***Project finance deals involve great amount of due diligence on bankability of the projects to ensure that the project produces the desired output and the cash flow generated by the project is enough to pay all debts.
PROJECT Finance is a relatively new concept in this country. The term itself is misleading as it literally implies the financing of projects in general. In fact, project finance uj-«fers to a particular methbdof financing projects.. Broadly, debt in a typical project may be financed through two different methods, namely: corporate finance and project finance. Under corporate finance the lending decision is based on the overall financial condition of the borrower including its corporate balance sheet. Even if the project to which loan has been given is not performing well the lenders can still expect to get paid if the corporate entity as a whole remains healthy. In case of project finance the lending decision is primarily based on the evaluation of the project and the special purpose vehicle (protect company) created to implement the project. The source of debt repayment is limited to project s assets and mainly to its cash flows. Therefore, project finance is usually on a non-recourse or limited recourse basis implying that project sponsor’s assets outside the project are not offered as security for debt repayment. Corporate finance on the other hand is often based on full recourse, meaning that all corporate and sponsor's assets are at stake for repayment of debt.
Project finance techniques are used mainly in capital-intensive projects characterised by highly leveraged debt. Previously the use of the technique was limited to mining, oil and gas development and similar extraction activities. In recent years, project finance is also being used in financing of infrastructures and other similar activities. In Asia alone, infrastructure projects worth US $ 500 billion were financed using project finance technique. In Bangladesh, several capital-intensive projects in power generation.and a container port are
in the process of being financed using this technique.
Ilie recent popularity of project finance is due to several factors. From the sponsors' viewpoint it allows them to mobilise large amount of debt to implement capital intensive projects. It permits them to do so with relatively small equity contributions and without exposing their corporate balance sheet. In a typical project finance deal debt-equity ratio could be 4:1 or even higher. From the lenders' perspective it allows them to focus their due diligence on project intrinsics without bothering about the details of corporate health. Project finance deals have also become possible because of financial and legal innovations involving Identification, mitigation and allocation of project risks among various participants of the project.
Project finance deals are structured around a number of simple premises. Firstly, a project must have predictable and robust cash flow that would enable repayment of all debts plus a fair return on equity over a reasonable period of time. Secondly, each major project risk has to be allocated to the party that is in the best position to absorb such risk. Finally, there have to be legally enforceable contractual arrangements Including provisions of events of default, liquidated damages, lenders' step-in rights and other security that create conditions for project participants to abide by the contract. In the ultimate analysis project finance is based on cash flows. That is why it is often euphemistically said that there are three important things to remember in project finance: cash flows, cash flows, and cash flowsl
The key features of project finance deals are discussea below:
Date-certain fixed-price construction contracts: Most important risk in any project is construction delay and cost overrun. Therefore, lenders in a project finance deal always insist on date-certain fixed-price construction contracts. Such contracts must also lay down the*various milestones for construction completion that lenders would monitor with the help of independent engineers. Such contracts not only ensure completion of the project on time but also help in planning infusion of funds into the project. The construction contractor has to agree to provide an agreed sum of liquidated damages for the failure on its part to achieve critical milestones. Based on the construction contractor's undertaking the sponsors provide similar completion guarantees to the government/ agencies.
Disbursement of funds and agent bank: The lenders in project finance deals would make sure that the funds lent to the project are used exclusively for the purpose of the project and are not diverted to other use. Therefore, lenders would agree with the sponsors on the project costs and a disbursement schedule based on independent engineer's review of the construction contract and Other project documents. Thereafter, lenders would appoint an agent bank that would receive both equity and debt as per agreed disbursement schedule and, using these funds, would make payments to contractors and suppliers and other similar parties.
Definite off-take and input supply arrangements: Usually
project finance deals are structured around some kind of definite off-take arrangements for project's output. These contracts generally take the form of take-or-pay contracts under which the off-taker guarantees to pay for making capacity available irrespective of whether or not the output is actually dispatched or used. Usually such capacity payments are adequate to service all debt and ensure a reasonable return .on equity. Power Purchase Agreement, common in power generation projects, is an example of take-or-pay contract. In addition to capacity payments the off-taker is also required to make usage payments (e.g. energy payments) in proportion to the output actually used. In addition to offtake arrangements project finance deals are often characterised by firm input supply contracts. Fuel Supply Agreement, common in power‘generation projects, is an example of such an arrangement.
Revenue cascade and use of escrow accounts: Lenders in project finance deals maintain strict vigilance on accrual and use of project revenues. Sponsors have to agree to channel project revenues into an escrow account and to set up a hierarchy of payments from such accounts. Again the agent bank referred to previously would administer the inflow and outflow of funds according to an agreed cascade pattern. The first charge from the account would be the agreed expenses required to run the project (e.g. organisation & management expenses), followed by any government dues and senior debt service payments. This is followed by payments to sponsors like subordinated debt
service, technical services fee. dividends etc. The latter payments can be made only after the priority payment obligations are met.
Credit enhancements by third parties: When lenders consider bilateral ' commitments made by project participants under various project agreements as inadequate, the lenders may require credit enhancements from third parties. For example, a bank with good credit rating may be asked to open letters of credit confirming infusion of equity by projects’ sponsors. Other examples of credit enhancements include various insurance, warranties • and partial risk guarantee (PRG). Recent debate regarding IDA partial risk guarantee for AES Harlpur project illustrates the use of credit enhancements in project finance deals. Under the proposed PRG. commercial banks would lend to the project in exchange of a guarantee that in the event of failure of the project company to service the debt. IDA will make the debt service payments. IDA in turn would require an indemnity agreement with the government before issuing such guarantee to the commercial banks.
Lender's step-in rights: In project finance deals both the sponsors and the government are required to inform the lenders if the project goes wrong in any significant way because of failure of one or more of the participants to fulfil their obligations. Examples of such situation would include failure to achieve any key construction milestones and/or payment defaults. In such a situation the lenders have a right to step in to revive the project by infusion of funds and even by bringing in a new operator. Various project agreements recognise such rights of the lenders.
Security: As mentioned earlier. project finance deals are structured on llmlted/non-re-course basis. Therefore, lenders have stringent security requirements under this arrangement. The standard security package would include all of projects assets including mortgage on Immovable properties. hypothecation on movable properties, assignment of project revenues, all project contracts and insurance.
Project finance deals involve great amount of due diligence on bankability of the projects to ensure that the project produces the desired output and the cash flow generated by the project is enough to pay all debts. It also involves evolving mechanisms to ensure that project funds are exclusively used for designated purposes and use of project revenues based on the agreed revenue cascade with repayment of senior debt as a high priority. It also requires weaving of contractual framework that would provide right incentives to the project participants to work in the best longterm Interest of the project. Finally, it also needs to provide a mechanism for the lenders to correct the situation through direct Intervention if something is grossly wrong with the project well ahead of time so that bankruptcy and liquidation could be averted.