This chapter gives a global perspective on project financing (financing long-term infrastructure, industrial projects and public services). The article explains how project financing works; which entities are usually involved in project financing transactions; and how project financiers deal with risk, with an additional focus on infrastructure development and privatisation trends in Brazil.
This article is part of the PLC multi-jurisdictional guide to construction and projects law. For a full list of jurisdictional Q&As visit www.practicallaw.com/construction-mjg.
Project financing is usually defined as the financing of long-term infrastructure, industrial projects and public services based on a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project. It is a financing technique that generally allows a company to raise funds to set up a project based on the feasibility of such a project and its ability to generate revenues at a level sufficient to cover construction and operational costs, as well as debt service and a return for the investor.
As the public sector's ability to invest in infrastructure projects diminished in the 1980s and 1990s, a global trend towards privatisation gathered pace. In Brazil, for example, privatisation was facilitated by the Brazilian Privatisation Programme (PND). At this time, the concept of privatisation became an integral part of the economic reforms initiated by the federal government. All effort was concentrated on the sale of state-owned companies tied to strategic sectors, including steel manufacturers, and petrochemical and fertiliser companies.
Between 1990 and 1994, the Brazilian federal government privatised 33 companies. In addition, it auctioned off its minority shareholdings in eight companies. As a result of these sales, the government made US$8.6 billion (as at 1 April 2012, US$1 was about EUR0.7). In addition, it transferred US$3.3 billion in debt to the private sector, bringing total returns to US$11.9 billion.
Private companies in Brazil (and elsewhere) have found it difficult to compromise their budgets during the long course of maturation of infrastructure projects. As a result, other entities have become important financiers of such projects. These entities include commercial banks, multilateral agencies, export credit institutions, pension funds, insurance companies and participants in international capital markets. As a financial model that adapts itself to the funding needs of projects developed by the private sector, project financing is an important instrument for the improvement of infrastructure in developing countries.
Project finance is becoming increasingly common in Brazil, with banks and law firms establishing dedicated teams to handle project finance transactions. According to the Brazilian Financial and Capital Markets Association (ANBIMA), 41 projects raised US$13.5 billion in 2010. Project finance is used in a number of sectors in Brazil. In 2010, according to ANBIMA, transactions in the power sector represented 36.1% of the total volume of financing, followed by transport and logistics then oil and gas, with 30% and 27%, respectively. Calculated by the number of projects, power ranked first with 66.7% of all projects disbursed in 2010. It is common knowledge that Brazil’s infrastructure is overstretched. The Brazilian government has been very proactive on the infrastructure front over the last few years, but a lot is still to be done. Hosting the 2014 Football World Cup and the 2016 Olympics puts additional pressure on the government to upgrade the current infrastructure, especially airports and transport systems. This huge need for infrastructure-related investment should lead to even higher levels of project finance in the coming years. (For more information on how Brazil manages its funding needs for infrastructure improvement, see box, Infrastructure development in Brazil: the role of the Brazilian Development Bank (BNDES).)
Against this backdrop, this chapter explains:
How project financing works.
Which entities are usually involved in project financing transactions.
How project financiers deal with risk:
by the use of different financial structures;
in the context of alliance contracting;
by adherence to the Equator Principles; and
that is political in nature.
According to the Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards (Basel II), November 2005, project financing is a method of funding in which the lender looks mainly to the revenues generated by a single project, both as the source of repayment and as security for the exposure. This type of financing is usually used for large, complex and expensive installations that might include, for example, power plants, chemical processing plants, mines, transportation infrastructure, environment and telecommunications infrastructure. Project finance will generally focus on the basic premise that both:
A newly-formed, often thinly-capitalised, special purpose vehicle (the project company) will own an asset (which may at that time amount to little more than a collection of licences and contracts granting the project company the right to develop and construct the project).
The project company’s lenders will finance (in part) the development and construction of the project on the basis of their evaluation of the projected revenue-generating capability of the project.
Project finance may take the form of financing the construction of a new capital installation, or refinancing of an existing installation, with or without improvements. In such transactions, the lender is usually paid solely or almost exclusively out of the money generated by the contracts for the facility's output, such as the electricity sold by a power plant. The borrower is usually a special purpose entity that is not permitted to perform any function other than developing, owning and operating the installation. The result is that repayment depends mainly on the project's cash flow and on the collateral value of the project's assets.
Projects like power plants, toll roads or airports share a number of characteristics that make their financing particularly challenging. Large-scale projects might be too big for any single company to finance alone. On the other hand, widely fragmented equity or debt financing in the capital markets may help to diversify risk among a larger investor base, but might make it difficult to control managerial discretion in the allocation of free cash flows and avoid wasteful expenditures.
Project financing is used to strike a balance between the need for sharing the risk of sizeable investments among multiple investors and the importance of effectively monitoring managerial actions and ensuring a co-ordinated effort by all project-related parties.
Project financing transactions require joint efforts from the lenders, investors, suppliers, off-takers (that is, contractual buyers of an end-product) and sponsors (that is, the entities ultimately responsible for the project) of the project to make the implementation of a project feasible. These parties deal with special challenges:
They require large indivisible investments in a single purpose asset. Project financing deals contemplate the creation of a special purpose vehicle with bankruptcy remoteness features as a ring-fencing technique, which usually results in credit enhancement for financiers and cost reductions for sponsors, although this is not usually mandatory.
Projects usually undergo two main phases, construction and operation, characterised by quite different risks and cash flow patterns. Construction mainly involves technological and environmental risks, while operation is exposed to market risk (fluctuations in the prices of inputs or outputs) and political risk, among other factors. Most capital expenditure is concentrated in the initial construction phase, with revenues starting to accrue only after the project has begun operation.
The success of a large project depends on the joint effort of several related parties, as issues such as a lack of co-ordination and conflicts of interest can have significant costs. All of the parties have substantial discretion in allocating the usually large free cash flows generated by the project operation, which can potentially lead to opportunistic behaviour and inefficient investments.
Project financing uses long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures, to align incentives and deter opportunistic behaviour by any party involved in the project.
Parties interested in becoming involved in a project financing usually:
Study the structures available for the project financing, including the advantages and limitations of each available model.
Establish criteria to evaluate the credit risk involved in the project and the impact of this on the interest rates to be charged by financiers.
Identify and allocate risks involved in the project, and develop and implement methods to manage those risks.
Formulate an accurate economic model to obtain the necessary finances on the international market.
Develop techniques for undertaking and understanding the necessary due diligence.
Monitor the project during its building and operational phases, and manage the project's financial documents. The parties may also consider securitising receivables.
In project financing, equity is held by a small number of sponsors and debt financing is usually provided by a syndicate of a limited number of banks. Concentrated debt and equity ownership enhances project monitoring by capital providers and makes it easier to enforce project-specific governance rules to avoid conflicts of interest or suboptimal investments.
The use of non-recourse debt in project financing helps to limit managerial discretion by tying project revenues to large debt repayments, which reduces the amount of free cash flow. In addition, non-recourse debt and separate incorporation of the project company make it possible to achieve much higher leverage ratios than sponsors could otherwise sustain on their own balance sheets.
Non-recourse debt can generally be deconsolidated, and therefore does not increase the sponsors' on-balance sheet leverage (that is, their debt to equity ratio) or cost of funding. From the perspective of the sponsors, non-recourse debt can also reduce the potential for risk contamination (that is, risks generating other risks). In fact, even if the project were to fail, this would not jeopardise the financial integrity of the sponsors' core businesses.
However, one drawback of non-recourse debt is that it exposes lenders to project-specific risks that are difficult to diversify. To cope with the fact that project financing involves credit risk based on the specific types of assets involved in the project, lenders are increasingly using innovative risk-sharing structures, alternative sources of credit protection, and new capital market instruments to broaden the investors' base.
Hybrid structures between project and corporate finance are being developed, where lenders do not have recourse to the sponsors, but the particular risks specific to individual projects are diversified away by financing a portfolio of assets as opposed to single ventures. An example of a hybrid structure that is becoming increasingly common is the public private partnership (PPP), with private financiers taking on construction and operating risks while host governments cover market risks.
There is also increasing interest in various forms of credit protection. These include:
Explicit or implicit political risk guarantees.
Credit derivatives.
New insurance products used to safeguard against macroeconomic risks, such as currency devaluations.
Other methods used to help offset the risks involved in developing large projects include changing the scope of projects to suit economic conditions. For example:
A refinery may change its mix of output among heating oil, diesel, unleaded gasoline and petrochemicals depending on these products' individual sale prices.
Real estate developers tend to focus on multipurpose buildings that can be easily reconfigured to benefit from changes in real estate prices.
To share the risk of project financing among a larger pool of participants, banks typically securitise project loans, creating a new asset class for institutional investors. This includes the launch of collateralised debt obligations (CDOs) (a kind of asset-backed security) and open-ended funds (collective investment schemes that can issue and redeem shares at any time).
The strength of the security package on offer will also impact on the "bankability" of a project. Typically, lenders will seek to take security over all of a project company's assets. However, in a project located in an emerging market with an undeveloped collateral framework, the practical reality of creating and/or enforcing security is that it may be expensive, time consuming and uncertain in outcome. In practice therefore, enforcement of security over a project company's assets is generally seen by lenders as a last resort. For many lenders, the main driver in taking security over a project company's assets is, should the project company face financial difficulties, to maximise the strength of their bargaining position against:
The project company's other creditors.
The host government.
The project company's sponsors.
Should a project face financial difficulties, the lenders' ability to enforce their security (with, subject to local law requirements, no obligation to share the benefits of the enforcement proceeds with anyone else) puts them in the strongest possible position in the context of any restructuring negotiations.
Project financiers will want to establish at the outset of a project whether the law of the jurisdiction where the project is located will recognise their rights as secured creditors and, if the project company becomes insolvent, whether their claims will be dealt with equitably. Any relevant issues would typically be described in a legal due diligence report in which, amongst other things, a lawyer working closely with local counsel, will (at a minimum) need to establish both:
Whether the relevant jurisdiction has a registration system for the filing of security interests.
Whether the relevant jurisdiction's courts, liquidator or equivalent officer will respect the security interests granted by a project company.
It should also be noted that in many jurisdictions (particularly those with little or no track-record of complex financings) the cost of filing or registering security can be significant (due to the several steps necessary in several locations where browsers, sponsors and lenders are located) and sponsors may argue that the creation of security is unduly burdensome and that the practical value of the security to the lenders does not warrant the related expense. Lenders will often seek to mitigate this by (if permitted by local law) requiring that certain of the project company's assets, such as its bank accounts, are held off-shore in a jurisdiction with a favourable security regime.
Over time different contract models have evolved for the development of large projects, including the Engineering Procurement Construction (EPC) model, favoured by lenders, and the Engineering Procurement Construction Management (EPCM) model. However, because the EPC contract approach shifts all of the risk of project completion, cost and performance to the contractor, it tends to trigger an adversarial project team relationship, potentially leading to conflict, contractual disputes and major claims that can undermine the project's financials and, ultimately, the success of its outcome.
This has led to the development of alliance contracting, which offers a unique system of project delivery where risks are shared between the owner and the contractor. Alliance contracts are incentive-based relationship contracts in which the parties agree to work together as one integrated team.
Alliance contracting can relieve the pressure of short-term demands and set the foundation for longer term structural improvement in the way the industry works. In addition, it significantly reduces the risks of claims and disputes between the parties through the use of inclusive and collaborative legal and commercial arrangements. These arrangements enable the parties to work together in an open and productive manner and can help to achieve the business goals of everyone in the relationship.
The foundation of alliance contracting lies in the different approach taken to co-operation between clients (sponsors) and contractors. Trust is the basis of an alliance contract, although a clear and transparent contract is still needed to support this spirit of trust. An alliance contract seeks to move away from the traditional "adversarial" approach in which parties are essentially competitors.
To achieve true co-operation, the parties to an alliance contract must invest in better and more frequent communication, which can at first seem to be a negative. However, this investment means that time is often saved in other areas. For instance, the client (sponsor) and contractor work much more closely as a team and are far less competitive, particularly as these teams are created early on in the project. In addition, an alliance board is created that plays an important role in mitigating conflicts and increasing efficiency.
At first sight, the shortcomings of an alliance contract, such as a lack of certainty concerning project length and cost, appear critical. In most alliance contracts the emphasis is on the result, for example, delivery of the project, rather than budgets and delivery dates. However, banks are adapting their lending practices to accommodate alliance contracting by:
Conducting enhanced due diligence. Due diligence of an alliance contract focuses not just on technical and engineering issues, but also on the alliance track record of the participants. Banks consider whether contractors have the right background, people and systems, and a genuine commitment to making the project work.
Examining the financing structure. This needs to be prepared for reasonably foreseeable over-runs by various means, including:
more equity, or contingent equity, in the form of sponsor standby commitments triggered by delays or cost over-runs, or even sponsor completion guarantees;
cost over-run debt facilities, typically attracting a higher margin and repayable by a cash sweep.
Requiring risk mitigation provisions in the contract. Such provisions include:
a gain-share/pain-share mechanism that seeks to achieve an alignment of commercial interests;
a reasonably prescriptive process for subcontracting and direct procurement;
a "reserved powers" provision under which particular topics of concern (for example, functional or output specifications, and emergencies) are taken out of the alliance board's jurisdiction and placed under the exclusive control of the lender;
a deadlock breaker to cover any prolonged failure of the alliance board to agree on a material issue.
Insurance. Professional indemnity insurance needs special wording to make it effective where the alliance contract has exonerated the contractor from liability for any negligence or defective design.
Project financing transactions may encounter social and environmental issues that are both complex and challenging, particularly with respect to projects in emerging markets. Large industrial and infrastructure projects, such as those for power generation, are increasingly being subject to social and environmental risk assessments before being approved.
Several financial institutions, known as the Equator Principles Financial Institutions (EPFIs), are following the international trend of adopting the Equator Principles (EPs) for project financing transactions, which are:
Principle 1: review and categorisation.
Principle 2: social and environmental assessment.
Principle 3: applicable social and environmental standards.
Principle 4: action plan and management systems.
Principle 5: consultation and disclosure.
Principle 6: grievance mechanism.
Principle 7: independent review.
Principle 8: covenants.
Principle 9: independent monitoring and reporting.
Principle 10: EPFI reporting.
Launched in 2003 and revamped in 2006, the EPs represent a set of socio-environmental guidelines adopted by 68 banks worldwide for financing projects of a value of US$10 million or more. The EPs are intended to serve as a common baseline and framework for the implementation by each lender of its own internal social and environmental policies, procedures and standards related to its project financing activities.
Adoption of the EPs by a financial institution is voluntary but once such adoption has been made, the adopting entity must take all appropriate steps to implement and comply with them. Every adopting institution declares that it has or will put in place internal policies and processes that are consistent with the EPs and that it will report publicly (as required by Principle 10) regarding its implementation experience. As part of their review of a project's expected social and environmental impacts, EPFIs use a system of social and environmental categorisation, based on the environmental and social screening criteria of the International Finance Corporation (IFC).
In any cross-border financing, the parties (and banks in particular) take a political risk in the sense that a collapse of the existing political order in the borrower's country or the imposition of new taxes, exchange transfer restrictions, nationalisation, or other laws may jeopardise the prospects of repayment and recovery. In project financing, the political risks are more acute for many reasons, including:
The project itself may require governmental concessions, licences or permits to be in place and maintained, particularly where the project is for power generation, transport, infrastructure or the exploitation of the country's natural resources (such as oil, gas and minerals).
The project may be crucial to the country's infrastructure or security and accordingly be more vulnerable to the threat of expropriation or requisition. Power projects, airports, seaports, roads, railways, bridges and tunnels are obvious examples.
The term "political risk" is widely used in relation to project financing and can conveniently be defined to mean both the danger of political and financial instability within a given country and the danger that government action (or inaction) will have a negative impact either on the continued existence of the project or on the cash flow generating capacity of a project. Different projects and different project structures will obviously encounter different types of political risk. However, examples of events that might be classified as political risks are:
Expropriation or nationalisation of project assets (including the shares of a project company).
Failure of a government department to grant consent or a permit necessary for starting, completing, commissioning and/or operating a project or any part of it.
Imposition of increased taxes and tariffs in connection with the project, including products generated by the project, or, potentially, the withdrawal of valuable tax holidays and/or concessions.
Imposition of exchange controls restricting the transfer of funds outside the host country or the availability of foreign exchange.
Changes in law having the effect of increasing the borrower's or any other relevant party's obligations with respect to the project, for example, imposing new safety, health or environmental standards or other changes in law that result in changes being necessary to the design of any equipment or process.
Politically motivated strikes.
Terrorism.
There is no single way in which a lender can eliminate all project risks in connection with a particular project.
However, one of the most effective ways of managing and reducing political risks is to lend through, or in conjunction with, multilateral agencies such as the World Bank, the European Bank for Reconstruction and Development and other regional development banks such as the African Development Bank and the Asian Development Bank. There is a view that, where one or more of these agencies is involved in a project, the risk of interference from the host government or its agencies is reduced on the basis that the host government is unlikely to want to offend any of these agencies for fear of cutting off a valuable source of credits in the future.
This is a persuasive argument and certainly one that has some historical basis. For example, when countries such as Mexico, Argentina and Brazil were defaulting on their external loans in the early 1980s, they went to some lengths to avoid defaulting on their multilateral debts, whether project-related or not.
Other ways of mitigating against political risks include:
Private market insurance, although this can be expensive and subject to exclusions. In addition, the term for which such insurance is available is rarely long enough.
Obtaining assurances from the relevant government departments in the host country, especially as regards the availability of consents and permits.
The Central Bank of the host government may be persuaded to guarantee the availability of hard currency for export in connection with the project.
A thorough review of the legal and regulatory regime in the country where the project is to be located to ensure that all laws and regulations are strictly complied with and all the correct procedures are followed with a view to reducing the scope for challenge at a future date. This may have a limited ability to mitigate against political risk but is something that should be undertaken in any event.
In some countries, host governments (or their agencies) may be prepared to provide firm assurances to foreign investors and their lenders on some of the above matters. Obviously such assurances are still subject to performance risk regarding the host government concerned, but at a minimum they can make it difficult, as well as embarrassing, for a government to walk away from an assurance given earlier in connection with a specific project, on the basis of which foreign investors and banks have participated in that project.
In recent years the use of arbitration as a means of settling disputes has become increasingly common due to the relative speed and privacy that an arbitral process affords. Another significant advantage of arbitration, given the often complex nature of disputes that arise from project financings, is the ability to designate an arbitrator better equipped to address complex technical issues than a judge with more general skills. It is also the case that, in some instances, an arbitral award may be more likely than a court judgment to be enforced in the home jurisdiction of the party against whom it is made as international treaty arrangements, such as the New York Convention, call for member states to give effect to arbitral awards made in other member states.
Judicial proceedings, in some circumstances, may still be preferable to arbitration, particularly if that jurisdiction's courts have the ability to compel parties to refrain from certain actions, disclose documents and order interim relief (which can be very useful when one party is seeking to prevent another party from moving assets out of a jurisdiction). For this reason, lenders will typically insist that the finance documents include an arbitration clause which applies only for their benefit, thus preserving the possibility of recourse to the relevant jurisdiction’s courts. In addition, as arbitration is a product of contract, only parties that have specifically consented to the arbitration of a dispute can be compelled to proceed in that forum.
Major infrastructure projects are springing up all over Brazil, particularly as the country is due to host the World Cup in 2014 and the Olympic Games in 2016. Based on figures from 2009, a total of BRL274 billion (as at 1 April 2012, US$1 was about BRL1.8) is expected to be placed into infrastructure projects between 2010 and 2013, an increase of 37.3% from 2009. Construction works are being launched throughout Brazil, even in the most remote states, and foreign investment in the field is increasing even further. (For more information on major infrastructure projects planned and underway in Brazil, see PLC Construction and Projects multi-jurisdictional guide: Brazil.)
BNDES is the main financing agent for development in Brazil. Since its foundation in 1952, BNDES has played a fundamental role in stimulating the expansion of industry and infrastructure in the country. Over the course of the bank's history, its operations have evolved with Brazilian socio-economic challenges, and they now include support for exports, technological innovation, sustainable socio-environmental development and the modernisation of the public administration.
The bank offers several financial support mechanisms to Brazilian companies of all sizes as well as public administration entities, enabling investment in all economic sectors. In any supported undertaking, BNDES focuses on three areas it considers strategic:
Innovation.
Local development.
Socio-environmental development.
BNDES' disbursements reached BRL168.4 billion in 2010, a 23% increase on the previous year. This includes Petrobras' BRL24.7 billion capitalisation operation. When this operation (a one-off) is not considered, the bank's disbursements for 2010 were BRL143.7 billion, a 5% increase on 2009, and growth that is compatible with previously made projections.
Industry accounted for 47% of the bank's total disbursements, followed by infrastructure, at 31%, and trade and services, at 16%. In all areas of activity (agriculture, industry, infrastructure, trade and services) disbursements grew in 2010, resulting mostly from the successful Investment Maintenance Programme (PSI). Launched in July 2009, the PSI was instituted to increase investment in the country in the face of the global financial and economic crisis.
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Qualified. Brazil, 1992
Areas of practice. Projects; construction law; engineering contracts.
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