Project finance in construction : a structured guide to assessment

Project finance has spread worldwide and includes numerous industrial projects from power stations and waste-disposal plants to telecommunication facilities, bridges, tunnels, railway networks, and now also the building of hospitals, education facilities, government accommodation and tourist facilities. Despite financial assessment of PF projects being fundamental to the lender's decision, there is little understanding of how the use of finance is perceived by individual stakeholders; why and how a financial assessment is performed; who should be involved; where and when it should be performed; what data should be used; and how financial assessments should be presented. Current uncertainty in financial markets makes many sponsors of construction project financings carefully consider bank liquidity, the higher cost of finance, and general uncertainty for demand. This has resulted in the postponement of a number of projects in certain industry sectors. Governments have seen tax receipts drastically reduced which has affected their ability to finance infrastructure projects, often irrespective of the perceived demand. Equity providers still seek to invest, however there are less opportunities due to market dislocation. Due to the demand for global infrastructure it is believed that project financings will return to their pre-crunch levels, or more so, however lenders' liquidity costs will be passed on to the borrowers. Lenders will also be under stricter regulation both internally and externally. The steps outlined in the guide are designed to provide a basic understanding for all those involved or interested in both structuring and assessing project financings. Secondary contracts involving constructors, operators, finance providers, suppliers and offtakers can be developed and assessed to determine their commercial viability over a projects life cycle. Special Features a structured guide to assessing the commercial viability of construction projects explains economic metrics to use in the decision making process detailed case study shows how stakeholders apply the concept of project finance Project Finance in Construction 5 Contents 7 List of illustrations 13 List of tables 15 About the Authors 17 Preface 19 1 Introduction 21 1.1 The development of project finance 21 1.2 Financial assessment 26 What is financial assessment? 26 Why perform a financial assessment? 26 Who is involved in the risk assessment process? 27 Where should a financial assessment be performed? 27 When should a financial assessment be performed? 28 What data are to be used? 28 How should assessment outputs be presented? 28 1.3 Purpose of this guide 29 1.4 Scope of the guide 29 2 Project finance 31 2.1 Introduction 31 2.2 Definition of project finance 31 2.3 The key characteristics of project finance 33 Special project/purpose vehicle 34 Contractual arrangement 34 Non-/limited recourse 37 Off-balance sheet transaction 38 Robust income stream of the project as the basis for financing 39 2.4 Legal and financial considerations in project finance 40 Legal 40 Financial 42 3 Financial instruments and cash flow modelling 45 3.1 Introduction 45 3.2 Debt finance 45 Senior debt 47 3.3 Mezzanine finance 48 Subordinate debt 48 Bond finance 49 3.4 Equity finance 51 3.5 Sources of debt and equity 54 3.6 Cash flow modelling and project financing 54 4 Risk management 59 4.1 Introduction 59 4.2 Risk 59 4.3 Risk management process 61 Risk identification 62 Risk analysis 64 Risk response 67 4.4 Typical risks in project financing 69 5 The financial assessment process 71 5.1 Introduction 71 5.2 The financial assessment structure 71 SPV assessment 71 Lenders’ assessment 74 SPV and lender final assessment 75 6 Case study 77 6.1 Introduction 77 6.2 Independent power project 77 6.3 Supply and offtake contracts 78 Supply contracts 80 Offtake contracts 81 Applications of supply and offtake contracts 84 6.4 Assumptions for initial assessment 85 7 Developing the base case model 89 7.1 Introduction 89 7.2 SPV’s initial assessment 89 7.3 Identify the estimated activities, time, costs and revenues of the project 90 7.4 Development of the base case model 91 7.5 Identify major project risks 93 7.6 Assessment of base case model incorporating risks 94 8 Initial economic assessment by lenders 97 8.1 Introduction 97 8.2 Financial package assessment 97 Finance package (1) 98 Finance package (2) 102 Finance package (3) 103 8.3 Conclusions 107 9 Financial engineering 109 9.1 Introduction 109 9.2 Financial instruments used in financial engineering 110 Forward rates 110 Financial futures 110 Swaps 111 Options 112 Caps, floors, collars, swaptions and compound options 112 Asset-backed securities 113 9.3 Refinancing 114 9.4 Reappraising public–private partnerships 114 9.5 Techniques applied in the reappraisal of PPP concession agreement 115 9.6 Other financial engineering techniques 116 10 Final assessment to determine project commercial viability 121 10.1 Introduction 121 10.2 Detailed risk assessment 121 10.3 Financial engineering 125 Tax holiday 125 Financial collar 127 Extending the concession 127 Increasing debt 127 Grace period 128 Phasing construction and operation 128 Upfront payments 128 Existing concession revenues 128 10.4 Summary 129 11 Financial close 131 11.1 Introduction 131 11.2 Due diligence 131 Technical 133 Legal due diligence 134 Trigger step in rights 136 Model audit and sensitivity analysis 136 Risk valuation 137 Term sheet 137 Inter-creditor agreement 137 Hedge strategy 138 Letters of credit 138 Reserve account 139 Escrow and ring-fenced facilities 139 Economic indicators 140 Taxation 140 Insurance 141 11.3 Financial close 142 Credit committee approval process 143 Due diligence report 144 Technical closure 144 Financial close 144 Technical commencement 144 Execute interest rate swaps 145 12 Islamic finance and project finance 147 12.1 Introduction 147 12.2 Islamic finance 147 12.3 Shariah 149 Qiyas and Litihad 149 12.4 Core principles of Islamic finance 150 Sharing (profit/loss and risk) 150 No unfair gain 150 No speculation 150 No uncertainty 150 No investments that are not in the public interest 151 No hoarding of money 151 Deception 151 Islamic financial institutions 151 Shariah supervisory boards 152 12.5 Project finance 152 The Ijara principle 153 Ijara Mawsufah Fi Al Dhimmah (forward lease) 153 Istisna’a 153 Sukuk 154 Sukuk al Istisna’a 155 A typical SAI deal 155 Hedging 156 Swaps 157 12.6 Other Islamic finance techniques for projects 157 Musharaka (equity financing) 157 Bai salam (forward financing) 158 12.7 Risks and liabilities 158 12.8 Summary 159 13 Conclusions and recommendations 161 13.1 Review 161 13.2 Conclusions 162 13.3 Recommendations 164 Appendix 167 Glossary 179 References 181 Index 187 1444334778,9781444334777,1444323849,9781444323849 Introduction Project finance Financial instruments and cash flow modelling Risk management The financial assessment process Case study Developing the base case model Initial economic assessment by lenders Financial engineering Final assessment to determine projects commercial viability Financial close Islamic finance and project finance Conclusions and recommendations. This work provides a structured process for determining the commercial viability of large construction projects - from gas pipelines and bridges to hospitals and schools - procured with project finance (PF). With this guide, readers can develop their own assessment structures as required using the assessment mechanism described.