance makes makes it possible possible to undertake undert ake projects projects that tha t

 

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P R O I E C T

F I N A N C E

would be too large or would pose too great a risk for one party on its own. This was the casee in 1995 when IIF cas F C helpe helped d structure financing for a $1.4 billion powe powerr project in the Philippines during a time of consid considerabl erablee econo economic mic uncertainty there. Sharing the risks among many investor investorss w was as an im important portant factor in getting the proj project ect launched. To raise adequate funding, project sponsors must settle on a financial package that both meets the needs of the project in the co context ntext of its particular risks and th thee ava avail ilable security at various phases of development and is attractive to potential creditors and investors. By tapping various sour sources ces (for examp example, le, equity investors, banks, and tthe he capital markets), each of which demands a different risk/return profde for its investments, a large project can raise these funds at a relatively low cost. Also working to its advantage is the globalization of financial markets, which has helped create a broader spectrum spectr um of financial instruments and new clas classes ses of investors. B By y contrast, project sponsors traditionally traditiona lly would have relied on th their eir own reso resources urces for equ equity ity and on commerciall bank mercia bankss for debt finan financing. cing. Particularly significant is tthe he increasing importance of 

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private equity inves private investors tors,, who te tend nd t o take a long-term view of their investments. The These se investors are are often willing tto o take more risk (for example example,, by extending subordin subordinated ated debt) in anticipation of higher returns (through equity or income sharing) than lenders. A project that can be structured to attract these investors-o supplement or even to substitutee fo substitut forr bank lend lendin ing g ma may y be able to raise longer -term finance more easily. Furtherr details on the main financial instruments and sourc Furthe sources es of fmancing for project finance appear in box 1.1.

-

 NO FREE LUNCH

For all its advantages, project finance cannot be said to offer a "free lunch." On the co con ntrary, trar y, it has rigorous require requirements. ments. To attrac attractt such finance, a project needs to be carefull carefully y structured to ensure that all the parties' obligations are negotiated and are contractually binding. Financial Financ ial and legal advis advisers ers and other experts may ha have ve to sp spend end considerable time and effort on this structuring and on a detailed appraisal of the proj project. ect. These steps will add to the cost of setting up the project and may delay its implementation. Moreover More over,, th thee shar sharing ing of risks and benefits brings unrelated pam pames es in into to a close and long relationship. A sponsor must consider the implications of its actions on the other parties associated with the project (and must treat them fairly) ifthe relationship is to remain harmonious over the long term. Since project finance structurin structuring g hing hinges es on the stre strength ngth of tthe he project itsel itself, f, the technical, financia financial, l, environmental, and economic viability of the project is a paramount

concern. weaken theore project is also likely weaken the financial returns ofAnything investorsthat and could creditors. Theref Therefore an essential step oftotthe he procedure is to ident d y and analyze analyze tthe he proje project' ct's risks risks,, then to allocate and mitigate them. Potential rrisks isks are many and varied. varied. Some may relate to a specific subs subsecto ector, r, other otherss to tthe he coun country try and policy environment, and still others to more general fac factors. tors. As the crisis that began in mid-

 

T H E

I M P O R T A N C E

O F

P R O J E C T

F I N A N C E

9

 

10

P R O J E C T

F I N A N C E

1997 has demonstrate demo nstrated, d, currency mismatches and government government related risks can have dev astating astat ing consequences consequences if overlooked. Though it may be costly and time consuming, detailed risk appraisal is absolutely necessary to assure assure other parties, including pas passiv sivee lenders lende rs and investors, investors, that tha t the th e project makes sound economic and commercial sense. sense. -

-

-

Similarly, lenders and investors must be kept abreast of the project's Similarly, project's operational per formance as it i t progresses progresses..

-

T h e largest share of project finance normally consists of debt, which is usually usually provid provid

-

ed by creditors with no direct control over over managing the project. project. They Th ey try to protect their investment investm ent through collateral and contracts, contracts , broadly known known as a security packa package, to help ensure that their loans will be repaid. Th e quality of the security security package package is closely linked t o the closely th e effectiveness of the t he project's project's risk mitigation. miti gation. Because Because project financ ing relies on the project's cash flows and the contractual arrangements that support and ensure those flows, it is essential to identify the security securit y available available in a project and to

-

structure the th e security package package to alleviate the risks risks perceived perceived by participants participant s (se (seee box addit ional support support in the form of sponsor assurances or 1.2). Some projects may need additional government governme nt guarantee guaranteess to bring credit risk to a level that can attract private financing.

-

-

The overall financial costs of a project finance transaction may not be as high as under corporate finance if the project is carefully structured, if it identifies and mitigates each risk to the extent possible, and if it sources finana fin anang ng appropriately from different cate-

 

T H E

I M P O R T A N C E

OF

P R O J E C T

F I N A N C E

11

gories of investor. T h e senior debt deb t compo co mponen nentt may be be more expensive, hhowev owever, er, bec because ause debtt repayment rel deb relies ies on the cash flow flow of of the project project rather than on th thee strength streng th of the sponsors' entire balance balance sheet. Th Thee project sponsors will need to t o carefully carefully weigh the advantages of raising rais ing large-scal scalee financing against the relati relative ve financial and adm administra inistra tive costs (both up -front and ongoing) of diie di iere rent nt source sourcess of fin finance. ance.

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IFC'S PERSPECTIVE

Th is report expl This explores ores the changing chang ing face of project finance finance in developing market^.^ I F C and, more recently, other multilateral, multilateral, bilateral, bilateral, and export credit institutions in stitutions have have played a strong stro ng supportive role in bringing project financ financee to t o its current volumes. volumes. Th This is role role was institutions sustain sustained ed flo flows ws of an estimated $25 $25 b i i o n highlighted in 1998, when these institutions at a time when there was was an abrupt decline in some types of private fl flows ows.. IFC, IF C, in particular, wa wass a pioneer of project finance finance in developing countries countrie s and has a unique u nique depth dep th of experienc experiencee in this field, which spans more than th an 40 year yearss in the practical implemen implementa ta-

tiony's of some 2,000 many to of mobilize them on finance a limited limited(both recourse Particularly in toda today's marketp mar ketplace lace,projects, , IFC's IFC' s ability loan basis.5 and equity for its own account and syndicated loans under its B -loan program), the the strength of its project appraisal capabilities, capabilities, and its experience in structurin structuringg complex transactions transactio ns in difficult environments have have been reassuri reassuring ng to other participants and important to the succes successsful financing of many projects. The report draws on IFC's experience in more than 230 greenfield projects costing upward of $30 billion that relied on project finance on a limited-recourse basis basis (appendii (appen dii A). It opens & th a brief description of the major international trends in project finance over over the past two decades and then turns to the essential ingredients of successful project financing. In view view of IFC's considerable experienc experiencee and the attention attentio n now n ow being given given to proj ect financing, fin ancing, especially among developing market participants themselves, themselves, the time seems ripe to let others benefit from that experience. The discussion in the pages that follow foll ow should be of particular interest t o private sector commercial commercial banks and investment investmen t banks in developing markets that tha t are giving thought thoug ht to financing fin ancing projects, private sector corporations corporati ons considering a new project in a developing country, other financial institutions, and governments in developing markets seeking seeking a better bet ter understanding unde rstanding of how project proj ect finance can help promote prom ote new investment. investment. -

Notes

Note that for some projects the date may differ from the project's fisfal year commitment date, because because of  the time lag between project preparation and and commitment date of finanang. 2. John D. Finnerty, Project Finannnghet-BaredFinnncidEnp'nemmng(New York:John Wiley and Sons Inc., 1996). 1.

 

12

P R O J E C T

F I N A N C E

some case cases, s, projectfinance structured with minority minorit y partiupation may also also confer tax or financial disclosure benefits on the sponsor. 4. Th e report concentrates on project finance for private sector projects. projects. Although some national and local govenunents seek to attract private private financing to public sector projects throug through h project finance smcturing, the expli and the techniques are similar, the project is under the explicit cit or implicit umbrella umbrella of government support. supp ort. 5. Since its founding in 1956,IF C has committed more tha than n $23.9 billion of its own funds and has arranged $17 b i i on in syndica syndicatio tions ns and underwriting for 2,067companies in 134 developing countries. IFC's total committed portfolio outstanding at June 30,1998,was $11.4billio billion n aand nd inclu included ded financing to 1,138 companies in 111 countries. 3. In

 

GLOBALIZATION AND THE RAPID GROWTH

OF PROJECT FINANCE

 

14

PROJECT

F INANCE

effects of globalization. Th e liberalization of financial markets, combined with effects advances in information technology, has given rise to new financial instruments, most notably a broader spectrum of debt and equity products and a wider range of risk  management techniques. Project finance, which relies heavily on the mitigation of  project risks, has been able to build on these financial products, making project financing possible even even in the face of commercial, commercial, interest rate, foreign exchange, and commodity risks. Until the 1997 crisis, this mutually reinforcing relationship was fos tering a rapid growth in project finance, finance, in industrial countries, and and also in developing markets, although the availability of new techniques in the developing markets remained much more limited. As noted in chapter 1, project finance flows to emerging markets reached an estimated $123 billion in 1997 199 7 before the financial crisis, crisis, representing representi ng more than t han a 25-fold increase over the previous previous decade. decade. T h e growth in i n th thee number of transac transactio tions ns any any

-

involving larger and larger proje projects cts was also impressive, rising from less than 50 in 1994 to more more than 40 400 0 in 1996 and 38 380 0 in 1997, before declining significantly in 1998.

Project finance also supported economic e conomic growth as many develo developing ping countries strengthened strengthe ned their macroeco macroeconom nomic ic management and liberalized their economic structures; this led to increased investment and a strong stro ng demand for financing, which was was reinforced by the transfer of project project finance techniques to those thos e countries countries and sectors having the appropriate regulatory and business framework The willingness of governments to create the regulatory h e w o r k to attract private investment (and in some cases t o provide provide additional additi onal support) also also created many new opportunities in developing markets, particularly in areas areas that tha t were previously previously the preserve of state sta te enterprise. As a result, -

public private partnerships been astandards fertile fert ile area forthe project financing. finanimprovement cing. T h e increasing resulting acce acceptan ptance ce of international internat ional have accounting accounting stand ards and in cor corporate accountability account ability and transparency have have also also improved improved the th e business and regulatory regul atory framework framewor k in many many counmes, counmes , thereby facilitating contract-bound transactions.This last point is important for project finance, which usually brings together a number of unrelat ed parties to complete a project. Project finance relies on a system that can ensure that agreed obligations obligati ons and and responsibilities betw between een its diier dii erent ent part parties ies will be met. MILESTONES IN IN PROJECT FINAN FINANCIN CING G

all regions Project finance finance has not flowed flowed to t o all countries countrie s and all geographic regions, just as all

have not have no t benefited equally equally from the dramatic increase increase in private capital f l m . T h e growth and spread of the t he project finance market can be seen in some of the major policy policy changes and innovative innovative projects structured over the past two decades (box 2.1) 2.1).. For the most part, part , project finance to developing developing countries has increased wherever wherever sponsors sponsors have found not only a relative relatively ly stable macroewnomic macroewnomi c environment but b ut also the following following favor favorable able con-

 

GL OB AL IZ AT ION

A N D

15

G R O W T H

ditions: regulatory reforms reforms openin ope ning g markets markets to competition competit ion and private investment; liber alized aliz ed foreign investmen investmentt regulatio regulations; ns; privatization programs that have increased invest ment opportunities; liberalize liberalized d financial financial markets markets promoting the deepening and broadening -

-

of local markets; markets; wider use of risk management manageme nt and other oth er financial products; improved legal h e w o r k s (p a rtic u l a rlyfor contract enforcement);and imprwe imp rwed d accounting stan dards, which have increased increased corporate corporat e accountabity and transparency.

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Throug h 1997 the lion Through lion's 's share of project finance volumes volumes went t o Asia, although its relative relat ive share declined in 1997 and more significa significantly ntly in 1998 1 998 (figure (figure 2.2). Between 1994 and 1998 developing markets in Asia received 41 percent of the estimated flows to developing developing countries, follow followed ed by Latin America and the t he Caribbean with a share of  31 percent. percent . Asia Asia's 's dominance dominan ce until unti l the th e latter latt er pa part rt of 1997, and Latin Lat in Americ America's a's since then (with abou aboutt 56 percent of flows in 1998), was due to t o high h igh levels levels of domestic investment and growth, macroewnomic stability (which increa increased sed the ability to attract attra ct -

long term financing essential to project finance), and a regulat regulatory ory framework relatively supportive of contract based finance. Countries in other regions, however, can and do attractt large flow attrac flows. s. T h e ability to sustain future growth in project finance fflo lows ws to individual developing countries will depend on o n continued improvements in the th e frame frame work supporting these flaws. flaws. Th e sectoral distribution of project finance transactions transactions in developing markets over over the same period is illustrated in figure 2.3. Th e import importanc ancee of infrastructure is clear, with 5 1 percent of flows over over the period 1994-98, including an increased increased share of 58 percent in 1998. -

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G L O B A L I Z A T I O N

A N D

G R O W T H

17

 

18

P R O j E C T

F I N A N C E

The gro growth wth in project finance and in total tot al capital flo flows ws to developing markets was particular parti cularly ly strong in the period from mid 1995 until the th e last few months of 1997 (aft (after er -

the onset of th thee Asia crisis crisis), ), and was accompanied by improved terms for fo r borr borrowers owers.. T h e spreads for private sector bor borrower rowerss and projects in developing markets declined dramatically (fig (figure ure 2.4); at the same time, available maturi maturities ties lengthen lengthened. ed. The There re was a sharp increase in the t he d demand emand fo forr bond bondss is issued sued by private corporatio corporations, ns, while a few bonds were issued issued for limited recourse projects. Loan pricing also became more flexible, -

frequently including grid pri frequently priang ang,, or multiple interest rate set settings, tings, depending on risk  changes, as as defined by certain events ov over er th thee life of the loan. Typical even events ts for proje projects cts might include project completion, a ch change ange in sover sovereign eign or company rating, le levera verage ge and other financial ratios, ownership, and debt amount o u t ~ t a n d i n ~ . ~ Thee tighter spreads and longer maturities se Th seeme emed d tied both to general market liq liquidi uidi

-

ty (noted by many who tthought hought that the pricing of som somee transactions was becom becoming ing excessively aggressive) and to improved perceptions of country risk. The success of eco nomic reform programs dramatically altered th thee external perceptions of many countries, particularly in Latin America; for example example,, Uru Urugua guay, y, Panama, and El Salvador Salvador joined  joined -

Chile and Colombia in 1997 in obtaining an inve investmen stmentt grade rating.f In some cases, corporations the themse mselve lvess obtain obtained ed a higher rating tthan han did their country. -

CAPITAL MARKETS FINANCING

Th e rapid g growth rowth of tthe he in internat ternational ional securities markets in recent yea years rs,, as ref reflecte lected d in the incre increased ased vo volume lume of ffinance inance and sophis sophisticat tication ion of thei theirr ins instrumen truments, ts, was linked tto o

 

GLOBALIZATION

A N D

19

G R O W T H

this overall improvement and h had ad a significa significant nt impact on fi financing nancing opportunities for borrowers in developing markets. Public financial markets. Traditionally,

developing countries' corporate equity and debt were placed directly with investors and creditor creditorss through private placements or syndica syndica tions. Tod Today ay,, the t he ca capital pital markets play an important role in fina financing ncing the private sect sector, or, aass shown earlier in table 2.1. Th This is has enabled many corporate borro borrowers wers to gain acce access ss to large-scale financing financing.. -

For the most part, this access has not yet extended to limited -recourse projects in developing countries, which conti continue nue to rely on commercial loan syndicati syndications, ons, although there have been some important exceptions, including AE AES S China Generating's 1994 $150 million equity offering offering for new powe powerr projects in Chin Chinaa and its 1996 $180 mil lion public bond offering. Only a few IFC-supported projects in some half -dozen countries (notably Argentina, Brazil, Mexico, an and d India) have gained access access to th thee international internation al bond and equity markets. Almost a l l of these projects are in countries -

with an investment grade credit rating, and their sponsors have been able to shift from commercial bank, development agency or export credit agency financing to securities markets transactions to take advantage of bot both h longer-term maturities and more flexible financing requirements. -

The main advantages of bond financing over bank loans are that they can reach a wider group of investors and therefore usual usually ly achieve a lower interest cost margin and longer maturity. Documentation also u usuall sually requires fewer covenants, so there is less

 

20

P R O J E C T

F I N A N C E

nego tiation negotiatio n with lenders an and d a faster conclusion. Securities laws, laws, howeve however, r, generally require a high h igh level of public disclosure of all the material contracts relating to a project, together with the details details of its financial activi activitie ties. s. Th at may be problematic if if informa inform a tion on materials materials is of a confidential confid ential nature. In I n addition, addition , considerable considerable legal, legal, accounting, and auditing aud iting expense expense may may be incurred in gathering the required required financial information, which may offset the lower interest cost costs. s. Another drawback is that the traditional bond structure does n ot provide the same degree of flexibi flexibilit lity, y, monitoring, or control of a creditor's credit or's interes in terests ts in the project as does bank ban k financing. Bonds are usually usually held as bearer instruments (with no central register of name namess of holders), sso o the sponsors sponsors may find it d i i c u l t to adjust covenant covenantss or financial terms if the project project's 's needs change. -

O f more concern for many potential borrower borrowerss is the volatility volatility of of the th e public securities securities market. T h e availability availability of senior loans is generally not as market sensitive as as bonds b onds,, as has been confirmed by the difficulties since the Asia crisis crisis erupted. A number of projects projects that before the th e crisi crisiss had hoped hop ed to t o tap the public bond markets m arkets have now reverted reverted to loan syndications syndications or private private placements, placemen ts, even though thou gh these the se markets m arkets hav havee also contracted significantly. Figure Figu re 2.5 illust illustrates rates the decline in bond and short term note issues since the last quarter of 1997. -

-

Over the longer term, however however,, project project related bond issues are expected to gain and sustain greater accessibility accessibility to public markets. To illustrate, i t is estimated e stimated 4 that global bond issuance issuance for project financing rose rose 23 percent in 1998 to $9.9 billion, even whiie -

-

bank lending declined 16 percent. Investors are are becoming more more familiar familiar with the struc tured aspects of project debt because of the success of other structured debt programs (for example, mortgage backed securities securities). ). Project bonds are also becoming more attractive to longer term fmed-income investors because they are backed by long term identifiable cash flows. The expanding use of development agencies through Export -

-

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G L O B A L I Z A T I O N

A N D

21

G R O W T H

Credit Agency (ECA) guarantees and insurance as well as thei theirr private sector equ equiva iva

-

lents will help reduce perceptions of risk and enhance credit ratings. One illustration of this was the increase in project ratings assigned by by the major rating agencies in 1996 and 1997 before the Asia crisis (for example, example, Standard and Poor's Poor's rated $5.5 biilion in 1996 and over $10 billion in 1997), although most greenfield projects remained below investment grade. Box 2.2 illustrates one expansion project that obtained an investment grade rating with with the help of IFC financing. -

Private placementmarket. Although most projects in developing markets will continue to have limited access to the public listed markets for securities, a significant liberaliza -

tion of U.S. U.S. securities regulations in 1991 opened open ed new opportunitie oppor tunitiess for limited-recourse financing financi ng through private placements. Previousl Previously, y, some non U.S. companies avoided the -

U.S. capital markets markets because because of a concern that tha t the registration requirements of the U.S.

 

22

P R O J E C T

F I N A N C E

securiti es laws (includi securities (including ng U.S. generally generallyaccepted accepted accounting accountin g principles) coul could d apply to offerings offeri ngs and resale resaless of securities. Sin Since ce 1991, however, a non U.S. issuer may make an -

international capital capital markets offerin offering g that th at is similar similar t o a public offering without having to register and without presenting US.-reconciled financial statements. These issu issues, es, called Rule 144A/Regulation 144A/RegulationS S issues, issues, m may ay not be made to tthe he p e r a l public but ma may y be made to an unlimi unlimited ted number of institutional buy buyers ers (QIBs) in the United States and to an unlimited number of investors outside the United States. Because there are more than 4,000 QIBs (mostly invest investment ment adv advisers isers,, pension fund manag managers, ers, insur -

ance companies, and banks banks), ), th thee market is quite broad. As wi with th publi publicly cly is issued sued bonds, bonds offered under Rule 144A gener generally ally contain fewer financial covenants than eeither ither commercial bank loans o orr development agenc agency y and ECA financing agreements. Of the more than $110 biion raised in the private placement market in 1996, about 80 percent came under Rule 1444. Private place placement ment financing costs are usually slightly higher than tha n those t hose for public se securities curities but still allow deve developer loperss of inte internati rnational onal projects to tap in into to a deep and liqu liquid id marke markett at relative relatively ly low ccost. ost. Equityhnds. Funds, also known as collective investment vehicles, are financial struc

-

tures for pooling and an d managing the money of multiple inves investors. tors. Th They ey offer investors a mechanism with which to buy securities they could could not otherwise hol hold d becaus becausee of  of transtrans-

 

G L OB A LI Z AT I ON

A N D

23

G R O W T H

action costs, legal restrictions, or lack of expertise.They The y also help hel p investors diver diversify sify assets, achieve better liquidity, and obtain the benefits of professional management and research.. Domestic companies benefit from funds because they provide greater acc research access ess to equity capital. Since 1984, 1984, when IF I F C helped structure one of the th e first country funds (for Korea), th thee volume of equity funds invested in developing deve loping markets has grown well beyond $100 billi billion. on. Most equity funds are country portfolio funds that t hat invest inve st in the listed securities of local companies, but a growing category are private equity funds geared to investing in large projects, including greenfield and unlisted securitie secu rities. s. IFC IF C helped promote one of the t he first such funds, the Scudder Latin American Trust for Independent Powe Power, r, which which was established in 1993 to make long term investments, generally equity type securities, securities, in private pr ivate power power projects in Latin America and the Caribbean.

-

-

Looking forward. Wi t h the onset of the East Eas t Asia Asia crisis crisis in mid 1997, financial financial mar ma r kets changed drastically.Project finance, having its biggest market m arket in Asia, was was particu larly hard hit. Many borrawers and projects in the region saw interest rate spreads  jump, as as did less creditworthy borrowers borrowers outside. outside. Liquidity Liquidit y in the t he bond markets, which -

-

-

are traditionally more volatile, declined dramatically; in many countries acces accesss disap

-

peared altogether. Activity in the lending markets also declined, exacerbated by the pullback of Japanese Japanese financial institutions instituti ons (major player playerss in the th e area) for domestic rea sons. son s. In I n the th e wake of these changes, the volume volume of new market transactions transac tions fell fell from monthly ave averag rages es of $18 b i i o n in Janu Januar ary y Octo October ber 1997 199 7 to $12 billion in November and December.5 Concern over the impact of the currency crisis on longer term eco nomic growth prospects in Asia and elsewhere has also slowed activity considerably. As -

-

-

-

a result, many projects hav havee been canceled or are on hold pending sta stabilizat bilization ion of eco nomic and financial markets. Of the projects going ahead, some that had not reached financial closure before the crisis are having to resort to t o more conservative conservative financing packages (at a higher cost; see table 2.2), or must seek other means to help mitigate the perceived increase in risks. risks. -

How soon East Asia and other developing markets affected by the crisis will be able to recover is as yet undear. Forecasts for the longer term are generally optimistic: institutions instit utions specializing specializin g in project finance expect pre 1997 trends in i n this area to t o resume once ew ew-nomic growth returns to the major developing markets. Much will depend, however, on a ret return urn of a willingness willingness of banks in Japan, Korea, Korea, and Taiwan, Taiwan, major suppliers suppliers of capital capit al -

before the crisis, crisis, to resume lending lend ing activities. I n the th e interim int erim,, projects will continue to be sponsored, particularly sponsored, particularly in the more more creditworthy creditworthy countries, countries, but sstructuring tructuring will be much are likely to rely more frequently on support from official more conservative, and sponsors are agencies to complete their thei r fina fi nana nang ng packages packages.. These The se trends tre nds are discusse discussed d next. next.

 

24

P R O J E C T

F I N A N C E

Notes 1. See, for example, Wor World ld Bank, Gfo6a(Dme/opmrntFinmrcc1998,March March 1998, and %ah DmeI4ping Counhics: The Rond to F i n a n d  Integration, 1998.

C+Ff-to

2. Adjustable features help lenders lengthen loan maturities,as they

ca n adjust pricing for changes in the futu future re credit standing of the borrower. October 1,1998, 1,199 8, more more than 50 developing countries had sovereign credit ratings (compared with just 3. As of October 18 in 1994); of these, 22 were considered investmen investmentt grade, as rated rated by Moody's Investors Investors Senice. 4. IFR Publishing, Prnject  Finance Intmational, Febr February uary 1999. 1999 . Publishing,Prnject  5 . World Bank, Bank,GIobaIEconomu GIobaIEconomuPro~pectr Pro~pectr  and the DmeIoping Countries,January 1998.

 

IFC'S ROLE IN PROJECT FINANCE

 

26

P R O J E C T

F I N A N C E

MULTILATERAL, MULTILAT ERAL, BILA BILATER TERAL AL,, A N D REGIONAL DEVELOPMENT DEVELO PMENT AGENCIES AGENCIES In response to the growing belief that private enterprise can be an engine for growth, many development agencies agencies have have switched the focus of their financial support from go gov v ernment to privat private e sector transac transactions tions and progra programs. ms. The Their ir willingness to invest in highrisk countries and sectors has has helped spread th the e grow growth th of project fina financing. ncing. In particu la lar, r, their abi abiity ity to ext extend end lon long g term financing and to directly guarantee or insure against certain project risks has enabled some large and complex projects to proceed, especially -

-

-

those involving public private partnerships. Whe When n development age agencies ncies parti participate cipate in -

the financing packa package, ge, even without explicit guarantees, the project often has a higher profile, profil e, which helps prot protect ect it against certain political ris risks. ks. IFC IFC is the largest muldlateral source of loan and equity financing for private sector proj

-

ectss in the developiig world; it is also a leading agency supporting project finance for the ect private sector. sector. Its experience spans more tha than n 40 year yearss and reaches int into o 134 countries. As of June 30,1998, IFC's total financing portfolio cove covere red d 1,138 companies in 111 coun

-

tries.. O tries Over ver th the e past fiv five e yea years, rs, other develo development pment agenciesincluding the European Bank for Reco Reconstruc nstruction tion and Development, the Inter American Development Bank (IDB), the -

Asian Development Bank, and the M i c a n Develop Development ment Ba Bank  nk  have

-

a ll increased

their

lending to the private secto sectorr (figure 3.2). In 1998, their total tot al finan finance ce to the privat private e se sector ctor

 

I F C ' S

R O L E

27

is estimated at $10.2 b i o n , of which I F C represents represents about $ $2. 2.8 8 b i i on . Alt Although hough figu figures res for their the ir project finance activities ar are e not available, they are estimated to represent at least

25 percent perce nt of these agenci agencies' es' total private sector lending. T h e syndicated loan programs (known as B loans) offered by some M D B s are also an important means of m o b i z i n g finance. Tota Totall B loan syndications in 1997 were about $4 b i i o n . IF C has b by y f i r the largest B loan program (box 3.1): it complete completed d $2.4 b i i o n in syn syndica dication tionss during fis fiscal cal 1998 and $9.8 $9.8 b i i o n betwe between en ffisc iscal al 1 1995 995 and 1998. -

-

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IFC'S IFC' S ROLE IIN N PROJECT FINANCE IIN N DEVELOPING DEVELOPING MARKETS MARKETS

Project finance finance has been part o off the th e cen central tral cor coree of IFC's activities since it began opera tions in 1956, and IFC remains the leading multilateral institution supporting private

-

IFC C supports project finance in three principal ways: sector project finance.1 IF ofprojectss withpriva te investors. I F C equity and long term debt  By  By sharing the ris k ofproject financing alongside alongside that tha t of other partners can help projects go forward. Thi Thiss is par ticularly important in countries having weak local financial markets or having diffi culty attrac attracting ting foreign investment. -

-

-

through ugh a ppra& aland sfr sfruedur ueduring ing skills. IFC's emphasis on  By heIping redueproject  risk thro careful appraisal and its broad experience in difficult environments ca can n help sponsor sponsorss structur stru cturee a financially, technically, technically, and environmental environmentally ly sound project. Th Thee agen agency cy's 's knowledge and understanding of different business environments may also facilitate the actual investment process by helping to secure administrative or regulatory approvals.

 

28

P ROJE CT

F I N A N C E

 By  By helping reduceperceivedrirA through itspresence in aproject. Because IFC  is an international organization owned by its member countries, its participation in a project provides provi des some some comfort in the face face of political risk. This gives it a strong catalytic role in many projects, especia especially lly in mobilizing loans from other financial institutions through syndications (B-loans). IFC, the lender l ender of record, extends the advantages advantages it derives as a multil multilatera aterall institution to other ot her participants particip ants in the syndicated loan, which may enable IFCb dients to obtain financing on better terms and allows financial institutio insti tutions ns to finance at lower perceived perceived risk.

 

I F C ' S

R.OLE

29

To illustrate IFC's IF C's role, role, this chapter examines its greenfield project financing financing over the past decade. The discussion also provides a useful backdrop to chapters 4 and 5, which describe the central features of successhl of successhl project structuring. IFC's greenfield project project finandug. T he ~rojectsreviewed reviewed for this report constitute the greenfield projects for which IFC has committed project financing on a limitedrecourse basis basis during the past 10 years (fiscal 1989-98).2 Th e sample consis consists ts of 291 project finance transactions (including additional investments investments and risk management facilities) for 233 greenfield greenfield projects approved approved and committed committe d by IF IFC. C. Th e total t otal cost of  these projects was was $30.5 bi ion , an and IFC$ total committed financing about about $8 billion including B-loan loans. s. These Thes e projects represent only part of IFC's total limited recourse -

including B loans. loans. These Thes e projects represent only part of IFC s total limited recourse financing during the period, which also included more than 400 expansion or other financings arranged for existing companies or projects. Although project finance is frethis review focuses on quently used to support the expansion of an existing ~roject,this greenfield projects projects becaus becausee these thes e endeavors, with their new plant construction c onstruction and an d new operations, pose the greatest challenge to structuring and risk sharing. IFC's investment. IFC IF C invests in projects through a mixture of debt, equity, and quasi equity. equ ity. I n almost all (95 percent) of the t he greenfield projects projects revi reviewed ewed,, IF C agreed agreed to provide long-term loans, and in half of the projects projects it also helped raise raise additional debt financing through its it s syndications (B (B-loans) to commerc commercial ial banks and other financial institutions. instit utions. Unlike many other development development agencies agencies,, IFC IF C has also also traditionally tradi tionally been been a major provider of equity funding to the private sector in developing markets; in more than half (54 percent) of the greenfield projects, it invested invested eq equity uity,, and in more than tha n a

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quarterr (27 perc quarte percent), ent), it als also o provided provided quasi -equity in the form of subo subordinated rdinated debt or convertible loans. Table 3.2 indicates the maxim maximum um and ave averag ragee amou amount nt of IFC$ support through diff different erent financ financial ial instruments in these projec projects. ts. IF IFC C and IFC-arrang arranged ed financi financing ng usu usually ally cov covers ers a significant share of tota totall project cost, although althoug h the agenc agency y itself is neve neverr the majo majorr investor and does n not ot take an active role in proje project ct manageme management. nt. T h e rel relati ative ve importance of o f IFC's overa overall ll financing to greenfield projects and of its different instruments is shown in figure 3.3. On O n avera average, ge,

IFCS own lending represented 11 percent of total project costs, whiie B-loans repre-

sented 13 percent, although th they ey av avera eraged ged 2 21 1 percent of the financing in proje projects cts w where here they were used. IFC's equity represented 2 perce percent nt of the total cost of the proje projects cts in which IFC I FC made equity in investm vestments, ents, and accounted for 7 percent of the equ equity ity in those projects. Quasi-equit equity y average averaged d 1 percent of total proje project ct cost and 5 percent of the cost in projects projects with qua quasi si-equity. IF C support for indiv individua iduall g grree

eld pr proj ojec ects ts has va varie ried, d, as as illustrat illustrated ed in fig figure ure 3.4 3.4,,

depending depen ding on th thee type of project and alternative financing avail availabl able. e. Overall, i t has averaged 2 7 percent of project cost, and in 52 percent of the proje averaged projects cts it ran ranged ged between 20 percent percent and 30 perce percent. nt. In 17 percent of the projects, IFC's support represented 30 percent or more of project ccost. ost. Whe When n syndicated loans arranged by I FC are included, the picture is rather different. For 36 percent of the projects, IFC support (including B-loans) was 20 percent to 30 percent percent of project co cost, st, but iitt reached 40 percent or more of total project cost in 35 percent of the projects.

 

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IFCH long-term financing is considerably longer tha than n tha thatt usua usually lly offe offered red in private markets. About 81 percent of IFCS of IFCS greenfield loans ha have ve a tenor of 8 years or more, but . a few have stretched even to 20 years. Syndicated SyndicatedB B-loans generally generallycover cover slightly shorter periods. period s. Projects are usually provided grace periods of 2 to 3 yea years rs before principa principall repayments start. Int Interest erest rates are determ determined ined according to prevailing market rates, depending on on the country, proje project ct risk, and tenor of the loan. Interest margins on the B-loans of the projects reviewed range from 0.5 0. 5 to 4.0 percent above Libor, mostly at

variable rates. Interest margins on IFCS own loans are slightly higher, reflecting their longer tenor. About 25 percent of IFCS of IFCS loans were provided at fixed fixed rates o off interest. Country distribution. IFC has financed greenfield projects in 69 countries (of which 18 are in Sub-Saharan Africa) ove overr tthe he past decade and in a wide range of sectors. Of  the 233 projects, 67 are in Asia, 61 are in Latin America and and tthe he Caribbean, and the remainder are spread among Europe (43), Sub-Saharan M i c a (26),and Central C entral As Asia ia,, the Middle East, and North Africa (36) (see figure 3.5).

I FC has relie relied do on nnts. project finance techniques for a large numberwere ofreprojects in difficult country envir environme onments. Of the 233 greenfield projects, 77 percent we in countri countries es with an Instihrtiona Instihrtionall Inves for rating of less than 45 at the time th thee project wa wass approved, and 27 percent were were in h high igh-risk countries with a rating of less than 25.3 By comparison, only about 10 percent of the total int internation ernational al project financing in developing markets over over the period 1994-98 wa wass iin n countries with a risk rating of less less than 25.4

 

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Sector distribution. Over the per period iod1989 1989 98, i n f i a s t r u m accounted for for the largest share of IFC greenfield finance (27 percent of the projects, or 41 percent in terms of project cost)(figure 3.6). Project finance techniques have enabled investm investment ent in this sector to to undergo rapid growth during the past fi five ve years. IFC$ support for i d k t r u c t u r e projects is particularly import imp ortant ant in L Lati atin n America and Asia, where it accounts accounts for nearly half of all all IFCH greenfield project finance activity (fig (figure ure 3.7)? Ot Othe herr sectors receiving receiving substantial substantial support have been oil and gas, manufacturing, mining, and chemicals. chemicals. In general, the pat pa ttern of IFC's participation in individual sect sectors ors in each region reflects both the investment investment activity activ ity in tha thatt secto sector, r, influenced by the pace of regulatory regulatory refor reform, m, and th thee abiity of the sector and the country to attract international capital flows flows with without out MDB or ECA EC A support support..

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Project size. FC's greenfield experience demonstrates that relatively small projects can be financed successllly using project finance techniques. Over the past decade IFC has helped finance projects projects rang ranging ing in s i i &om $5 million (the cutoff for the th e sample) for an agribusiness project in Europe to $1.7 b i i o n for an oil refining and petrochemical petrochemicalss projec projecttin Asia. biio ion; n; three three wer weree Five projects (2 percent of the total) had an iniinitial cost of more than $1bi in Asii, one in Latin America and the Caribbean, and one in Sub-Saharan Africa. However, 46 percent of IFC-suppo supported rted green greenfiel field d projects projects cost less less than $50million (20 percent less less than $20 million), and 6 67 7 percent lless ess than $100million. Overall, IFC 's greenfield project project finance activity rrefl eflect ectss it itss mandate man date to finance proj projects ects that tha t do not have have easy easy ac acce cess ss to t o internationa intern ationall marke markets. ts. EXPORT CREDIT AGENCIES

Export credit agencies more bec recent in the th eTh project fi finance nance of market, theirto vohune quickly of financing hasare become omeparticipants very significant. The e willingness manybut manyECAs ECAs

vohune of financing has quickly bec become ome very significant. Th Thee willingness of many ECAs to support suppo rt com comple plex x private sector projects has greatly boosted tthe hegrowth of project financing in developing countries (table 3. 3.3). 3). The Th e primary objec objective tive of most ECAs, which are usua usually lly government agencies, agencies, is to promote pro mote the their ir home-countryexports.Traditionally,this has been done through credit insurance and loan guarantee facil facilitie itiess that tha t protect protec t exporters against against the comme commercial rcial and political rrisks isks of exporting, aswell as through direct medium- and long-term loans to foreign buyem. In the past five years a number num ber of ECAs (notably in Japan, France, Germany, the United Kingdom, and the United States) have extended extended their thei r support to limit limited ed-recourse projects in developiig mar market kets. s. Th T h e driving force behind this move has been the more aggressive promotion of exports by manycounhies and, perhap perhapss moree important, the changing nature of international finan mor finance ce goingto developing economies, econom ies, which which has created new demands for ECA-type support. A significant share of  new ECA commitments in recent years has flowed flowed tto o project financing, although this share declined in 1998 as a number of large large projects were delayed or canceled (figure 3. 3.8). 8).

 

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I n a typical projec projectt finance transaction, an ECA E CA provides provides political risk coverage dur

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ing the t he project construction period, and a takeout take out comprehensiveguarantee for com mercial merc ial bank lending (or occasion occasionally ally a direct dir ect loan) after the construction is complete. EC A loans loans normally normally tied to contracts with companies companies in the home country, country, but this -

EC A loans loans are norma normally lly tied to contracts with companies companies in the home country, country, but this is not always the case, as, for example, example, the Untied Unt ied Overseas Loan Program offered offered by Japa Japan' n's Ministry Ministr y of International Interna tional Trade and Industry Industr y (MITI). Large projects, using equipment equipm ent from several several countries, frequently freque ntly include include financing finan cing from several several ECAs. For example, the Nahuelsat satellite project in Argent Argentina ina used guarantees from from the t he ECAs EC As of France and Germany to gain access to commercial bank loans, as well as IF C sup port, to get ge t the t he project off off the ground. ground. -

For project sponsors, a major advantage of ECAs is their financial capacity. capacity. Al l have the net worth (or political backing) to support large transactions, and several (includ ing JapanExim and USExim) hav havee no n o financial limit for individual transactions. As -

reported in InfiYIstructure Finance (February 1997), Guandong Zhuhai Power Project (China) received JapanExim finance amounting amounting to about $600 million without a gov ernment or sponsor sponsor guarantee, the first time an ECA had financed projects in China on a limited recourse basis.

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POLITICAL RISK INSURAN INSURANCE CE AND A ND GUARANT GUARANTEES EES

MDBs and ECAs ha have ve als also o been major innovators in other types of insurance and guarantee activities activities and the thereb reby ha have ve encouraged many invest investors ors to enter de developing veloping markets in recent years. years. Thi Thiss protection normally perta pertains ins tto o political and other non commercial risks. Although risk insurance and guarantees are available in private mar

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kets, the governme government nt backing of multilateral and bilateral agen agencies cies enables them to absorb risk not acceptable to private insurers or guarantors. By way of example, guaran

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tee programs offered by the World Bank Group the International Bank for Reconstruction Reconstru ction and Developmen Developmentt (IBRD (IBRD), ), IIFC FC,, and Multilateral Investment

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Guarantee Agency (M1GA) (M1GA)-help -help stimulate private sector activities in developing countries by mitigating mitigatin g noncommercia noncommerciall risk riskss facing investors and lenders. Each mem ber of the t he group offers different kinds of guarantees, and the IBRD IB RD requires a sover sovereig eign n counterguarantee, countergu arantee, whi while le M IG A and IF C do not. A number of other multilateral orga -

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nizations have also created risk  transfer mechanisms of various kinds. One such pro gram,, at the Inter American Development gram Deve lopment Bank, is similar in desi design gn to that of the IBRD, while others, such as that of the Inter Arab Investment Gua Guarantee rantee Ag Agenc ency, y, are also available for selected projects. -

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By far the largest of the multilateral agency programs is offered by MIGA. the gaps in politic political al Established in 1988 with capital of $1billi billion, on, MIGA's rol rolee is to risk coverage for foreign investment in developing markets. MIGA's advantag advantagee in tthe he

 

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marketplace stems from its ownership structure (as of the end of fiscal 1998, MIG A had had 138 member countries), and its abii ab iity ty to provide provide covera coverage ge to investors from all its mernber countries. MIGA's political risk guarantees guarantees cove coverr primarily equity equit y and related debt investments, including shareholder loans and loan guarantees, as well as technical assis tance and management management contracts. M I G A can generally insure investments investments either in new projects proje cts or in i n th the e expansion, modernization, privatization, privatization, or financial restructuring of  existing ones. T h e risks co covere vered d are expropriation, expropr iation, war and civil civil disturba disturbance, nce, currency transfer tran sfer,, and breach of contract, co ntract, provided provided the th e claimant cl aimant is denied deni ed appropr appropriate iate judicia judiciall or arbitration arbitrat ion relief. relief. M I G A also has develo developed a Cooperative Underwriting Progra Program m (C (CUP UP), ), under which it i t issues issues a contract for the entire amoun amountt of insurance requested requested b by y own n account, with the an investor but retains only a po ti on of the ex expos posure ure for its ow remainder underwritten underwritte n by private insurers. insurers. The Th e IBRD I BRD offers offers partial credit credit and partial risk guarantees guarantees designed designed to help open new areas to project financing and other forms of  funding by private capital. capital. Th e partial credit guarantee covers all occurrences of non payment for a designated part of a financing (usually (usually the later l ater maturities) matur ities) and is typicall typically y used for public projects involving sov sovereign borrowing. Partial risk guarantees cover cover specified sovereign risks arising from the nonperfor mance of nonperformance of sovereign sovereign contractual obligations or certain political force force majeure events. Such obligations might include maintaining the agreed regulatory framework, including includin g tariff tari ff formulas; delivering inputs, such as fuel supplied to a private power company; compensating for project delays delays or interruptions inter ruptions caused b by y governm government ent actions or political poli tical events, events, or cove covering ring currency currency transfer risks related to the nonavail-

ability of foreign exchange. Two other groups of insurers are active in the political risk market: ECA and other national agencie agenciess and private sector sector underwriters. underwriters. More than 20 countries, most of them members of the th e Organisation Organ isation for Economic Co-operation and and Development (OECD), (OECD) , have established established agencies agencies or programs of political insurance to promote int internation ernational al investment by their own nationals. By far the largest insurance programs are those established by Export-Import Insurance Department Department and MITI (EID/MITI) in Japan, OP IC in the United OPIC United States, States, and TREUARBEIT in Germany. Germany. Th e programs of the Export Credits Guarantee Department (ECGD) in the United Kingdom and Compagnie Franqaise d'Assurance pour le Commerce ExtCrieur (Coface) in France are also signdcant. Thes These e programs offer long-term coverage at reasonable premiums, although many have have somewhat narrow and changeable eligibility criteria. A small group of private insurers have also developed political risk coverage. The major firms include Lloyd's Lloy d's of London, American Internation Int ernational al Underwriters (AIU), Citicorp International Trade Indemnity Indemnity (CITI), (CITI) , and Unistat Assurance. Private insurers usually offer cover coverage age up to a maximum of  7 years, compared with 15 or 20 years for national schemes, and

 

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they impose higher premiu premiums; ms; at the same ttime, ime, most offer greater flexibility in struc turing turin g coverag coverage, e, although currency transfer and political vio violence lence aare re not covered in many developing countries. countries. T h e actual volume of political risk insurance insu rance is difficult to to determine determ ine becaus becausee of tthe he secre secrecy cy surround surrounding ing its use use.. Mo Most st insusance companies do not publish publi sh the amount of risk they ha have ve underwritten, nor d do o the th e insur insured ed parties or gove govern rnments (against whose potential poten tial actions insurance is sought sought)) like tto o publicize its exi exisstence. Informal estimates, how howeve ever, r, suggest th that at as much as $10 billio billion n to t o $15 L i o n could have been issued in 1997.6

Notes activities include financial sector sector loans and institution-build building ing projects, projects, corporate cor porate financing, and advisory and technical ass assistan istance ce s e ~ c e s . 2. Expansion projects are excluded excluded from the t he rev iw , prnje prnjects cts with an initial project cost of less than $5 millinn are also exclud excluded. ed. Th Thee comm commitment itment stage is the point aatt which IFC (and other creditors and investors) formally and legally commit to finanang the project. In the final stage, the project is complete or materially complete; compl ete; for some projects close close to t o com completi pletion, on, this figurehas been estimated. 3. Institutional Investor rating of  country risk: 0 25, high risk; 26-45, medium risk 45+, low risk Twice a year Institutional Investor Investor polls 75 to 100 international banks to grade countries from 0 (the highest chance of a sovereign default) to 100 (the least chance). 4. Based on information in Capital DATA PmjrfFinmr~Ware; although the information i nformation included included in this data base is not strictly comparable comparable to IFCb greenfteld projects reviewed here, it provides a broad overview of  market transactions. 5. I n terms of project numbers the most importan importantt se sectors ctors are infrastructure infrastructure(27 (27 percent), hotels and tourism (12 percent), petrochemicals (11 percent), food and an d agribusi agribusiness ness (11 percent), and manufacturing (8 percent). 6. See World B a n k  Financial F l m s and  the  the DeYe(oping Countries 1998.

1. Other IF IFC C core

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MITIGATING

MAJOR

PROJECT RISKS

IFC$ experience in financing more than 230 greenfield projects projects over the past 10 years demonstra demo nstrates tes above above all the importance of  of  identifying risks at the outset of each project. Indeed, it is essen

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tial to assess risk in

all all

aspects of the project. Of particular con

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cern are the experience, commitment, and role of the sponsor in tha t sector or type of project that project and the anticipated anticipated market demand for the project's output. Although projects run into difficulty for many reasons, reasons, the most frequent freque nt ones in IFC's experience are weaknesses in the sponsor's overall management of the weaknesses th e project project and its construction, and laver than projected projected demand for for the th e project's output by the time it becomes operational.

IDENTIFYING PROJECT RISKS

Successful project finance structuring rests on the strength of the project itself. Identifying the project's risks and then analyzing, allocating,and mitigating them are the essentials of project financing.

Appraising the project. A project is appraised to identify its risks and to assess its technical and environmental feasibiliv (that is, whether iitt will functi whether function on as expected expected), ), along with its i ts financial and economic econom ic viabilit viability y (that is, whether it will generate sufficient cash flows flo ws to repay debts and produce a satisfactory rate of equity return). This Th is is a critical critical initial step. T he scope scope of a typical project project appraisal is illustrated in appendix B, which sets out the criteria followed in a standard standard F C appraisal of a manufacturing project. project.

Because Beca use each project is based in its own environment environm ent and hence is unique, the relative relative emphasis placed placed on each aspect of the th e

appraisal will depend on o n the individual individual project.T h e various various risks identified will also affect the financing financing structure appropriate appr opriate fo forr

 

MITI GATIN G

PRO JECT

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39

Every project face facess many and varied risks, some speci specific fic to its subsector subsector and others to its country c ountry and policy policy environment. environment. Still others are of a more general nature. A typical project faces both commercial and policy risks. consist of (a) project speci specific fic risks connected with wi th developing and constructing the project, operating and maintaining the assets, and finding a market for the output; and (b) broader economic environment risks related to interest int erest rate rat e changes, Commercial risk

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inflation, currency risk ri sk international interna tional price movements of of raw materials, and energy inputs, all of which have a direct impact on the project but are beyond the control of the project sponsors. NoncommerciaZ orpolicy  risks are (a) project specific policy risks arising from expropria -

tion, changes in the regulatory regime, regime, and the failure of the government governmen t or its it s public enterprises to meet contractua cont ractuall obligations; and (b) political risks resulting from events such as war or civil disturbance. Just how essential it is to identif y and mitigate risks at the outset - rat her than wait wait for a negative event to happen and then rely on the goodwill of the parties to resolve i t i s dramatically illustrated by the sharp devaluation of the Th Thai ai baht in i n 1997. Within a period of only three weeks, the baht bah t slipped by more than tha n 20 percent against the U.S. dollar, doll ar, then t hen dropped even further. Because of Thailand's Thailand 's previous previously ly strong economic position, however, power purchase agreements of international power projects in

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Thailand Thailan d typically typically did not factor fact or exchan exchange ge rates into int o the calculation of purchase price. A number of power proje project ct sponsors subsequently subsequently sought to t o renegotiat re negotiatee their PPAs with the state electricity distribution company company.. Th e severity of each risk ris k also needs to be assessed. assessed. For example example,, sponsors and credi tors may need to assess assess the th e government's macroeconomic record, record, whiie creditors would -

need to evaluate the technical and managerial competence competence of the t he sponsor.T h e risks for long term lenders are different differe nt from from those for equity e quity investo investors, rs, which are different diffe rent again from those faced by by contractors or suppliers. In addition, addition , risk has a subjectiv subjectivee quality quality.. -

W h a t represents an unacceptable risk to one investor may may be routine or manageab manageable le for another, depending on their prior experience experience and knowledg knowledge. e. A first step ste p in effectivel effectively y mitigating mitigati ng each risk is to idenafy the party that is in the best position position to manage manage that risk, or whose actions have a bearing on its outcome. For example, the project sponsor is the one best able to manage commercial risk If the projec projectt will be subject to significant government regulation (as in a telecommunications telecommunications project), assurance assurancess will be sought from the government. T h e next step is to allocate, allocate, price, or mitigate mitigat e each each risk between the parties via via contractual agreements. In a successful successful financing, the risks risks do not disap pear but are borne by the parties best able to manage them. Risks that cannot be -

 

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M I T I G A T I N G

P R O J E C T

R I S K S

41

 

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allocated can still be ameliorated ameliorated through thr ough the th e selection selection of proper credit enhancement enhancemen t

and monitoring monitori ng methods. Box Box 4. 4.1 1 looks at some typical project-specific commercial risks from a lender's viewpoint. CONSTRUCTION RISK

In assessing risk, it is also often helpful to look at the various stages of the project sepaand financing requirem requirements. ents. Most Mos t projects rately, since each may have a different risk  consist of three th ree main phases: phases: development, development, construction and start s tart-up, and operation. I n the th e developme development nt phase, risk is usually very high, and only o nly equity capital from the main sponsors is generally used. used. During Durin g constructio con struction n and start-up, risk is is high and large a

volumes of of finance finan ce are required, required , typically typically in mixture of equity, senior debt, sub subordinat ordinat ed debt, debt , and guarantees. guarantees. In the operational phase, risk risk is generally lowe lowerr (becaus (because e the outlook is less less uncertain), uncertain) , and it i t may may be possible possible to refinance senior bank debt in the

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capital markets with cheaper, less restrictive bonds. prospective sponsor assess assesses es the project's scope, seeks seeks I n the development development phase, the prospective any necessary regulatory and concession concession approva rovals ls from the government or municipal authorit ies, and attempts to attract financing. Risks authorities, Risks sometimes arise arise because because of of unclear and arbi a rbitra trary ry government processes, which cause cause long lon g delays delays and may even lead sponsors to abandon an otherwise sound sound project.

In the construction constr uction phase, th the e major major risk is that constructi c onstruction on will not be completed on time or will not meet the specitications specitications set for the t he project. project. An incomplete project is unlikely unli kely to be able to generate cas cash h flows flows to support suppor t the t he repayment of obligations to investors and creditors. Long Lon g delays delays in construction construc tion may may raise the cost costss of a project significantly and erode its financial viability. A project may fail to reach completion for any of a number of reasons, ranging from technical design flaws to difficulties with sponsor management, financial financial problems, or changes in government regulation. Project companies hedge construction construct ion risk primarily by using fixed-price, certain-date construction contraas (including tulnkey contracts), with wit h built -in provision provisionss for f or lliqui iquidated damages if the contractor co ntractor fails fails to perform, perform , and bonuses for better bett er th than an expected performance. Th e project company will probably also also take out ou t business start-up and other kinds of standard stand ard insurance, include a constructio con struction n contingency in the total cost of  the project, and build in some excess capacity to allow for technical failures that may prevent the project from reaching the required capacity. Because lenders cannot control the construction process, they seldom assume completion risk, which is usually the responsibility of the project company, its sponsors, contractors, equipment suppliers, and insurers insu rers.. Typica Typically, lly, creditors and investors are interested intere sted in both the physical physical and fina finan ncial aspects of project completion.

 

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PROJECT

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R I S K S

projec ect't'ss abii ab iity ty tto o sustain production at a certain  Physical completion is defined as the proj capacity for a spe specif cified ied period of time, su such ch as one m month onth or o r one q quarter uarter of the operat o perat ing year. Before this, the project would also be certified as technically complet complete, e, that is, as meeting a l l techn technical ical design specifi specifications cations..

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 Financial inancia l completi completion on is defmed as the project's abiity to produce below a certain unit cost for a specified specified period of time, such as si six x months; t o have a mini minimum mum level level of  working capital and achieve a certain current ratio; and to achieve a minimum debt -

ratio or debt to equity ratio for a certai certain n period, pe riod, such as one year. s e ~ c coverage e -

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most common threat to phys physica icall completion completion is cost ove overru rruns. ns. If  costs significantly exceed exceed th thee in initial itial financing p plan, lan, they will affect the project's financial rate of return and, if they cannot be financed, may even lead those involved to abandon the project project.. IIn n 45 percent of the IFC-supported greenfield projects reviewed reviewed for this volCost overruns. Th e

 

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ume, project costs excee exceeded ded initial estimates estimat es and co committed mmitted financing. To ensure tha thatt unexpected costs do n unexpected not ot jeopardize th thee project's phy physica sicall completion, most credit creditors ors and minority investo investors rs insist on a commitment for standby financing as part of th thee initial financial package. package. Th This is is usual usually ly provided b by y th thee sponsor spon sor throug through h con contractual tractual agree ments, which IFC calls lls a project funds agreement (a fform orm of st standby andby facility). Standby IFC ca facilities are usually provided as subordinated loans or equity, with the sponsors provid ing the bulk of the th e facil facility, ity, although this bur burden den may be shared (box 4.2). -

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Financial completion. A new project may reach physical completion bu butt not become financially healthy or self  sustaining for any number numb er of reas reasons, ons, such as supply problems or weak market demand. If financial completion is not achieved, profitability will suffer, -

and the project is likely to encounter debt service difficulties. Project documentation document ation will normally include a financial financia l completion agre agreement, ement, wh which ich specifi specifies, es, in cont contract ract form, the initial financial expectations of the project against which creditors and investors are willing to invest funds. Under a financial completion agreement, the signa tories (almost (al most alw alway ayss th thee main sponsors) typically provide subordinated loans loans o orr addi tional equity to t o the project until the agreed agreed financial perform performance ance is achi achieved eved.. By requir ing sponsors to t o meet project financial completion, lenders greatly reduce the defa default ult risk  of a projec project. t. IIn n severa severall IFC projects with such a requirement, requirement , financial completi completion on wa wass not no t ach achieve ieved d until seve several ral yea years rs after physica physicall complet completion, ion, duri during ng which time the ssponsor ponsor -

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wass calle wa called d up upon on to provide additional addition al financial resources to the project (box 4.3).

 

M l T l C A T l N G

P R O I E C T

R I S K S

45

Although requiring sponsors to ensure the proj project's ect's financial completion certainly protects lenders' interests, it may place a heavy and possi possibl bly long term burden on the sponsors. spons ors. Th Thee perceived project risks risks and the relati relative ve bargaining positions of of lenders and sponsors may determine h a v stringent the finanaal completion requirements will -

be in the project loan documentation. In IFC's projects, financial completion require ments were used more frequently in the early 1990 1990ss than in tthe he mid-1990s, perhaps becaus bec ausee of greater competition and a growing familiarity and degree of comfort with

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the nature of these risks, risks, but they hav havee become more common again ssince ince the East Asian crisis that began in mid 1997. -

ONGO ON GOIN ING GP PRO ROJECT PERFORMANCE

Mos t projects funded under a project finance structure are long term enterprises, Most e nterprises, usua usuall ly lasting 10 yea years rs or more. Dur During ing thi thiss time, significant changes tha thatt undermine the project's viability may take place, such as in the availability and cost of project inputs, -

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the technical performance and management of the project, and the market demand for the pro projec ject's t's output. I n the t he case of large pro projects, jects, sponsors will attempt t o prearran prearrange ge long term purch purchase ase contracts for impor important tant inputs (for example, rraw aw materials or ener -

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gy supp supplies) lies) to limit the impact of price vo volatil latility, ity, particularly in the case of primary commodities. T h e proje project ct company will also ask its suppliers for performance guaran tees on technical components and may subcontract the project's project's operation and mainte

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nance to a specialist company, with penalty payments if performance if  performance is not up to standard. MARKET RISK

Changes in the demand for proj project ect output hav havee been the leading ccaus ausee of revenue and profitability prob problems lems in IFC supported green greenfield field pr proje ojects cts.. Th e quality of tthe he market -

analysis, and of aaccompanying analysis, ccompanying revenu revenuee and margin forecasts, greatly aff affects ects future prof  itability. Oft Often en the appraisal of market demand is overoptimistic, perhap perhapss because th thee strength of new trends is not fully appreciated, and the project never achieves the sales

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and revenue volu volumes mes projected. A 1992 appra appraisal isal for an IFC supported project to man ufacture concrete piping brings the point home: the proj project ect comp company any fai failed led to gain a single large order ffor or its product, becau because se demand prov proved ed much more sensi sensitive tive tha than n -

-

expected expec ted in a subsequent economic do downturn wnturn and pros prospectiv pectivee purch purchasers asers (mainly stateowned companies) were sensitive only to the price, not the quality, of the product. In sum, the t he appr appraisal aisal comp completely letely misrea misread d the market. Market Mar ket risk is difficult tto o hedge against spe specific cifically, ally, unless there is a single buyer or small group of buyers for the output. Signing a purchase or sales sales agreement with the price and quantity clearly specified with a seller or buyer who has a good credit standing is an excellent way of hedging product price risk to ensure the project will generate rev-

 

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enues. Projects having a single product prod uct whose price may vary widely, as is the case in the mining minin g sec sector, tor, are particularly vulnerable to chang changes es in demand and need tto o hedge against product price ris risk k Equally important, impor tant, iin n projects wh whose ose succes successs or failure rests on the price of one raw material input, there is a need to hedge the price of that materi al. Sponsors of IFC projects have have used several several mechanisms to mitigat m itigatee market risk, notably power purchase agreements, other offtake agree agreements ments,, cal calll and put options, and forward contracts. -

 An  An ofla ke agreement agreement obliges the offtaker (often a sponsor) to purchase all or part of  the project's project's out output put (for an exa exampl mple, e, see box box 4.4). An offtake agreement with a reputable foreign sponsor has the th e ad added ded benef benefit it of making foreign forei gn exchan exchange ge avai available lable to the com pany A few examples examples of its many forms are agree agreements ments to buy buy up to a certain amount per year at the prevailing market price; buy buy enough to t o ensure debt payment; or buy enough to t o provid providee foreign exchange exchange for debt service or to reduc reducee foreign exch exchange ange risk  (if foreign exchange exchange is available available in th thee domestic market). -

Apwompurcha.ce agreement is a form of  offtake agreement commonly used in power

projects in emerging marke projects markets. ts. Th Thee purchasing entity is frequently a government agen agency cy.. A PPA specifies specifies the power purchasing price or the method o off arriving at iit. t. Althou Although gh tthe he

price may not be fixed explicitly in the agreement, as long as the varia variables bles determining the price are dearly spelle spelled d out, the t he sales sales agreement mitigates mitigates one imp important ortant proje project ct ri risk  sk 

 

MITIGA TING

Call andpuf Call  andpuf options  options are

PROJE CT

R IS KS

47

useful hedges. A put option gives gives a project company the option to sell sell its output at a f k e d pric pricee at some point in the future. This Th is arrangement protects the cash cash flow of the project during the time tim e covere covered d by the put. S i a r l y , a call option would allow allow the project company to buy its input inpu t aatt a fixed price in the t he future. On e limitation of option agreements, howeve however, r, is is ttha hatt new project companies companies may have have to reach a stable level level of output before before they are able to enter into them. Sponsors may havee to us hav usee other means means to support su pport the th e project' project'ss cash flows in such cases. cases. In addition, ad dition, product options op tions in the market usually usually do not go beyond two years years in maturit maturity. y. Therefore options may not be feasible for longer-term hedging in many projects. also

Forward sales Forward  sales orpurrh orpurrhaze aze ronfrarfs ronfrarfsprov provide ide another means of hedging hedg ing product produc t price risk  (box 4.5). A project may wish to enter into i nto a forward purchase contract to stabfize the

price of a key raw material, such as cotton, a critical input of some textile projects. projects. Some I F C projects projects have have used this method. method . At times, howev however er,, it can have a negative negative impact, as as one IFC-supported textile ~ r o j e c discovered dt iscovered in 1993 when the project company entered into a forward cotton-buying contract. As it turned out, world cotton prices prices peaked peaked that ye year ar,, with the result that tha t the th e project ccompany ompany was obliged to ~ u r c h a secotton at a price price thatt exceed tha exceeded ed the subsequent sub sequent market price, price, much to the th e detriment de triment of o f its competitive competitive position. By 1996, it was in default of its loan.

MANAGEMENT RISK

u ncommon n for a new operation, perhaps perhaps in an emerging market environment It is not uncommo unfamiliar to the project spons sponsors, ors, to run into managerial or technical difficulties. difficulties. Technical or manage managerial rial difficulties. If a project is in a sector that is completely new to the country, there may be no qualif~edtechnical and managerial personnel to run it. it . In

 

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such cases, it may be necessary to obtain sustained technical assistance from, and a man agement agreement agreeme nt with, a foreign technical partn partner. er. Sponsors may als also o issue issue a letter of  comfort to ass assure ure creditors that the projec projectt company will be run in a sound business manner. In one IFC-supported consumer electronics assembly project, technological change expected to span five years actually took place in one year, with significant

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,

adverse effects adverse effects on tthe he proje project ct the sponsors lacked the technical or financial reso resourc urces es to restoree th restor thee proje project' ct'ss competi competitivenes tiveness, s, and the project fa faile iled. d. IIn n contrast, in an au auto to man ufacturing project in Europe, strong tech technical nical and financial support from the sponsor enabled the project ccompany ompany to reorient itself when its market changed dramat dramatically ically,, and thereby' there by' to regain its profitability. Maintenance expendi expenditures tures may account for a significant share of operating cost, particularly ticula rly for project projectss us using ing high technology equipment. Project profitability ma may y be undermined if the equipment fails to meet initial technical specificat specifications ions and perfor mance or frequently breaks down. Technological performance is normally guaranteed by -

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the provider of the technology techn ology or equipment, but the expens expensee of routine mainten maintenance ance has traditionally been borne by the project company. An important part of the appraisal is to estimate the t he cost of main maintenance tenance ov over er the life of a pro projec ject. t. Maintenance risk can

then be mitigated through a long -term senice agreement with the manufacturer of the equipment, who is in the th e best position to understand th thee technology and associa associated ted cost ri risk sks. s. Such aan n agreement no nott only red reduces uces the u uncertainty ncertainty surrounding future maintenance costs but also provides incentives to improve the efficiency and reliability of the equipment, which in turn can improve prof profitabil itability. ity. E C O N O M I C RISK

A pro projec ject's t's financial sustain sustainabilit ability y throu through gh dl phases of its life can also be affected by

broader risks arising from the th e eeconomic conomic and policy environment, particularly interest rate and foreign exchange risk. Currency risks. Currency risks risks arise whenever foreig foreign n exchange funds, in the form of 

equity or debt, de bt, are used to finance the project. Such risks risks are associ associated ated in p part art with for

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eign exchange exchange converti convertibility bility and the foreign ex excha change nge rate rate.. Macroecon Macroeconomic omic st stab ab ity, it y, the balance of payments situation, and the t he foreign exchange rate policy in the project country are importan imp ortantt factors to consider in assessi assessing ng currency risk risks. s. Foreign exchang exchangee risk 

can be a major concern, partic particularly ularly if the th e project generates revenues only in local currency. A shortage of local long-term funds caused by weak local financial markets often leaves lea ves pro projects jects in dev developing eloping countries with a large amo amount unt of foreign currency funding. I n IFCH limit limited ed recourse greenfield projects, foreign currenc currency y financing covered 77 percent of total project costs. Such levels expose a project to foreign exchange and interest rate risks. For this reason, most large projec projectt finance transactions are restri restricted cted tto o -

 

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49

schemes that can generate reven revenues ues large largely ly in hard currency, currency, are linked tto o a hard curren

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cy, or are takin taking g place in ccountries ountries where private investors and creditors are confident lessons les sons of tthe he East Asia crisis are that convertibiity will be maintained. Th e expected to lead to t o even grea greater ter em emphas phasis is on risk mitigation in thi thiss area in tthe he future. Currency risk r isk ca can n be mitigate mitigated d in a n number umber of wa ways ys::

W

 Mix local currency and foreign cwrenry loans. AU projects involve some local costs.

Overall currency risk can be reduced by covering these costs with local funding to the extent possible, possible, mixing local and foreign funds so tthat hat the project does not rely exce excesssive sively ly on foreign funds. For exampl example, e, a major new ttransport ransport project in Asia rrequirin equiring g nearly $1 billion in financing fina ncing obtained half the funding iin n local cu curren rrency, cy, thereby ssig ig nificantly reducing the project's currency risk 

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 Index outputprices to the exchange rate. Indexing has been frequently frequent ly used to shield a project from exchange rate ri sk Although currency cconve onversio rsion n still poses a risk, being

able to link project charges to th thee exchange rate can help limit project curren currency cy ris risks ks..

Indexing is often use used d in infrast infrastructure ructure projects, where revenu revenues es are mostly in local currency and the t he project ccyc ycle le is especiall especially y long. Th This is arrangemen arrangementt is vulnerable to

dramatic changes in the t he exchange rate, h how owev ever, er, aass demons demonstrated trated by the E East ast Asian crisis. Many projects found the government or other contracting parties unwilling to honor indexing if it would mean passing signifi significant cant local price inc increas reases es on to cus customers. Swap Sw ap cur curren rency. cy. W h e n a local currency sswap wap market exists, local currency can readily be

swapped with a major foreign currency to remove a project's currency risks. But many developing countries have no such market. In such cases, it may be helpful to create a swap swa p between the foreign currency risk the project is try trying ing to avoid and anot another her for eign currenc currency y tha thatt the project can obtain at a more stable eexcha xchange nge rate. I n one of tthe he developing -country power power projects fo forr which IFC helped arrange B-loans, it also extended a $3 mill million ion risk management facility to mana manage ge interest rate aand nd Ja Japane panese se yen currency risk on yen payments to th thee const construction ruction contrac contractor. tor. Obtain contingency sponsor support. I n some countries, foreign exchange m may ay be avail avail-

able at project start-up but may not be guaranteed in the future. Foreign sponsors ccan an pledge contingency contingenc y foreign currency support in various w way ays. s. In one ccement ement project in Asia, the foreign sponsor has committed itself to the purchase, in U.S. dollars, of  enough cement c ement tto o provide th thee local project co company mpany with sufficient dollars to serv service ice IFC's dollar-denominat denominated ed loan if th thee project company is unable to purchase enough convertible hard currency in th thee local market.

 

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When en a project earns convertible hard curre currency ncy,, its foreign  Establish an escrow account. Wh earnings can be deposited in a special escrow account. Usually for IFC supported projects, projec ts, the deposit required at any gi given ven time is the minimum amo amount unt needed for -

debt servi service ce over the next six month period. Among IFC's proje projects, cts, tourism and min ing projects have used used such accounts most often. oft en. Such an arran arrangement gement would enable -

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a hotel, say, to bill clients in hard currency currency and rremit emit th thee funds to an account off  shore. In projects with foreign currency revenues, revenues, an esc escrow row account can also hel help p th thee borrower borrow er avoi avoid d potential repatriation diffi difficultie culties. s. I n 1992, in one hotel projec projectt in -

Africa, I F C and the sponsor successfully negot Africa, negotiated iated with the govern government ment to maintain an offshore escrow escrow accou account. nt. Th This is prove proved d pr prudent, udent, as became clear in 199 1994 4 when tthe he government attempted to impose foreign exchange restrictions that threatened to sever severely ely hamper th thee company' company'ss operations; these were lifted when the government wass rem wa reminded inded of the earlier agreement. Obtain governmentguarantee governmentguarantee @reign

convertibil rtibil exchange availability. Guarantees of conve

ity ity are not routi routinely nely aavai vailab lable le for proje projects cts in developing countries but may b bee obtained in certain situations(box 4.6).

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Interest Inter est rate rate risk

Long term loans at flo floating ating (varia (variable) ble) inter interest est rates are the n norm orm for -

projectt debt in international proje projec project ct financing financing.. The ave averag ragee maturit maturity y of  of IFC's IFC's own loans to greenfield projects projects is 10 year years; s; a majority of th these ese (75 percent) are floating rate loans loans.. Th e international interest rate environment ccan an change dramatically dramaticallyduring during this maturi i nterestt rate risk is not properly hedged, financial projections based on ini ty period. If interes tial rate assumptions can be significantly affected nega negativel tively. y. Project sponso sponsors rs can use a variety of measures measures to mitig mitigate ate against interes interestt rate risk: isk:

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51

R I S K S

 Negotiate a j x e d interest rate. Fixed rate debt removes one source of risk from a proj

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ect. Although commercial banks relying on short term funding source sourcess are reluctant to lend at fxed interest rates for a long period, they may be able to arrange a mix of  floating and fixed rate funding, which would reduce a pro projec ject's t's in intere terest st rate ris risk  k  Some fixed rate financing financ ing is al also so avai availab lable le from multilateral and bilateral lenders. For $40 0 millio example, IFC provided a fmed rate loan of  $4 million n for a power project costing about $350 million million.. T he sponsor req requested uested this ar arrangement rangement be becaus causee E EC C A financing, the princip principal al sou source rce of support, wa wass at floating interest rates. In a few ca cases ses,, a lender -

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may actually prefer to lend at fxed rate rates. s. In another pow power er proj project, ect, the I F C B loan included a fixed fixed interest rat ratee portion tha thatt came from an institutional investor whose -

liabilities were also fixed. I

Convert the interest rate. Project sponsors may prefer to borrow at a floadng interest

rate to take advantag advantagee of a later expected ffall all in interest rates. IFC, as a matter mat ter of poli cy, allows borrow borrowers ers to effectiv effectivel ely convert their I F C loans fro from m floating to fixed inter est rates by ente entering ring into int intere erest st rrate ate swaps with borrowers. A borrower's new fmed

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rate is equal to the market's swap rate (that is, the fixed-rate equivalent of Libor), of  Libor), plus the borrower's spread over Libor plus a small conversi conversion on ffee. ee. Th This is conversi conversion on feature has proved usell for a number of project sp sponsors. onsors. Swap interest rates. Interest rate swaps are becoming a more and more popular hedge -

for project projects. s. Althou Although gh such swa swaps ps are readily ava avail ilab able le in the international risk man agement market, most developing market projects do not have the necessary credit standing to be accepted as a counterparty in the market, at least at project start up. I F C is frequentl frequently y abl ablee to bridge a pro project ject compa company ny and th thee interna international tional market as -

noted above in the case of floating to fmed rate convers conversion ionss of I FC loa loans. ns. IIn n addi tion, IFC may be able to provide swaps for the clients' non IFC loans and to obtain longer-term interest rate sw swaps aps (up to 15 years) than a project company is likely to get from the international market dire directl ctly. y. In one wastewater treatment pro project ject in Latin America, for exampl example, e, I F C pro provid vided ed a long term option for the company to change from from floatin floating g rate to fured rate at the ongoing swap rate rate,, exer exercisable cisable one time, as long as no default occurred. -

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Financial risks. Proper sequencing of of loan repayments can reduce the bunching of loan service, thus relieving the project of undue pressure on cash flows. In one IFC backed mining project project with existing IF IFC C aand nd o other ther senior loans, the agency pr provi ovided ded a new -

senior loan with a grace period of four years, rather than t han tthe he usu usual al two y years ears,, to permit project expansion. Repayment of the new loan began only after the previous senior loans had been fully repaid. Matching loan repayment schedules to ta take ke advantage of large cyclica cycl icall cash flows is an another other way of sec securing uring loan repayment (box 4.7).

 

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ENVIRONMENTAL RISKS

T h e drivers for environmenta environmentall due dil dilige igence. nce. Th e incl inclus usio ion n of envi environm ronment ental al rris isk k fa facctors into the project apprai appraisal sal pro proces cesss is not a new disaplin disapline. e. Awa Aware re of the devalue devalued d collateral collat eral of contaminated land and pos possib sible le lender liability for cleanup, most large commercial banks factor basic environmental issues (legal compliance, contamination, out standing compensation claims) into their due dilige diligence nce p proc rocess ess when lendin lending g tto o industries. I n the case of pr project oject finance finance,, diminishing val value ue of collat collateral eral iiss n not ot the primary driver for undertaking undertak ing environ environmental mental due dilige diligence. nce. As the introductory introductory chapter tto o this -

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publication emphasizes, well-structured project project finance iden identifies tifies and addresse addressess al l the factorss that may weaken ffinanci factor inancial al returns. Whi Whiie ie rarely "deal killers" in their the ir own right, environmental, health and saf safety ety,, and social iissu ssues es can have a negative impact on operating cash flow flow,, divert ma management nagement attention from other priorities, or gene generate rate adversarial relationships relati onships with employe employees, es, regulatory age agenci ncies, es, or the local commu community. nity. I n this sense, environmental due diligence for project finance finance is very much centered on seeking assurance that day-to-day operations will run smoothly during project desi design, gn, construction, and operation. In turn, the project's project's botto bottom m line will not be negati negatively vely affected by environmental risks. Depending on tthe he country in which iitt is located, the same project with the same en envi vironmental issues issues ma may y be subje subject ct to different regulatory standards. T h e degree of compliance monitoring and enforcement of regulatory standards may also vary widely from

 

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RISKS

country to country country.. Sound project finance n needs eeds to be based on understanding the con text in which the project project must operate and ensuring that the right mechanisms mechanisms ar aree incorporate incor porated d iinto nto the t he loan documentation in order that applicable environmental stan dards of performance are met. Withou Wit houtt such mech mechani anisms sms,, attempts to t o veri verify fy smooth day day to day operations may prove problematic.

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Whiie these drivers also motivate IFC, there is a different dimension to IFC's approach to environmental due diligence in project finance. As an internation inter national al organi zation whose missio mission n is to promote sustainable sustainable private sector sector developmen development, t, IF I F C must examine exam ine whethe whetherr each project is faithful to its mission. mission. T h e scope of IFC's due dili

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-

gence will include issues issues such as con consult sultation ation with affected parties, development and implementation of resettlement action plans, plans, and effort effortss to t o av avoi oid d degradation of natural habitats. habitat s. These The se iissues ssues may well go beyond the legal requirements of the t he project country, country, or the traditi traditional onal projec projectt boundary ending at the t he propert property y line of a project. project. I F C will have failed in its goal of sustainable development if it does does not addre address ss impacts to people

and the t he environment, whether inside or outsid outsidee the traditional pioject boundaries. boundaries. U ph n t consideration of these issues could add value to the project's long term viability by reducing reduc ing the risk that the project project will get overtaken by changing political or regulatory agendas agend as in the host country. -

These factors reinforce reinforce each each other in the need to conduct thorough environmental environmental and social due social du e diligence. T he goal of this process process is to ffind ind a management strategy that tha t will not reject all proje projects cts with any environmental and social social risks, at the t he one on e extreme, or ignore these impacts altogether, at the other. Project finance, in which seemingly highrisk issues are effective effectively ly manag managed ed and mitiga mitigated, ted, often provides provides the strongest stron gest develop develop ment impact impac t role and profitability, Project develop developers ers and their thei r financiers therefore there fore have dear incentives to assess potential environmental and social risks to find ways to mini mize their exposure and improve the long term viability of the t he project. -

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f environment T h e pro proce cess ss of envir onmental al du duee diligence. Project Project develo developer perss and financie financiers rs are are now broadly familiar familiar with the t he practice of assessing assessing environmental impacts and conti contin n gent liabilities, Most Mo st such assessm assessments ents focus on tthe he p potenti otential al impacts of project con

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stru ction and operati struction op eration on against standards standa rds prov provided ided by applicable applicable local local llaw aw.. Wher Wh eree regu latory standards are either nonexistent or uncertain, well acce accepted pted inter internation national al stan dards may may be substituted. substituted. Th e World Bank environmental guidel guidelines ines (now titled the Pollution Prevention andABatement Handbook) are often used as the benchmark to mea sure environmental performance, as as they represent widely widely accepted accepted internation inter national al stan dards. I F C , for example, example, appraises each project tto o ascertain whether it could meet the th e applicable appli cable World Bank environmental guidelines. Furthermore, Furth ermore, IF IFC C gives consideration to whether the project project could be implemented in accord accordanc ancee with its own environmental -

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55

IFC C adopted its ow and social social polic policies. ies. Dur During ing 1998, IF own  n environmental and social policies

(see box 4.8), with the aim of provi providing ding clear clearer er guidan guidance ce tto o its clien clients ts and it itss st&. While they ar aree in harmony with those of the World Bank, IFC's policies are more closely close ly aligned t o the private secto sector. r. T h e World Bank environmental guidelines and IF IFC C environmental and social policies provide a h e w o r k for addressing br broad, oad, crosssectoral development issu issues. es. Public sector institutio institutions ns aass well a; private sector sector entitie entitiess

refer to them in their projects. IFC IFC seek seekss to introd introduce uce environmental due di diligence ligence aass early as pos possible sible int into o the project finance process, process, aass it i t brings the biggest "value added" t o financiers, project develo develop p-

ers, and other stakeholders if environmental issu issues es are addressed at the design stage.

 

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Wi th this app With approach, roach, ccapital apital costs asso associate ciated d with environmen environmental tal upgrades ccan an be factored into i nto tthe he ffin inan anaa aall appraisal for tthe he project, and the risk riskss of expe expensiv nsivee'retrofits" disrupting disrupti ng cash flow later iin n the t he proj project ect's 's life are minimized. "Ecoeff~cient"equipment equipment raw and processes also often have lower overall operating costs due to less product or raw material losses (reducing pollution to air,water, or soil). An illustration of this conc concept ept in practice is given in bo box x 4. 4.9. 9. Early efforts efforts to establish and promote a transparent relationship and meaningful dia loguee wit logu with h affe affected cted people and comm communities unities freq frequently uently bring benefits of good commu

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nity relationship and oper operation ationss without disruptions. To this end, I F C req requi uires res dis disclo clo sure of key project informa information, tion, including envir environmental onmental asses assessmen smentt reports and soci social al reports, such as resettl r esettlement ement action plan plans, s, at the World Bank's Infoshop. Disclosure of  information informat ion to local stakeh stakeholders olders and public consultation enhances the project's abiity

to coexist coexist with tthe he surro surrounding unding communit community y and tto o contribute tto o its social development (box 4.10).

 

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Once the environmental and socia sociall ri risks sks associat associated ed with a proje project ct are identified, the risks must be allocated to ;he parties best best suited to bear them. In the world of ccomp omplex lex projects, wit with h compl complex ex environ environmental mental and social impact impactss spilling ove overr the t he tradi traditional tional project proje ct b boundary oundary and into a wider area o of  f influence, influence, risk allocation becomes a difficult task; sometimes the parties capable of addressing such risks, such as the host govern -

ment, remain outside the t he traditional contractual relation relationships ships bet between ween the financier and the sponsor of of the project. I n these ccas ases es,, IF C attempts tto o draw part parties ies outside the project boundary to a multiparty discuss project discussion ion in an atte attempt mpt to broker mitigation and management measures measures that tha t are accepta acceptable ble to al concerned. rned. Wi t h its rela relation tion alll parties conce

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ship with the host government and dose ties to the World Bank, I F C often delivers unique solutions to complex environmental and social problems.

Looking into th the e future. In the future,even more emphasis will be placed on monitor

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ing and a nd managing the environmental and social impacts of project operation operation,, in respo response nse to raising raising national sta standard ndardss and increasing attention to portfolio manageme management nt among both MDB MDBss and ECAs. T he envir environment onmental al and soc social ial asse assessmen ssmentt prov provide idess a snapshot of what impacts may occur. As governments, MDBs, and ECAs have discovered, devel opers and operators opera tors must be prepared for a long term management effort if  they hope to -

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mitig ate project impacts. Th e capacity of the devel mitigate developer oper to provid providee such long-term man agement of environmental risks risks iiss as importan importantt as the completion of the ini initial tial environ mental and soci social al asse assessmen ssment. t. I n ot other her words words,, tthe he dev develo eloper per's 's st& must be trained and

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experienced experience d iin n managing environmental iss issues, ues, and a sound manag management ement sys system tem must be in i n pla place. ce. IFC is therefore increasing increasingly ly involve involved d in capacity building of sponsoring companies. IFC's traini training ng programs aare re th thee cor cornersto nerstone ne of succes successs to enhanced environ

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mental management by IFCS financial intermediary intermed iary partners (see box box 4.11). Certifi cation t o formal environm environmental ental management systems, such as international standard I S 0 14001, can also provide additional assurance that environmental risks - and the

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financial risks that may be associated with them life of the project.

will be effectively effectivel y managed over the

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POLITICAL RISKS

One of th thee challenge challengess p pose osed d by a prospective limited recourse project in emerging emerg ing mar kets lies in assessing assessing and managing political ri risks sks ov over er the long life th that at most proje projects cts

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have. Political risk arises from the fact tthat hat some unforeseen political event may change t h e pro projec ject's t's pI.ospects for profit profitabili ability. ty. Th This is might be an act of government (for exam ple, a change in a law, law, regulation, or administrative decision), or general instability instabilityin in the -

political or soci social al ssystem ystem as a result of war, strife, or freq frequent uent changes in government. Political risk risk insurance, the main way o off directly pro protectin tecting g against pote potential ntial political risks,, is discuss risks discussed ed in chapte chapterr 3.1 3.1 Another important wa way y for a foreign sponsor to miti-

 

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gate local political risk is tto o attract local participants into the project. project. Th e sponsor could could offer to share equity equi ty with local investor investors, s, borrow borrow from local lenders, or enter int into o a local purchasing agreement for raw raw material supplies. Under such arrangements, arrange ments, the local participants are likely to become stakeholders in th thee success success o off th thee project. The Their ir interest in the project project will provide important protection against arbitrary national or local govern govern ment decisions. -

Note 1. Fo Forr further discussion discussion,, see Gerald T.West, "Managing Political Risk-The Role of Investment Insuranc Insurance, e," J o u d o f P r o j e c t  Finance (Wiiter 1996).  Mr. West is senior adviser, MIGA.

 

STRENGTHENING PROJECT SECURITY

A ~roject'sstructure and security ~ackage can help mitigate risk  can

Because project financing relies on the pro project ject's 's cash flows, the

contractua l arrangement contractual arrangementss that support thos thosee fl flow owss are aan n essential part of the security available in a ~roject.T he security p packa ackage ge therefore will include all the contracts and assurances provided by various parties involved in the project to mitigate risk. T he quality of the security p packa ackage ge is particularly important t o passi passive ve investors, investor s, who normally pro provid videe much of the financin financing g but do not ha have ve the t he capacity to bear signi significant ficant operating ris risks. ks. Once their money is is disburs disbursed, ed, they usually hav havee littl littlee ccontr ontrol ol over a project. If the type and quality of security available are strong, the project becomes more creditworthy, and a greater share of project costs can be funded tthroug hrough h borrowings. Table 5.1 illustrates the types of  security that can be derived from various elements of a project. SECURING PROJECT ASSETS

Project debt is normally secured by a first mortgage lien on project assets, as well as the direct assignment to lenders of tthe he proj project ect's 's right to receive payments under various contracts, such as a pur chase and sale contract or a financial support agreement. Security -

will also include covenants restricti restr icting ng the

project com compan pany's y's scope of activity to protect creditors' interests (for example, by limiting their ability to pay dividend dividendss to equity inv investo estors, rs, or ttheir heir aabi biit ity y to expand expa nd tthe he project without permission, as well as as ongoing finan-

Whenever it is possib possible le and meaningf meaningful, ul, an IF C loan is secured by a mortgage on the project as assets sets.. T he valu valuee of a mortgage depends, however, on the nature of the project and the project's financing financin g structure. If the pro project ject is in manufactur manufacturing, ing, the val value ue of 

 

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the mortgaged land, plant, plan t, and equipment equi pment can usually secure secure a substantial substanti al amount of the th e project loan. If it is a highway project, however, the underlying assets may have no sig

-

nificant realizable realizable value value in relation to t o tthe he project's debt. In general, creditorswill try to

assure themselves that the expected realizable value of the assets secured by a mortgage will comfortably exceed exceed their loans. In practice, I F C frequently requires that tha t the value value of  the mortgaged assets assets equal15 150 0 percent of the th e loan's loan's principal princi pal value. value. If a mortgage mo rtgage on project assets has limited practical value until the project is complete, creditorswill nor mally ma lly also insist on some form of precompletion guarantee.

-

Note, too, that certain project structures preclude a traditional mortgage, in which case creditors w i l l seek other security meas measure ures. s. If the project has a government conces conces

-

sion, for example, example, the underlying project assets belong to t o tthe he government and therefore -

cannot be mortgaged, but they may be leased from it, as is the case in some infrastruc ture projects. projects. Under such an arrangement, arrangeme nt, the project project company agree agreess to improve improve and operate the assets assets and and then to return them to the government government at the end of the conces conces

-

sion. A combination of sponsor guarantee guarante e and concessi concession on assignment may be used as

5.1 1 and alternative loan collateral; boxes 5.

5.2

illustrate ways ways of doing doin g this. this .

WEAK MORTGAGE FRAMEWORK

Some countries, perhaps for historical reasons, prevent project lenders from creatin creating g adequate mortgages for their loans. Under Indonesia In donesian n law, law, for for instance, agricultural land

 

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canno t be mortgaged to cannot t o foreigners. I n some cases, cases, a country may just be establishing an effective mortgage law when a project is already underway. In others, pieces of the mortgage law regarding certain types of assets may may be missing missing altogether, as as in countries count ries where land belongs to the state and no private land ownership is allowed (box 5.3). Project sponsors sponsors can then the n only lease lease land user rights right s for a specific period of time. ti me. A mortgage on the land user rights rig hts may also also not be legal. legal. Several Several I F C projects have have obtained an interim sponsor guarantee as loan security. Once land user rights become mortgagable an mortgage on i t is effected, effected, the sponsor guarantee guaran tee expir expires. es. and d the mortgage

Box

A Call

Option on Sponsor Shares Mortgag gage e Cannot B Be e Established When a Mort 5.3.

recently tly helped arrange about abo ut 8 40 million in direct and syndicated loa loans ns for a greenIFC recen field project In a country that had previousl previously y attracted little foreign forei gn investment. At the

time the t he loan agreement agreement was was slgned, the country did d id not no t have mortgage laws laws,, so a mort mo rt gage could not be regtstered to secure the IFC loans. As atte atternat rnatwe we sec~rity sec~r ity,,FC obtained a call optlon for the foreign sponsor's entire shares in the projecr company at a nom~nal price of  $1 . The op default lt occurs occurs before a mortga m ortgage ge can can be estab optf tfon on 1s exercisable if a defau l~shed.In the loan agreement, IFC required the compan company y t o establish establish the mortgage as as soon as feas~ble,but before this this 1s done, the call opt~onhelps prorect IFC's loans. It 1s -

-

tto o IFC the forelgn partner's Interest In the joint equivalent to assign~ng jo int venture. Beca Becaus use e the foreign partner 1s the majority shareholder shareholder of the t he project, by by ownin ow ning g the foreign part par t ner's ner 's shar shares es,, IFC could co uld take control cont rol of the t he company in the event of a defaul def ault. t. It could co uld then the n restructure restru cture the company or dispose dispose of its asset assets s in a way way th that at protec pro tected ted the Interests of the lenders. The call optio op tion n agreement also g,ves the fore~gnsponsor the flrst rlght to purchase IFC shares at a prl rlc ce eq ~ atlo tthe he outstanding outsta nding IFC loan principal and interest, if IFC decides to sell its shares. -

In other countries, restrictions may exist that may affect the structuring o f project security. In Sri security. Sr i Lanka, Lanka , for example, the law stipulates that once on ce a lender takes a compa ny's fxed assets as security, i t will only have have recourse recourse against such assets. assets. Th e lender lend er with -

security on the t he fixed fixed assets assets will have no recourse against any of the company's other assets, even if the value value of secured secured fixed assets assets is not n ot sufficient to t o repay the secured debt; in addition, addit ion, security security on such other othe r assets is is not n ot enforceable. I n 1996, IFC IFC helped finance one of the country's first independent power projects, a new 6 63 million project to build, own, and operate a medium-size diesel power plant. Th e plant utilizes residual fuel oil, a by product generated by the state owned petroleum petroleum corporation, corporatio n, and considered considered the -

-

least cost option optio n for increasing local generatin gene rating g capa capacit city. y. Since the t he compan company's y's fuced or immovable immova ble assets assets such such as land and plant p lant were not no t adequate to provide provide loan security for all lenders and since the most important assets of the company were in fact the arrange -

-

 

STRENGTHENING

PROJECT SECURITY

63

ments with with the government an and d the pow power er purchaser, the senior lenders, including including IFC, took the following following loan securi security: ty: 4 4

first mortgage over the movable assets of the company

first assignment of all insurance policies first pledge of sponsors' and other key shareholders' shares in the company first assignment by way of security of all government approvals and agreements, including the PPA, the implementa implementation tion agreement, agreement, the th e fuel supply supply agreement, and the government undertaking undertaking

first assignment ass ignment by way way of securit security y of the co com mpany's rights r ights under project pro ject agreements such as project funds agreement, retention account agreement, and shareholder sh areholder agreement first charge on the th e com compan pany's y's bank accounts, including offshore accounts. To ensure ensure that the company company will not create security on its fixed assets in favor of  third parties,, the parties th e lenders requir required ed tha thatt th thee compan company' y'ss articl articles es of incorporation be amended to require the prior approval of a qualified major majority ity of shareholders for the th e company to b bee able to create security on its fuced uced assets. assets. Th is will allow the senior se nior lenders, lenders, in their capacity as sharehol shareholders, ders, to ensure th that at if they enforce the sec securi urity, ty, the fuced assets of the company remain available. available. ASSIGNIN ASSI GNING G PROJ PROJEC ECT T RE RECE CEIV IVAB ABLE LES S A N D PROJECTAGREEMENTS

Anot her common way to achieve Another achieve loan secu security rity iiss to obtain an assignment of project project receivables (see box 5.4).Th This is enables cred creditors itors to determine how project funds will be used if the project runs into diiculty. Assignments could include in clude receiv receivabl ables es due under offtake agreements. A project usually has many other kinds of agreements covering such matters as government concession, concession, management, and supp supply ly.. Premature termination of  any of these agreements could adversel adverselyy affec t the project. project. As a common business prac tice, the party terminating terminatin g an agreement prematurely has to pay for the damages cause caused d to the th e other parties. parties. In view view of the harm tto o th thee project, lenders will make sure that they are assigned the damage dam age payments. -

ESCROW ACCOUNTS

Escrow accounts accounts can be use used d not only to mitigate foreign currency risks (see (see chapter 4) but also to ensure that contract obli obligations gations can be met. I n particular, particular, they can help con trol project expenditures. Although a project may generate sufficient cash flows to repay its debt, sponsors could divert these flows flows to serve other purposes within or outside the th e project. To make sure that the project's fIee cash flows flows are used first of  al l for debt ser vice vice or othe otherr pre agreed expenses, lenders often require that an escrow account be estab lished with a reputable bank bank.. An escrow account collects all or part of the project cash

-

-

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flows to be used for expenditures as agreed. If th thee escrow account is also pledged pledged to lenders, i t has the t he added advantage of improving the project's overall security package. THE SPONSOR'S ROLE

project's ect's best support suppor t usually comes from its sponsors, namely, the parties who have A proj developed and designed the project and who will be the primary beneficiari beneficiaries es of its su succcess. Sponsors play a central role even in nonrecourse and lirnited-recourse lirnited-recoursefinancing, financing, where they may cover only a relatively small portion of a project's overall overall cost and may rel rely y on other othe r creditors and investors t o finance the project. project. Their The ir experience, experience, commitment, and energy will still be crucial to the th e success success of the project in al l its dimensions and through all its stages.

 

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Strong sponsors typic typically ally pr provi ovide de a sound equity bas basee at the outset of the project, additional funding or other suppor supportt as needed du duri riig ig the cons construction truction p period, eriod, and ongoing technical and managerial support duriig project operations. Even more impor tant, sponsors must be able to provide effe effectiv ctivee support whenever it is needed. In one

-

IFC supp orted hotel ~rojectin Europe, E urope, the local sponsors' assets, which were were primarily in real estate, w were ere illi illiquid. quid. Each time the hotel needed funding, the local sp sponsors onsors had to resort to short term borrowi borrowing, ng, eventually eventuallyweakening weakening significantly the position of  -

-

theirr othe thei otherr busines businesses. ses. F Frequent requently, ly, sponsor suppor supportt extends beyond direct financial assis

-

tance to supplyi supplying ng inputs or purchasing project outputs to help ensure operational and financial viabiit viabiity. y. As this chapter illustrates, reco recours ursee to t o the t he main sponsors iiss frequent frequently ly the preferred means of of mitigating risk  SPONSOR EQUITY COMMITMENT

Every project needs a strong equity base. base. The T he largest equity share, ty typic pically ally held by the major sponsor, is frequently a maj majority ority share. In 64 percent of IFC's of IFC's greenfield projects, the sponsor held 51 percent or more of the equity. For all the projects, sponsor equity represented 26 percent of of tota totall project ccost ost at th thee time of commitment. A substantial financial commitment by the main sponsor also helps ensure project success by (a) mak 

-

ing it exp expensi ensive ve for the spo sponso nsors rs to abandon the project, thus encouraging them tto o take a strong and lasting interest in the project and to seek to remedy diff difficulties iculties tha thatt will arise; (b) expediting decision making, particularly where the sponsor holds a majority share; and (c) (c)increasing increasing the confidence of other parties in the project. As a project lender, lend er, IF C almost without exce excepti ption on requires tha thatt sponsors maintain a certain leve levell of  project ownership. ownership.This This requiremen requirementt typic typicall ally y lasts fo forr the entire period of the loan agreement. T h e spec agreement. specifi ificc lev level el and duration of share ownershi ownership p are usually specified in a share retention agreement between major creditors and investors and the main sponsors. SECURITY FROM SPONSORS

Lend ers frequently require sp Lenders sponsors onsors to pledge their shares in the project company as part of the t he lloan oan security pac packag kage. e. Thi Thiss is particularly impor important tant if lenders feel tha thatt the value o of  f  the mortgaged assets is insufiaent or that th at tthere here iiss uncertainty about the enforceabity of  the mortgage. Effec Effecting ting a pledge of shares is usually a relatively simple procedur proceduree and, once obtained, obta ined, can be a use useful ful negotiating tool for lenders. Wh When en sponsor sponsorss pledge thei theirr shares to lenders, lenders lenders may take control of the company in tthe he event of de default fault and may also take whatever steps necessary to protect their the ir investment investments. s. A pledge of sponsor shares to improve security is used in about half of IFC's of IFC's projects (see box 5.5 for one example). DEFERRING PAYMENTS TO SPONSORS SPONSORS

I t is not uncommo uncommon n for a sponsor to ente enterr into supplier relati relations ons with a project. For example, the sponsor may purchase part of the project's output or supply raw materials or services (such as a distribution dis tribution network) network).. I n one project desig designed ned to inc increas reasee hydro-

 

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Box 5.5. European Textile Project: Pledge of Sponsor Shares to Strengthen Loan Security a European woolen text~le r~vat~zation project, a foreign text~lecompany invested e q i ty an and d owred 66 percent of  !he shar shares. es. Lo Loc cal emoloyee emoloyees, s, domestic and foreign Invest Investment f ~ n d sanother , bilateral development agency, and IFC IFC owned the balance. The two development aaencles are the main senlor lenders to the project. The IFC IFC loan is secured by an offshop escrow account account for loan service, a first-ranking mortgage on :he compaIn

ny's assets, assets, and and a pledge of shares to to

IFC

by the foreign sponso sponsor. r.

IFC awed the sponsor to pleage its shares was Tne man reason rhat IFC was that tha t mortgage la law w was not well established in the country, and ther there e had not yet been a case in wh,cn a mortgage was s~ccessfullyenforced to protect lenders. By obta~nlnga share pledge, IFC IFC could rake control control of the th e project if  things went wrong, wherher the mortgage could be successfullyenforced or not. not.

carbon production for existing oil and gas wells, the local sponsor guaranteed to provide provide a certain number of oil wells for the company to operate on. Defemng raw material pay

-

ments or service fees to the sponsor in the case of project cash

flow shortages

can also

help strengthen the project's financial robustness.

Red~cin~repayment exam ampl ple, e, IF C supported a $330 million project to risk. I n one ex produce produ ce methanol meth anol for export, an impo importa rtant nt element in th the e gove governme rnment's nt's program to

reduce reduc e dependency on crude oil exports. T h e projec project's t's raw material, natural gas gas,, is sup

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plied by the t he local sponsors, w whiie hiie exp export ort sal sales es are handled by the foreign sponsors. IFC helped provide loans and equity funds of about $130 million. Loan security was in the t he form of a mortgage, insurance, and sponsor support suppor t for project completion. In addition, I FC required required that two other condition conditionss be met fiom the time of the project's physical completion until the IFC senior loan was fully repaid. First, the local sponsors would, if  needed, defer defer a portion of the payme payment nt due to it for gas gas supplied to the project. Any such deferral would be structured as subordinated debt to the project company so that the project company could firs firstt use cash flaws to service its its senior debt. Second, the for

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eign sponsors, if needed, would defer a portion porti on of sales sales commis commissions sions,, also in the th e form for m of  subordinated debt to the project company, so that the project company could first service its senior debt. Th The e project has bee been n performing well since it began production. Th The e IFC loan is current and is not expected to face repayment difficulties.

SPONSOR GUARANTEES Although project finance is normally structured without direct recou recourse rse or guarantees from the sponsor, they may be necessary on occasion, especially when some aspect of the project risk cannot be mitigated or is considered beyond the creditors' abiity to absorb. absorb. The Th e most comm common on form of this arrangement is is a precompletio precompletion n guarantee (box (box 5.6).

 

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Because project risk is usually very high before project completion and difficult to assess or control in certain respects, sponsor guarantees may be extended to creditors before the physical or financial completion of the project, as discussed earlier. In some projects, they take the th e form of a partial loan guarantee guarantee,, which guarantees guarantees only a portion of the loan principal and interest payment. This reduces the lenders' exposure somewhat but still leav leaves es them with a share of th thee risks. Th e main purpose of a partial loan guarantee is to give lenders an additional inducement to finance a project. Partial guarantees vary greatly in form and can be adapte adapted d to suit many situations. In a European manufactur ing project supported by IFC, its loan of $1 $13 3 million is guaranteed by the main foreign

-

sponsor for aan n amount up to $5 million. Occasion Occasionally, ally, a full guarantee may be needed before financing can be attracted (box 5.7).

 

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project, howe howeve ver, r, a standby sta ndby letter of credit was arranged by the sponsors to support their commitment to restore production in the event of a for force ce majeure majeure event. PROJECT INSURANCE

O f the numerou numerouss ri risks sks that projects are likely to face, many can be allocated to part parties ies willing to accept them via contracts, as shown in the foregoing for egoing exa exampl mples. es. But some risks in pro project ject fina finance nce -commonly referred to as force majeure risks

cannot be contractual-

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ly allocated. These risks are associated with fire and natural disasters, and they have to be dealt with by the purchase of insurance. IFC IFC requires that all its projects have ade

-

quate insurance insura nce to cover cover such risks. Broadl Bro adly, y, there are two types of force majeure risks. On One e affects tthe he pro project ject directly, as in the case of an earthquake or fire; the other indirectly, as in the case of a natural calamity tha thatt prevents a supplie supplierr from fuIffing its commitments to the project. Market insurance can usually be purchased to mitigate agai against nst these risks. T h e insurance pro

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ceeds are used to restore production or repay loans (box 5.9). Political risk insurance is discusse disc ussed d in chapter 3. GOVERNME GOVE RNMENT NT GU GUARANTEE ARANTEES S

Governments may directly guarantee the default risk of a state e entity ntity that is party to a project.Th This is form of guarantee is most often seen in infr infrastructure astructure p proj rojects ects.. Wh When en an independent power producer sells power to a state owned powe powerr distributo distributorr through a -

 

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PPA, for example, it is crucial that th the e distributor distribu tor be able to pay for the th e power. power. Since in below w market rates, IPP project some countries electricity prices have been politically set belo lenders will hesitate to provide provide loan loanss without a government guarantee guarantee for the default default risk of the th e distributor. As part par t of an IFC -supported power power project approved in 1994, for

example, the government of India guarantees the payment obligations of the state elec

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tricity board, which purchases power power from the company company under a long term PPA. -

SECURI SEC URING NG EQUIT EQUITY Y INVESTMENTS

T h e principal objec objective tive of project security is to t o protect pr otect project debts, because because debt gen

-

erally eral ly constitutes the t he largest share of the th e financing fi nancing package from passiv passive e investors and bears a fixed return, with no potential for higher returns if the project is very successful.

But minority investors with equity or quasi equity investments in the th e proje project ct will also -

seek some form of exit. exit. For projects that are not publicly listed on any eexchange, xchange, this frequently indudes a put option for their shares. shares. I n view of  of IFC's minority shareholder status in many proje projects, cts, most of which are not listed on a stock exchange exchange at the time of its investment, the agency agency needs needs to ensure an appropriate exit strategy strategy from the investment. T h e purpose of IFC's IFC's investment in equity is is primarily to ensure that th the e company company has a solid solid start. In I n principle, IFC con

-

siders its developmental role fulfilled

when a project reaches the stage of mature and

profitable operation, at which point poi nt it i t will usually try to exit the project as soon as pos

-

sible.. Wi th a put option, sible option, IFC can exit without difficulty and use its funds fund s in other new projects proj ects.. Indeed, at a t times a properly structured structured put option ma may y be critical to limiting the downside risk of an equity investment. In other ot her cases, cases, IF C may see seek k a best effort -

commitment from the main sponsor sponsor to list the project on the local exch exchange ange within a certain number of years. Th This is form of commitment, whiie not having the same force as as a legal agreement, helps further IFC's developmental objective by strengthening local capital markets.

 

SUMMARY A N D CONCLUSIONS

Over the past decad decade, e, project finance has entered the mainstre mainstream am of investments in developing markets. It has gained new impetus in the dynamic enviro environment nment created by the increasing increasing globaliz globalizaation and sophisticat sophistication ion in financial mark markets, ets, on the one hand, and by policy reforms (particularly privatization programs and a nd major infrastructure schemes previously the domain of governments) that have stimulated private sector investment, on the other. As a result, the volume of flows related to project finance expanded dramatically dramatically during the 1990s aand nd formed a large part of the ove overall rall inueas inueasee in flows to developing markets. This growth wa wass matched by greater competition in finan finanaal aal markets, which reduced reduced funding costs and le lengthened ngthened the periods of support, while the gradual co conve nvergen rgence ce of th thee de debt bt markets for bonds, syndicated loans, and private placements enabled projects to gain access to finance through a broader spectrum of instruments. The growing use of securitization techniques also increased the liquidity liqui dity and attractiv attractiveness eness of proj project ect de debt bt tto o a wide widerr range of  investo inv estors rs in deve develo lope ped d coun countrie tries, s, and to a more l i i t e d extent extent in developing markets. A relatively relatively long per period iod of macroeconomic stabiity and policy reform in major developing markets increased investors'willingness to support more complex projects and a broader range of country and market-related risk risks. s. IIn n more d*cult sectors and countri countries, es, though, projects were often completed with the active support of  of official official financing agen agencies cies,, including MDBs and ECAs. The crisis that began in East Asia in mid -1997 has has brought about a signifi significant cant pause in tthe he project ffinance inance market. Th e crisi crisiss has dampened growth and investment investme nt opportunities in most countries, causing sponsors and governments to reas reassess sess the finan-

71

 

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cial and economic viab viability ility of proposed projects, and investors to reev reevaluat aluatee the risks, particularly wit with h regard to foreign exchange exchange,, market demand, and contract enforcemen enforcement. t.

Liquidit y in the commercial bank and broader securities m Liquidity markets arkets al also so contra contracted cted sign signifi ificantly, reducing access dramatically for most borrowers, including those seeking project finance. Many existing projects, espe especially cially those in the pro process cess of impl implementat ementation, ion, ca came me under serious strain and had to be renegotiated or restru restructured ctured to get back on ttra rack  ck  FUTURE OF PROJECT FINANCE I N DEVELOPING MARKETS

T h e problems cr created eated by the fi financial nancial cris crisis is tteach each a valuabl valuablee les lesson: son: greater care must be exercised exercised in sstructuri tructuring ng projects and assess assessing ing their risks. Despite th these ese problems,, howeve lems however, r, project financ financee is still a usef useful ul means for investors, creditors, and other unrelated parties to share the costs, risks, and benefits of new investment in an economically efficient, transparent, transparent , and fair mann manner. er. Once financial markets stab stabilize ilize and growth and investm investment ent resume, project finance techniques are likely t o regain in importance. T h e inve investment stment needs in many developin developing g mark markets ets remain enormousworld Bank  estimates for new infrastructure investments alone over the next decade are in excess of  $250 b i o n p peer ye year ar - a n d pursuing them is essential t o development. Yet few compa companies in the t he private infrast infrastructure ructure mark market et have sufficient financial resources or experience in developing m markets arkets to undertake major capital projects alone. Sharing tthe he risk riskss through project finance or other means will help get these t hese proje projects cts off the ground. BROADENING APPLICABILITY

Project finance techniques were were earli earlier er of interest mainly to mining and oil and gas projects aiming to attract foreign currency funding. Over the past decade, infrastructure projects, particularly in the telecommunicationsand electr electric ic utility secto sectors, rs, ha have ve attracted major project finance flows. Large flows have gone to a number of countries, but they havee been concentr hav concentrated ated (figure 6.1), and many countries have not even begun to exploit the potenti potential al pro project ject finance techniques of offer fer.. IIn n 1997,65 percent of total gro gross ss flow commiments reportedly went to projects in just 1 10 0 countries, and th they ey w were ere ev even en more concentrated in 1998. In the future, infr infrastructure astructure proj projects ects ar aree like likely ly to continue being in the lead in pro projject finance in developing markets. Along with the strong need to rebuild existing infra structuree assets, there is an increasing tendency of governments to privatize existing structur assets and to seek priv private ate sector assistance in the construct construction ion of new as assets sets.. In I n regions that th at hav havee seen considerable priv private ate sector sect or involvement aalre lready ady,, such as La Latin tin America and the th e Ca Caribbean, ribbean, many governments are moving b beeyond the telecommunications and power sectors and introducing policy reform to improve service and efficiency in more

 

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complex sectors, such as water supply and wastewater treatment, and in a broad range of transport projects. Whi ie he Whiie heavy avy re relia liance nce on foreign finding will continue, because of the tremendous investment needs that th at could n not ot otherwise be met, these projects are lik likely ely to be more conserva cons ervativ tively ely structured in all respects in the wake of the financial ccrisi risiss tha thatt began in mid-1997. Unlike the th e traditional natural resou resource rce projects, many recent projects were domestically focused focused aand nd sought to mitigate the risk of fore foreign ign curren currency cy funding through PPAs and other offtake agreements under long-term government concessions. Some projects suffered suffered badly as a result of the currency crisis that began in Eas Eastt Asia Asia.. This demonstrated again the danger of relying heavily on foreign currency funding when a project has no natur natural al hedge agains againstt currency risk. It also showed that offtake agreements are are not a substitute for a careful assessment of market and ccredit redit ri risk sk Many contracts proved unenforceable unenforceable in the face of cata catastrophic strophic ch changes anges in tthe he underlying assumptions for for exam example ple when pric pricing ing w was as linked to a foreign exchange r a t e - a n d governments were politically unable to rev revise ise tariffs as calle called d for in the agreements.

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IMPROVING POLICY ENVIRONMENTS

As

the financial cris crisis is that beg began an in Eas Eastt Asi Asiaa ha hass shown shown,, the extent to t o which project finance can be employ employed ed in individual countries depends on their overall economic and pol icy framework The broader use of project finance techniques depends ultimately on a sound policy environment. Some developing countries have already undertaken sigdcant

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reforms in the th e macroeco macroeconomic nomic and policy framewo framework, rk, thereby layi laying ng the groundwork and improving the opportunities for project finance. Although IFC has used project fmance in a

 

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F I N A N C E

broad range of country environments (IFC's greenfield projects projects ov over er the past decade were in

69 countries), individual projects projects cannot aact ct as a catalyst for economic development and growth unless the overall framework is supportive. Project finance techniques are most successfu successfull in an economic and country environment where business business dealing dealingss are tra transparent, nsparent, contra contracts cts are respected (partic (particularly ularlycontracts between state and privat privatee sector entities), and a framework ex exist istss for reso resolvi lving ng disputes fairl fairly. y. In a project finance structure, most of the risk mitigation depends on the assurance of one one party tto o another, pr provided ovided throu through gh some form of contract. Altho Although ugh contract agreements for fo r large project projectss oft often en specify a foreign jur jurisdic isdiction tion (such aass New Yor York k or English law) or international arbitration for legal action in disputes, borrowers frequently need nee d to sue in loca locall courts tto o enfo enforce rce the their ir rights. This is particularly true if project ssecu ecu rity includes real estate. estate . In I n many ca cases ses,, local courts will apply local law law,, regardle regardless ss of tthe he -

contract terms. The financial crisis that began in mid 1997 has further reinforced the importance of addressing addr essing these structural issu issues. es. For one thing, capital is more like likely ly to retum-and in larger amounts-wher wherever ever the lega legall and judi judicial cial sys system tem ha hass demonstrated -

it can provi provide de a fair basis for resolving difficult situations. For another, a general policy framework that creates a sound, stable regulator regulatory y and macroecon macroeconomic omic environment is more likely likely to attr attract act long term project finance for investment. Equally important, mar tax ket mechanisms are needed to create the t he right incenti incentives, ves, aass is a tr transp ansparen arentt legal and tax framework. framewo rk. And state owned companies, companies, in economi economies es where they have an im importa portant nt -

-

-

role, need to hav havee the capacity to deli deliver ver.. can also do a great deal to facilitate private financing for projects by pro viding a legal and judici judicial al framework that is conducive to private contractual activity. Above Governments

-

all, the regulat regulatory oryb b e w o r k should be clear and consistent, consiste nt, and policy should aim to keep the macroeco macroeconomic nomic environme environment nt stable. Instabi Instability lity can wreak seriou seriouss havoc, as it did in Pakistan in 1998, when the governm government ent soug sought ht tto o cance cancell a number of independent powe powerr projects, alleging corruption, corruption,against against a backgro background und of macroeco macroeconomic nomicuncertainty tha thatt had eroded the financial ability of the public power utilities to fulfill thei theirr commitm commitments. ents. While there are a number of ways, as this report illustrates illustrates,, to compensate for a weak domestic legal and regulatory environment, they will inevi inevitably tably enta entail il additional trans transaction action and financing costs and still leave a project vulnerable to unexpected adverse developments. INVESTOR APPETITE APPETITE FOR DEVELOPING DEVELOPING MARKET MARKET RISK

Globalization and the th e liberalization of financial financial markets during the 1990s encouraged many investors to enter developing markets. These forces also helped create the instru ments to mitigate or control th thee risks inherent iin n projects, such as interest rate changes or pri price ce movements in product productss and cur currenc rencies, ies, although these hedging instruments have had limited availability to date dat e iin n developing markets. -

 

SUMMARY

A N D

C O N C L U S I O N S

75

In IFCS experience, the succe success ss of project financing depends in large measure on good goo d ris risk k management.Thou Though gh time consuming and complex, complex, this strategy offers enormous benefits. benefits. For projects in whic which h th thee ris risks ks have been identified, clarified, and -

appropriately mitigated up front, private ffinanciers inanciers are freque frequently ntly willing to provide sig nificant amounts of funding and will bear project specific commercial risks. In more stable country environments, priva private te financiers have also born bornee some nonspeci nonspecific fic com

-

-

-

mercial risks, including inflation or currency risks. At times, however, such risks can have serious repercussions.T repercussions.T h e large local curr currency ency deval devaluations uations in As Asia ia in 1997 and 1998 produced a significant significa nt financial weak weakening ening tha thatt may aff affect ect how lenders and investorss beh investor behave ave in the future. Th e major commercial ris risk k underlying most projects is is tha t hatt of noncomple noncompletion. tion. All financing package packagess should contain rigorous standards and o obligations bligations to ensure that the relevant parties will help bring the project to completion. After completion, market risk  is the main concern of most projects. This is often diicult to assess accurately, yet crit ical to the outcome. Projects need to be able to withstand adverse developments such as -

new competitors or overall declines declines in demand iiff they are to be succes successful sful.. T h e sponsor, including its expertise in the sect sector, or, pl plays ays a vital role in this regard. S Sponsors ponsors will gen -

erally provid providee some form of support or guaran guarantee tee to eensure nsure project completion and will seek contractual marketing arrangeme arrangements nts or othe otherr mean meanss by which to hedge market risk.. Even in projects tha risk thatt have no financial recourse to the t he sponsor, strong, experi enced, and committed technical and financial partners can be critica criticall to a project's ssuc uc -

-

cess, not only during the construction period but also during ongoing operations. I n cess, addition, conservat conservative ive financial strumoring can help a project withstand a wide variety of risks, both expected and unexpected. Continued Conti nued innovation in tthe he packagin packaging g and diversificati diversification on of project finance riskfor example, example, through sec securitization uritization and th thee pooling of  of ccisalso help expand sponsor and investor awa awaren reness ess of, and interest in, project finance in developi developing ng mar

-

kets. Because of the current risk  aver averse se environment, a numbe numberr of sponsors are combin ing several projects projects into one fi financing nancing pool tto o help divers diversify ify ris risk. k. -

-

TOWARD STRONGER LOCAL FINANCIAL MARKETS

T he extent to which project finan finance ce can be used in individu individual al countries aalso lso depends on the depth of local financial markets. In recent years project finance techniques have been used mainly to attract international financing to developin developing g market markets. s. Wi With th the gro growin wing g popularity popular ity of project finance, these techniques have helped finance projects that have no obvious way to earn hard currency to repa repay y foreig foreign n loan loans. s. Although instruments inst ruments for hedgi ng foreign currency ar hedging aree available in financial markets, they are difficult difficult to obtain against long term obligations or are ofte often n very expen expensive. sive.T h a t is why many projects -

 

76

P R O J E C T

F I N A N C E

failed to have protection against the substantial depreciation in a number of local curfailed rencies in late 1997 and 1998. Project finance techniques and structures can be equally appropriate for raisin raising g local financing for local projects. projects. Local funding can help mitigate (or avoid altogether) the th e significant signif icant interest rate and foreign currency rrisk iskss many projec projects ts fa face. ce. T h e local market must have some dep depth, th,an howev however, and lenders must beSuch able tto o invest ove over r the long te term (as can pens pension ion funds and d life er, insurance companies). conditions currently exi exist strm in only a few developing markets.1 As noted in chapter 3, international sources financed 77 percent of th e total costs of the IFC-supported projects reviewed for this volume. Howeve How ever, r, the th e averag averagee share of foreig foreign n financ financing ing in these proj project ectss declined as the th e risk  ratings of the countries in which they were located improved, eve even n tho though ugh these countries generally had greater access to foreign finance.2 Despite their access to internation al sources sources of funding, tthe he project projectss found local financing an attractive option bec becaus ausee of  the rel relati ative ve maturity of o f th thee dome domestic stic financial mark markets. ets. Finan cial mar Financial market ketss both both loca locall bond and equity ma rket rk etss- ne ed to be wel welll deve develope loped, d, and reform reformss directed at creating a transparent an and d efficient local banking network must be in place before project finance can be widely used in individual markets to support

-

new investment. Prior to th e cris crisis, is, the international m market arket for project bonds, particularly through privat privatee placemen placements, ts, had been developi developing ng rap rapidl idly. y. Although the bond markets have proved volatile to date, as project bonds become more established as an asset class, they offer the prospect p rospect of long-term finance (of twenty years or more) much more suited than tha n commerc commercial ial loans to the needs of lar large ge project projects. s. Local bond markets could play an even more valuable role. Governments can help meet these prerequisites by encouraging the deepening and broadening of local fmancial markets. encouraging markets. As local financial markets develop develop,, project finance structuring can more appropriately be use used d for a broad er range of sectors sectors tha thatt hav havee no ready access to foreign exchange, including manufactur ing and service. Reforms in industrial countries, such such as th thee Privat Privatee Finance Initiative in the United Kingdom Kingdom,, hav havee flustrated how projects like schools, schools, hospitals, and prisons can be privat privately ely financed, given th thee appropriate domestic framewo framework. rk. I n conclusion, p project roject finance can pl play ay an imp important ortant role in an ap appropriate propriate envir environ onment. I t does not, howev however, er, offer a "free lunch," but bu t demands a rigorous framework if it is to be successfu successful. l. As markets develop, in terms of their financial regulatory and policy strength, project finance will be used with greater confidence and on a sustained basis in a much broader spectrum of countries, sect sectors ors and types of projects projects.. T h e willingnes willingnesss of  the multilateral financial institutions such as I F C and the maj major or export credit agenci agencies es to support suppo rt project finance transactions, particularly in higher-risk environments, will continue to help expand these horizons.

 

S U M M A R Y

A N D

C O NC L US I O N S

77

Notes 1. For discussion of IFC's activities in promoting local financial financial markets, se seee IFC IF C Lessons Lessons of  Ekperience 6,  Financial Imtitutions, 1998.

2. Risk ratings as defined by Institutionalhzlutor. For high-risk countries in IFC's sample (those rated less than 25),local financing represented 14 percent of total tota l project cos cost; t; this increased to 20 percent for mediumrisk countries countries and to 31 percent for low-risk countries (rated 45 or more).

 

APPENDIX A. GREENFIELD PROJECTS SUPPORTED BY IFC THROUGH LIMITED RECOURSE PROJECT PROJECT FINAN FINANCING CING,, FISCAL 1989 98 -

(MILL IONS OF U. U.S. S. DOLLARS)

-

Fiscal year

Estimated project cost

Company

Country

Sector

Crown (China) Electronics Company Company Limi ted Dunastyr Polisztiroigyarto Rt. Dusa Endustriyel lplik Sanayi Eska Turizm ve Ticaret A.S. Kewalram Philippines Incorporated (KPI) Kiris Otelcilik ve Turizm A.S. MasstockZambi Masstock Zambia a Limit ed Minera E~ondidaLimitada Operaciones al Sur del Orinoco Peroxythai Limited Po Polilima marr S.A. de C.V. Polipropileno de Venezuela S.A. Politeno Linear lndustria e Cornerci Cornercio o S.A S.A.. Sariville Turistik Tesisler A.S. Shell Gabon S.A. Shenzhen YK YK Solar Energy Company Limite Limited d (SSE)

China Hungary Turkey Turkey Philippines Turkey Zambia Chile Venezuela Thailand Mexico Venezuela Brazil Turkey Gabon China

Manufacturing Chemicals Chemicals Hotels and tourism Textiles Hotels and tourism Food and agribusiness Mining and extraction of metals metals Mining and extraction of metals metals Chemicals Chemicals Chemicals Chemicals Hotels and tourism Oil and gas Manufacturing

Bahia Sul Celulose S.A. ln lnde delp lpro ro S.A. de C.V. Mersin Enternasyonal Otelcilik A.S. A.S. Migranja S.A. Petroken Petroquimica PetroquimicaEnsenad Ensenada a S.A S.A.. Siam Siam Asahi Technog Technoglass lass Company Company L imite d Spintex Holdings Swaziland Limited Tetra Pak Pak Hungary Limit ed Togotex International S.A. A. Turism ve Yatirim A.S. Twen?. First Ce ntury Oleochemicals Sdn. Sdn. Bhd. UCAL Fuel Systems Limited Wahome Steel Limited Yeditepe Beynelmilel BeynelmilelOtelcilik Otelcilik Turizm ve Ticaret A.5

Brazil Mexico Turkey Uruguay Argentina Thailand Swaziland Hungary Togo Turkey Malaysia India Ghana Turkey

Timber, pulp, paper Chemicals Hotels and tourism Food and agribusiness Chemicals Manufacturing Textiles Timber, pulp, paper Textiles Hotels and tourism Chemicals Manufacturing Mining and extraction of metals metals Hotels and tourism

Debt IFC loan

IFC syndication

IFC equity

 

Al Bardi Paper Mill Company (S.A.E.) Al Hikma Farmaceutica (Portugal) Limitada Automated Microelectr Microelectronics onics lncorporated Avantex Mill Corporation Best Chemicals and Plastics lncorporated Eka Chemicals de Venezuela C.A. Engepol Engenharia de Polirneros Herdilla Oxides and Electronics Limited Hopewell Energy (Philippines) (Philippines) Limit ed Hotel Investments (Ghana) Limited Hotel Orbis Bristol Limited Liabilit y Company Leptos Calypso ypso Hotels Limit ed Magyar Suzuki Corporation Makati Shangri-La Hotel and Resort lncorporated Mines d'Or d'Akjoujt S.A. Oleoducto de Colombia S.A. Productora d e Alcoholes Hidratados C.A. Societe ENNASR de Pec Peche he Victoria United Hotels Company (S.A.E.)

Egypt Portugal Philippines Philippines Philippines Venezuela Brazil India Philippines Ghana Poland Cyprus Hungary Philippins Mauritania Colombia Venezuela Morocco Egypt

Timber, pulp, paper Chemicals Food and agribusiness Textiles Chemicals Chemicals Manufacturing Chemicals lnfrastructure Hoteis and tourism Hotels and tourism Hotels and tourism Manufacturing Hptels and tourism Mining and extraction of metals Oil and gas Chemicals Food and agribusiness Hotels and tourism

Alcatel Network Systems Romania S.A. Aquaculture de la Mahajamba (Aqualma) Bosques y Maderas MaderasS.A. S.A. (BOMASA) Celular de Telefoni Tel efoni a S.A. de C.V. Chemagev Chem agev Limite d DesarrollosTuristicos Desarrollos Turisticos del Caribe S.A. Dynamic Textile Industries Limited Elbo Gaz Gaz Mamulleri ve Kont roi Cihaglari Sanayi ve Ticaret A.S. Fibranov Fibr anova a S.A S.A. Ghanian -Australian Goldfields Goldfields Limit ed Hidroelectrica Aconcagua S.A. The Mexico City Toluca Toluca Toll Road Misr Compressor Manufacturing Company Company(MCMC), (MCMC), S.A.E. Petrozirn Line (Private) Limited P.T. Bakrie Kasei Corporati on P.T. Rimb Rimba a Partikei lndonesia

Romania Madagascar Chile Mexico Poland i Domin can Republi Republic Bangladesh

Infrastructure Food and agribusiness Timber, Timber, pulp, paper Infrastructure Indus trial and consumer ser service vices s Hote Hotels ls and tourism tour ism Textiles

Turkey Chile

Manufacturing Timber, pulp, paper

Ghana Chile Mexico Egypt Zimbabwe lndonesia lndonesia

Mining and extraction of metals Infrastructure lnfrastructure Manufacturing lnfrastructure Chemicals Timber, pulp, paper

 

Fiscal

Estimated project

Debt IFC

IFC

IFC

year

cost

Company

Country

Sector

P.T. Swadharma Kerr y Satya Serena Beach Hotel S.A.E. Shin Ho Paper (Thailand) Company Limited Societe Miniere de Bougrine (SMB) Westel Radiotelefon KFT

Indonesia Egypt Thailand Tunisia Hungary

Hotels and t ourism Hotels Hotels and tourism Timber, pulp, paper Mining and extraction of metals lnfrastructure

Alexandria Carbon Black Company S.A.E. Eacnotan Cement Corporation Belize Electric Company Limited C.S. Cabot Spol sr.0. Cayeli Baki r lsletmeleri A.S. Central Sukhontha Company Limited Companhia Central Brasileira de Acabamentos Texteis

Egypt Philippines Belize Czech Czec h Repu Republic blic Turkey Thailand Brazil

Oil and gas Construction materials lnfrastructure Oil and gas gas Mining and extraction of metals Hotels and tourism Textiles

Compania Boliviana de Gas Natural Comprimido S.A. Fer Ferroex roexpres preso o Pampeano, S.A.C. Ghim Li Fashion (Fiji) Limited Hel Helios ios S.P. PA. A .. Hopewell Powe Powerr (Philippines) (Philippines) Corporation Hotel Camino Real S. S.A. A. Hotels Polana Limitada Huta L.W. Sp. z.o.o. IdealSanitaire Ideal Sanitaire MactanShangri Mactan Shangri-La Hotel and Resort Incorporated Metanol de Oriente, Metor S.A. Northern Mindanao Power Corporation Nuevo Central Argentina S.A. Puerto Quetzal Power Corporation Rupafil Limited The Samui Beach Company Shenzhen Tai-Yang PC PCCP Company Lim Limite ite d Tripetrol Exploration and Production Company Yanacocha Yanacoch aS.A. S.A. Yantai Mitsubishi Cement Company Limited

Bolivia Argentina Fiji Algeria Philippines Costa Rica Mozambique Poland Tunisia Philippines Venezuela Philippines Argentina Guatemala Pakistan Thailand China Ecuador Peru China

Chemicals lnfrastructure Textiles Chemicals lnfrastructure Hotels and tourism Hotels and tourism Mining and extraction of metals Construction materials Hotels and tourism Chemicals lnfrastructure Infrastructure lnfrastructure Textiles Hotels and tourism Construction materials Oil and gas Mining and extraction of metals Constructionmaterials

loan

syndication

equity

 

Albadomu Malatat ermelo Es Kereskedelmi Kereskedelmi B BT T Autokola Nova Hut as. Aytac Dis Ticaret Yatirim Sanayi A.S. Bacell Sewicos e Industria IndustriaLimitada Limitada Bona Sp. 2.0.0. Bumrungrad Medic al Center Company Company Limited

Hungary Gech Republic Turkey Brazil Poland Thailand

Food and agribusines agribusiness s Manufacturing Food and agribusines agribusiness s Timber, pulp, paper Food and agribusiness Social services

Club Ras Ras Soma Hote Hotell Company Crescent Cresc ent Greenwood Li mited DLF Cement Limited ErnpresaDiatribuidora Ernpresa Diatribuidora Norte Sociedad Anonima S,A Emprera Electrica Electric a Pangue S.A. S.A. Fauji Cement Limited Hidroelectrica Aguas Zarcas 5.A. Papa Regional Telephone Company Rt. Peters Peter s Flei schindustrie Und Handel Aktiengesellschaft

Egypt Pakistan India Argentina Chile Pakistan Costa Rica Hungary

Hotels and tourism Textiles Construction materials lnfrastructure lnfrastructure Construction materials lnfrastructure lnfrastructure

Poland Pakistan Thailand El Salvador Tanzania Nigeria Thailand Zimbabwe Argentina

Food and agribusiness Textiles Oil and gas Infrastructure Hotels and tourism Hotels and tourism Chemicals Hotels and tourism lnfrastructure

AES Lalpir Limited Aguas Argentinas Al Keen Keena a Hygienic Paper Mil l Company Limited Baria Baria Fertil izer and Agricultural Forestry Products Import -Export Sewim Company

Pakistan Argentina Jordan

lnfrastructure lnfrastructure Timber, pulp, paper

Vietnam

Infrastructure

Borcelik Celik Sanayii Ticaret A.S. Clovergem Celtel Limited Compagnie lvoirienne de Production dmElectricite CompaniaTratadora Compania Tratadorade de Aguar Negros de Pwrto Vallarta SA. SA. Dalian Float Glass Company Limited Electricidad de Cortes 5.A. de R.L. De De C.V.

Turkey Uganda Cote d'lvoire Mexico China Honduras

Mining and extraction of metals lnfrastructure lnfrastructure lnfrastructure Manufacturing lnfrastructure

Regent Knitwear Limited Sta Starr Petrol eum Refining Company Limited Telemovil EiSalvador Ei Salvador 5.A. Tourism Promotion Services (Tanzania) Limited Tourist Company of Nigeria Limited Tunte?Petrochemicals Tunte? Petrochemicals (Thailand) Public Company Limited Victoria Falls Safari Lodge Hotel (Private) Limited Yacylec S.A.

 

Fiscal year

Company

Country

Sector

Estimated project cost

-

Debt IFC loan

IFC syndication

IFC equity

Grand Hotel de I lndependance Indo-Jordan Chemicals Company Limited Kohinoor Energy Limited Manzanillo Manzani llo Int ernati ernational onal Terminal Panama nama S.A A.. Nahuelrat S.A.

Nantong Wanfu Special Aquatic ProducbCompany Limited Nesky Incorporated P.T. Bakrie Kasei Pet Prism Cement Limited SmithJEnron Cogeneration Limited Partnership Societe d'Exploitation des Mines #Or de Sadiola 5.A Sprint Spr int R.P. Telekom Sp. 2.0.0. United Power Power C orporation Westel 90 900 0 G5M Mobi Mobill Tavk Tavkuzle uzlesi si Rt. AES Pak Gen (Privat (Private) e) Company Comp any Apache Qarun Corporation LDC Consorcio Aeropuertos Inter Internacio nacionales nales S.A A.. Crescent Industrial Chemicals Limited Depsona z.a.0.

Dupont Suzhou Polyester Company Limited Energy Ener gy Africa Haute Mer Limited Limi ted Gul Ahmed Energy Limited GVK Industries Limited Limi ted Himal Power Limited Jor Jordan dan Mobile Mobil e Telephone Services Com Company pany Limi Limited ted Mercado Mayorista Mayor ista de Santiago S.A. Modern Aluminum Industries Compa Company ny Limi Limited ted Morn ing Star Star Cement Limited Nanjing Nanji ng Kumho Tire Compan Company y Limi Limited ted Pangarinan Pangarina n Electric Corporation Corporatio n Plantation Planta tion Timber Products Products (Leshan) Limited

Guinea Jordan Pakistan Panama Argentina China Poland Indonesia lndia Dominican Republic Mali Poland Oman Hungary

Hotels and tourism Chemicals lnfrastructure lnfrastructure lnfrastructure Food and agribusiness Manufacturing Chemicals Construction materials

Pakistan

China

lnfrastructure Oil and gas gas lnfrastructure Textiles Food and agribusiness Textiles Oil and gas Infrastructure lnfrastructure lnfrastructure lnfrastructure Food and agribusiness Manufacturing Construction materials Manufacturing lnfrastructure Timber, pulp, paper

Eswt

Uruguay Pakistan Russia China Congo Pakistan lndia Nepal Jordan Chile Jordan Vietnam China Philippines

lnfrastructure Mining and extraction d'metals lnfrastructure lnfrastructure lnfrastructure

204.3 246.2 165.0 235.7 185.0

 

PT Hotel Santika Nusajaya Rain Calcining Limited Reynolds Chile S.A. Rupafab Limited Sawinskayadeiyo Company Company Terminales Portuarias Argenti nas S. S.A. A. Tourane Hotel Limited Uch Power Limited Vina Kyoei Steel Limited Weihai Weidongri Comprehensive Foodstuff Company Limit ed

lndonesia lndia Chile Pakistan Russia Argentina Vietnam Pakistan Vietnam

Hotels and tourism Oil and gas Manufacturing Textiles Services lnfrastructure Hotels and tourism lnfrastructure Construction materials

China

Food and agribusiness agribusiness

Abuja International Diagnostic Diagnostic Center Agrocapital S.A. Asia Power (Private) Li mited Baltic Malt Sp. z.o.o. Bangkok Mass Transit System Corporation Limited Beijing Hormel Foods Company Limited Datel Tanzania Limited Engro Paktank Terminal Limited Fairyoung Ports Investments (Holdings) Limited Ferrocarril del Pacifico S.A. Foremost Dairy Company Limited International Hou House se Property Limited Jamaica Energy Partners Jingyang Cement Company Limited Messer GasesDik Dikhei heila la Company Compa ny S.A A..E E.. Norgips Opole Sp. z.o.o. Owens Coming (India) Limited P.T. GleneaglesHospital Corporation RT. Pramindo lka t Nusantara (Pramindo) Proyectos de ln fraestructu ra S.A. San Miguel Haiphong Glass Company Societe d'EconomicaMixte d'Economica Mixte Hotel Pointe des Blagueurr Sucorrico S.A. Sucrerie de Bourbon-Tay Ninh Limited Suzhou Huasu Plastics Company Limited Termi nal Mariti Mar iti ma de Alt amira ami ra S.A. A. de C.V.

Nigeria Ecuador Sri Sri Lanka Poland Thailand China Tanzania Pakistan China Chile Vietnam Tanzania Jamaica China Egypt Poland lndia lndonesia lndonesia Colombia Vietnam Vietnam Brazil Vietnam China Mexico

Social services Food and agribusiness lnfrastructure Food and agribusine agribusiness ss Infrastructure Food and agribusiness lnfrastructure Chemicals lnfrast~cture lnfrastructure Food and agribusiness Industrial and consumer services ces lnfrastructure Construction materials Chemicals Construction materials Manufacturing Social services lnfrastructure lnfrastructure Manufacturing Hotels and tourism Food and agribusiness Food and agribusiness Chemicals lnfrastructure

 

Fiscal year

Company

Country

Sector

Tianjin Kumho Tire Company Limited Toftan A.S.

China Estonia

Manufacturing Timber, pulp, paper

Estimated project cost 122.5

12.0

IFC equity

Vika W w d Sawmill Vimaflour Company Limited

Latvia Vietnam

Timber, pulp, paper Food and agribusiness

19.0 26.0 26.0

AES Merida Ill de R.L. de C.V. Agrisouth Chile 5.A. Baku Coca-Cola Bottlers Limited

Mexico Chile Azerbaijan Republic Nepal Brazil Mexico Bulgaria Brazil

Infrastructure Food and agribusiness

250.0

Food and agribusiness lnfrastructure lnfrastructure lnfrastructure Hotels and t ourism lnfrastructure

Uzbekistan India Pakistan Kenya Senegal Russia

Chemicals Social services Chemicals Infrastmcture lnfrastructure Food and agribusiness

Bangladesh Nepal Uzbekistan Uzbekistan Uganda Kazakstan Venezuela Romania Mozambique Guatemala West Bank and Gaza

lnfrastructure Hotels and to urism Hotels Food and agribusiness lndustrial and consumer services services Mining and extraction of metals Oil and gas Mining and extraction of metals lnfrastructure Manufacturing lnfrastructure

Bhote Koshi Power Company Private Limited Bulk Services ServicesCorporation Corporation Comercializadora La Junta Jun ta S.A. de d e C.V. V. Compa gnie des Hotels d e Luxe S.A. A. ConcessionaresDa Rodovia Presidente Pres idente Dut ra S.A. A. Core Pharmsanoat Duncan Gleneagles Hospitals Hospitals Limit ed Engro Asahi Polymer and Chemicals Chemicals (Private) Limit ed Grain Bulk Handlers Limited GT i Daka Dakarr LLC LLC International Bottlers LLC LLC Internat ional CommunicationTechno Technologie logies s (Bangladesh) Limited Jomsom Mountain Resort (Private) Limited JV "Uzcasemash" LLC JV "Urcaseservice" LLC Kasese Cobalt Company Limited Kazgermunai Minera Loma de Niquel, C.A. Mobil Rom S.A. MO MOZAL ZAL S.A.R.L. L. Orzunil Palestine lndustrial EstatesDevelopment and Management Company

Industrial and consumer services services

57.1

39.0 39.0

 

1998 1998***

1998 1998 1998 1998 1998

Patagonia Min t S.A. Plantat ion Timb Timber er Productr (Hubei) Limited PLM Beverage Can Manufacturing z.a.0. Romanian Romani an Efes Brewery Brewe ry S.A. A. Terminal Termi nal de Cruceros Punta Langosta. Cozumel S.A. de C.V. Unipak Nil Nile e Limited Limit ed Usina Hidre Hidrelectr lectrica ica Guilman-Amorin

Argenti na China Russia Romania Mexico Egypt

Brazil

Food and agribusine agribusiness ss Timber, pulp pulp,, paper Manufacturing Food and agribusine agribusiness ss Infrastructure Timber, pulp, paper Infrastructure

* $3 mil lion i n equival equivalent ent guarantee. Underwriting of5% of international internationalbond bond issue fo for r the project Commitment August 1998. L.

 

APPENDIX B: A SAMPLE IFC PROJECT APPRAISAL (O F A TYPICAL MANUFACTURING PROJECT)

1. PROJECT DES DESCRI CRIPTI PTION ON

a. Proposed ownership structure and sponsor sponsor information b. Legal Lega l status statu s of project and status of government approval approvalss (including government and/or local authorities' attitude toward project, exemptions/advantages to be enjo enjoyed by project, license licenses, s, permissions required, re quired, proposed measures/actions that could could affect the project) project) c. Major Majo r products to be produced (quantity (qua ntity and speafications, including chemicdphysical properti properties es when appropriate) appro priate) d. Project's Project's comparative advantages advantages e. Project's anticipated economic contributions (e.g., in the generation of foreign foreign exchange, employment, technology transfer tra nsfer))

2. CAPITAL INVESTMENT

a.

b. c.

d. e. f.

g. h.

Project site i. Size and location of project site site (in (in relation to availabilit availability y of rraw aw materials, labor , and accessibilit accessi bility yfor to project its markets) ii. utilities, Current Curr ent labor, use and value of land projec t site; estimated value value in new use iii. Infrastructure requirements requirements iv. Legal agreements for land use use rights righ ts v. Exist Ex isting ing pollution pollu tion -related liabilities Civil works and buildings build ings Major and auxiliary equipment i. Estimated requirements requirements and costs costs (imported vs. local and duties) ii ii.. Potential suppliers/contractors Project Proj ect management (plant (pla nt construct cons truction ion and supervision servic services, es, including background and experience exp erience of supervisor Preopera Preo perating ting requirements and costs Contingencies (physical) and escalations (financial) Initial working capital requirements requirements Contracting and purchasing procedures to be b e used

3. PROJECT SCHEDULE SCHEDULES S

a. Construction, startup, operations operations b. Expenditures c. Funding (including timing of  funds needed during project implementation) d. Regulatory compliance compliance

 

P R O J E C T  A P P R A I S A L

4. PRO PRODUC DUCTIO TION N PRO PROCE CESS SS

a.

Production Produ ction technology v vs. s. state of the

ar t

87

b.

Scale and scope of production optimal al siz sizes es i. Rated capacity and comparison with optim ii. Expected operat operating ing effic efficiency iency iii. Frequency of shutdowns, chang changeovers eovers patents, ts, lic licenses enses held) iv. Previous experience with technology (including paten -

~

c.

Produ Production ction proce process ss Plant layout and production flow diagram i. ii. Critical operationshottlenecks iii. Options for future expan expansion sion or m modification odification d. Production requirements and costs (per unit) mat erials (sources, quality, local vs. vs. domestic, contractual i. Raw materials arrangements) ii. Consumables iii. Utilities (sources, reliability) iv. Labor v, Maintenance vi. Fees and royalties e. f. g.

vii. Expected changes in operatin op erating g effici efficiency ency Annual capital investment Quality control Technical Techni cal ass assistan istance ce agreements i. Status of negotiations (proposed terms) ii ii.. Patents and proprietary tech technology nology iii. Training and support for plant staff

5. ENVIRONMENTA ENVIRONMENTAL L IMPA IMPACT CT

a. Descri Description ption of environmental impac impactt b. Plans for treatment of emissions and disposal of effluents issue suess c. Occupational health and safety is d. Local regulations (plans for compliance) 6. MARKETING AND SALES

a.

b.

Product definition Competitive position position of product/company advanta tages vs. vs. comp competitio etition n (current ( current and fu futur ture e- price, quality, etc.) i. Product advan capita ta G GN N P and ii. Target market(s) (including population and per capi their future growth)

 

88

P R O J E C T F I N A N C E

c.

Market structure of annual annua l consumption of products to be i. Demand (volume and value of

made by project last five years, future futu re five years) years) pos ition, strategy) ii. Supply (domestic vs. foreign--capacity, cost position, iii. Existing and projected tariff situation situati on affecting products iv. Market Mark et trends tre nds in future (new products, potential pote ntial competitors, compe titors, etc.) etc.) v. Projected Projecte d market share by segment seg ment

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d. Marketing, Marketin g, distribution, and sales sales organizational arrangements arrangemen ts and fees fees 7. MANAGEMENT AND PERSONNEL

a. b. c. d. e. f.

Organization Organiz ation chart and manpower requirements Key Key operational operatio nal officers officers (including (includi ng background and length of experience) Technical staff and consultants (background and experience) Management targets and incentive incentivess Management agreement Personnel practices

8. FINANCING

a.

Total cost of project project (including (including details on major items of fixed fixed assets and working capital) b. Background statement stateme nt on all sponsors and participants, showing their financial or other interest in the project project in construction construction,, in operation operations, s, and in marketing Capital structure (proposed amounts and sources)  c. i. Proposed debdequity structure ii. Equity (a) Shareholder structure (b) Long-term plans (stay privatdgo public) (c) Quasi-equity (subordinated (subordinated debt, deb t, etc.) iii. Debt (a) Long-term debdworking capital (b) Domestidforeign (c) Desired terms and conditions (d) Funding Fun ding sources sources alread already y identified (note any findi fin ding ng restricted in use) iv. Overrun/standby arrangements d. Margin and break -even analysis i. Unit cost structure as percent of unit sales price ii. Cash and full-cost bases iii. Fixed and variable costs e. Financial Financi al projections Projected financial statements statement s (income statements, cash flows, balance i. sheets, sales revenues, production costs, depreciation, taxation, etc.) ii ii.. Clear statement of a ll assumptions iii. Sensitivity Sensitivi ty analyses under unde r diierent scenarios

 

P R O J E C T

9. COPI COPIES ES OF LEGAL LEGAL DOC DOCUM UMEN ENTS TS

 A P P R A I S A L

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a. Join Jointt venture agreemen agreements ts b. Articles of association c. Governme Government nt approval documents/business license d. Land certificatdred line map e. Mortgages, if any f. Loan agreements g.

Major contracts including Offtake agreements ii. Supply agreements iii. Technical assistance agreement iv. Management agreement i.

 

G LO S SARY

Balance Sheet: An accounting statement that displays displays the assets, assets, lliabiliti iabilities, es, and equity of a company as of a specified date. By definition, the value of assets on a balance sheet must equal the th e value value of lia lities plus net worth (owners' equity). B-Loan: Loan syndicate syndicated d by multilater multilateral al lender, such as IFC, which acts ac ts as sole lender-of -recor record d on behalf of the funding p part artidp idpant ant (commercial (commercial banks and other institutional institution al investor investors). s). Build-Own -Operate (BOO ): Similar Similar to build build-own-(operate)-transfer,with the excep excep tion that the project company has a concession life as long as the expected economic life of the facility (typically 30-50 years).

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Build Own -(Operate)-Transfer (BOT, sometimes BOOT): A form of privatized project development in in which wh ich a government grants grants a concession concession of defined and limited duration to private sector sponsors to build a project, hold an ownership position in it, arrange the balance of financing from third parties, and operate the project for the life of the concession. Usually, the concession life is significantly shorter than the facility's economic life (for a coal -fued power plant, typically 15-20 operating oper ating years years for the con cession vs. a plant life of 30 40 years.) Usu Usuall ally, y, the project ownership transfers to the bi government at no cost after the concession term. -

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Call Opt Option ion:: Th e right to buy an asset asset at a fured price during a particular period of  time (opposite of a put option).

Cash Flow Statement: An accounting statement that th at shows shows the pre- and after-tax cash flows flows generated generated by a project during its operatin operating g period. This Th is statement is used in financial projections projections and investmen in vestmentt decision analysi analysiss to determine determ ine a project's project's abii ab iity ty to pay debt service and service service its equity capital. Collateral: T he physical physical and contractual asset assetss pledged as as security for amounts amou nts owed owed to a lender or lessor.

 

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F I N A N C E

Comple Com pletio tion n Guarante Guarantee: e: Completion may may refer either to the project project's 's physic physical al comple completion (that is, the period prior to t o reaching th thee deemed start of commercial commercial operations), or to the project's project's financial completion (that is, when its operations reach reach an agree agreed d level level of  financial sustainability). Th e first refers refers to the undertakings which a turnkey contractor is expect expected ed or prepared or required to give to a project company to ensure physical completio completion n of the t he project. Contractor Contrac tor completion complet ion guarantees typically cover price, schedule and facility performance. T h e contractor's performa p erformance nce guarantees guarant ees are normally secured by performance bondss and penalt bond penalties ies in the form of spec spec ed and capped liquidated liquidated dam damage ages. s. T h e second broad category category of completion guarantees include includess contractual undertakings by the project project shareholders to the t he project project lenders (usually (usually thro through ugh the project project company), company), to pay (or provide the cash to the project company for it to pay) the project's scheduled debt service as it falls due, in the event the project company does not pay the debt ser vi vice ce as due, until the project reaches financial sustainability (that is, the level of financial performance agreed at the project outset). Concession Conces sion Agreement: Agreeme nt: Agreement, usual usually ly with a government authority, to operate the project or provide the specified services for a certain period of time. ContingencyAllowance (or Contin Contingency): Term used used to encompass both base cost/physical continge contingency ncy and an a n escalation contingency. A base cost contingency contingen cy is a nonspecific provisio provision n for costs c osts that tha t are expected tto o be

incurred, but that cannot be ascribed to specific cost categories (for example, land, boiler, turbine, owner' owner'ss cost, working capital). A continge contingency ncy provisio provision n is expected to be expended expen ded to complete the project, project, but it cannot be predicted which items will consume it. Normally estimated as a percentage of the aggregate of the specific cost items, it forms part of the base financing requirement of the project. Normally, a separate contin gency provision, provision, sometime sometimess referred to as a "price contingency," is made for cost escalation expec expected ted to be incurred during the precompletion period. Costt Overruns: Cos Overr uns: Unplanned cost increases incurred by a project company during a project's precompletion period. Whiie usually referred to as "construction overruns," the reference in the word construction is in fact to the period, and not necessarily to the actual cost of plant construction itself, even even though tthe he cost is is normall y a major component of the t he overrun (that is, it is possible to hav havee a "construc construction tion ov overrun errun" even if the cost increase increase resulted entirely from from higher than t han budgeted interest costs associated associated with a completion delay).

 

G L O S S A R Y

93

Covenant: An undertaking in a loan agreement by a borrower borrower to perform certain acts (positive covenant), such as the timely p prov rovisi ision on of finan finanaal aal statements, or to refrai refrain n from certain acts (negative covenant), such aass in incurri curring ng furth further er indebt indebtedness edness be beyond yond an agreed level, or paying dividends in exce excess ss of accumulated ear earnings. nings. Most are transactionspecific. A breach of covenant of covenant is a default. Cr Cred edit it Enhan Enhancement cement:: Some extra secur security ity prwided to lenders to encourage encourage them to to lend to a project. Credit enhancement is used as a means of reinforcing the credit strength of a projec project. t. Such credit enhancement can includ includee ot other her assets ple pledged dged as security for an obligation (extra collateral); guarantees from a project sponsor or host government; letters of credit payable to the project company as security for a project participant's contr contractual actual under undertaking takings; s; a deb debtt servic servicee res reserve erve fund; andlor a contingent equity commitment. Credit Rating: A ratin rating g ass assiigned by an independ in dependent ent credit ratin rating g ag agen ency cy.. An opinion of the future ability, legal obligation, and willingnes willingnesss of a bo bond nd issuer or othe otherr obligor tto o make M l and timely payments on principal and interest due to investors. investors. Th e opinion is based on a qualitative and quantitative analysis by the rating agency. Creditworthy: A term used to describe a project, a sponsor or other participant, or the substance of a contractud undert undertaking aking from one of the them, m, that is cons considered idered b by y prosp prospec ec

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tive project lenders to be worthy of recei receivin ving credit (a loan), or is an acceptable form of  security for recei receiving ving credit. Debenture: A debt obligation bond secured by the general credithalance sheet of the borrower rather than th an being ba backed cked by a specif specific ic lien on property; i t is therefore no nott col

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lateralized. De bt Capacit Debt Capacity: y: Th e total amou amount nt of deb debtt a bor borrow rower er can suppor support, t, gi given ven its earnings expectations (and their stability), its equity eq uity ba base se,, and the terms of tthe he ava availa ilable ble debt (a borrower ha hass more debt capacity if the ava availa ilable ble loan repayment terms are longer or the t he in interest terest rat ratee is lower, lower, other things bei being ng eq equal). ual). Debtmquity Ratio; Debt to -Equity Ratio: Th Thee ratio of a firm's debt to its equity. Usually expressed as a relative proportion, as in 60/40 or 70/30. The higher this ratio, the greater the financial lever leverage age and financial risk (that is, risk of illiquidity and insol vency) of the firm. -

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De bt Servic Service: e: Payme Payment nt of all monies owed by a borrower to a lender; includes fees fees,, interest, and principal. Periodic debt service is the total tot al payment of interest and princi-

 

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P R O J E C T

F I N A N C E

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