«Project Financing and Risk Analysis Riad Dahel The Arab Planning Institute Kuwait November 1997 Paper prepared for presentation at an ESCWA Expert ...»
Project Financing and Risk Analysis
The Arab Planning Institute
Paper prepared for presentation at an ESCWA Expert Group Meeting on
“Institutional Aspects of Privatization”, Beirut: 1-3 December, 1997.
Since the beginning of the 1980s, a worldwide phenomenon of privatization
has been taking place, involving an increasing number of countries both developed
and developing. Just in the latter, the World Bank (1996) reports that total revenues from privatization amounted to $112 billion over the period 1988-94, reaching almost $27 billion in 1992 alone. Furthermore, approximately over the same period the majority of privatization transactions in these countries involved sales of industrial State-Owned Enterprises (SOEs) while infrastructure revenues represented a third of total revenues (Sader, 1995). This is to indicate the high value of a typical infrastructure project, whether in power, telecommunications, water and sanitation or transport. In addition to the large number of infrastructure projects privatized to date worldwide, an increasing number of greenfield projects are being undertaken with a significant participation by the private sector.1 The 1994 World Development Report, devoted to infrastructure, underlines the importance of this sector for economic development. The report notes that although developing countries spend 4% of their annual national output on infrastructure, two trends emerge: first, the quality of infrastructure services provided is well below par; and second, a significant infrastructure deficiency still remains.
The low quality of infrastructure services is mainly a reflection of the low efficiency believed to characterize a large number of SOEs, and the improvement of which constitutes one of the main objectives of privatization.2 As to the infrastructure deficiency observed in developing countries, it is mainly due to a combination of population growth which necessitates continuous infrastructure development and the reduced budgetary resources which most of these countries have had to face since the beginning of the 1980s.
In response, most governments turned to the private sector not just to take over existing infrastructure projects but also to undertake much needed new projects. Therefore, the poor quality of infrastructure services and the financial constraints faced by governments have contributed to weakening the argument traditionally made in favor of publicly-owned infrastructure, that is, its strategic importance to the economy.
Private sector involvement in infrastructure can take many forms. UNCTAD (1995) identifies four of these forms: service contracting, management contracting, privatization of development rights (which includes leasing and concessions) and private sector initiatives (which includes divestiture, full or partial). With respect to new investment projects in infrastructure, concession and particularly the BuildOperate-Transfer (BOT) arrangement (and its variants) has become in recent years the primary form of private participation in infrastructure.3 A BOT arrangement helps reduce the pressure on government finances and also bring in private sector efficiency to a project through its various phases. Despite the large initial costs and the long time frame of an infrastructure project, private financiers are increasingly interested in investing in this sector, which indicates that they expect to realize competitive rates of return given the potential risks associated with this type of investment.
In this paper, the scope is limited to the concession form of private sector involvement in infrastructure in developing countries, and more specifically the BOT arrangement (in the broad sense). Under this type of arrangement a number of financing sources are available to the project sponsors. However, financing a new infrastructure project may be a risky undertaking. The purpose of this paper is to analyze financing issues in the context of risk. The first part presents the different forms of financing an infrastructure project. The second part examines the main risks to which project financiers may be exposed, and discusses management of these risks.
Under the BOT approach, an infrastructure project can be either undertaken by a special purpose corporation or sponsored by an established company.
Financing of the project is typically of the nonrecourse or limited recourse type whereby the lenders can only be repaid from the revenues or cashflows generated by the project or from the sale of the assets if the project fails. Depending on the nature of the project, these revenues can be market driven or contract driven. In the first case the service is provided directly to the end user, like in a toll road project for instance. In the second case the service is provided to a specific customer, like when power is delivered to a public utility. Thus, under nonrecourse or limited recourse financing, also called project financing, potential lenders would be exposed to the various risks associated with the project. Furthermore, since an infrastructure project typically involves several parties each attempting to minimize its risk exposure, raising the funds for the project can be a very complex undertaking.4 In this context, the perception of the various providers of funds of the risks involved and the way in which these risks are allocated among the parties, will strongly affect the financing structure of the project.
In a recent evaluation of private participation in infrastructure projects in which it had been involved over the last thirty years, IFC (1996) reports that the average debt-equity ratio was 58:42 and also that 67% of the project costs were financed from foreign sources.5 Considering the leading role played by IFC in providing loan and equity finance to private sector investments in developing countries, the above figures could be taken as a fair approximation of a typical financing structure of an infrastructure project.6 In addition to the risks involved in an infrastructure project and how they are allocated among the parties, the financing structure also depends on the types of domestic and foreign sources of funds available. The various sources of financing could be broadly classified into three main categories: loans, debt securities and equity.
Loans The sponsors of an infrastructure project can obtain part of the funds required to undertake the project in the form of loans from financial institutions, mainly commercial banks. These funds could be raised both on the domestic and international markets. Infrastructure loans have two characteristics that distinguish them from other types of loans: they are significant in value terms, and they can only be repaid from the cashflows generated by the project. Therefore, they require that the lending institution be large and also that it have some experience in project financing which can be a very complex undertaking. Most banks in developing countries are still small by international standards and do not yet have the necessary know-how to engage in this type of financing. Consequently, international banks are still dominant in infrastructure lending.
Banks are generally restricted by their regulators as to the size of the loans they can provide to a single client, sector or country. They are also constrained by the time profile of their deposits. Therefore, they negotiate very carefully the terms of their involvement in a new infrastructure project in order to avoid the possibility of default by the borrowing party, which is the primary risk faced by any financial intermediary. To this end, banks engage in project risk management which covers the whole period of their exposure, that is, all phases of the project (engineering and construction, start-up and operations) if the loan extends into the operations phase.
Given the size of an average infrastructure loan, it is usually underwritten by several large international banks and in which domestic banks may take part.
Although syndicated loans require considerable time to be packaged, their main advantage is that they limit the exposure of each bank. Furthermore, the participation of a domestic bank in the deal and its willingness to take on part of the risk gives more confidence to the foreign partners in the viability of the project.
The same can be said about participation by multilateral government agencies such as IFC, the Inter-American Development Bank or the Asian Development Bank.7 Export credit agencies (ECAs) may also take part in the financing package provided by banks. This is usually the case for BOT projects which necessitate imports of equipment. However, opinions may differ as to the importance of the role of ECAs in infrastructure financing. O’Sullivan (1996), quoting two experts one from a commercial bank and the other from an ECA, notes that the bank officer believes that an ECA involvement is time-consuming and costly, while the ECA officer states that ECAs give more confidence to banks when they are involved in a project.
Debt Securities An alternative to loans available to sponsors of an infrastructure project are debt securities, essentially bonds. If a large firm with good credit ratings is the main sponsor of the project, it will not face major difficulties in issuing these bonds whether on the domestic or international markets. These long-term securities are mainly purchased by institutional investors such as pension funds and life insurance companies. For pension funds, the long-term nature of contributions and retirement payments make their investment policies long-term, and thus bonds are suitable securities for these institutions. Life insurance companies also have long-term investment policies since their revenues extend over a long period. Furthermore, these institutional investors generally face strict regulations and are limited as to the types of securities in which they can invest. Highly rated corporate bonds are considered by regulators as acceptable investments for these institutional investors.
Another type of bonds which may be issued by the sponsors are revenue bonds. Unlike bonds issued by an established company, these bonds are backed by the cashflows generated by the project as well as the project company assets. This is a riskier type of investment and thus potential investors will be very demanding and will scrutinize all aspects of the project before committing any funds.
Commercial paper, a short-term security, may also be issued by the sponsors. However, this type of security can only be issued by large and established companies and sold at a discount on international markets. Commercial paper can be a suitable source of funds to meet short-term needs of the project company.
In developing countries, bond markets are still limited to government securities. Therefore, for a private firm to issue bonds, it generally has to access international markets. Even then, IFC reports that greenfield projects face difficulty in marketing these bonds when they do not involve a strong sponsor and do not have government support.
Equity Unlike bonds which are fixed-income debt securities, equity securities represent ownership in the corporation. Although preferred stock characterized by fixed dividend is also an equity security, common stock is the main equity security.
The common stockholder is the residual claimant on the corporation’s income as well as assets, and is not guaranteed any return since the corporation is not required to pay any dividend. Therefore, common stocks are a risky investment. However, the stockholder may be willing to forego dividends if the value of the stock increases significantly, and thus he can derive a substantial capital gain.
In order to raise equity for an infrastructure project, the sponsors may access both the domestic and international markets.8 Stock markets in developing countries have grown noticeably in the last few years, especially those known as emerging markets. Therefore, sponsors will encounter less difficulty to market this type of security locally than in the case of bonds. Furthermore, issuance of stocks of infrastructure companies on the domestic markets will contribute to the development of these markets which in turn will make it easier for these companies to raise funds in the future.
Equity investment in a new infrastructure project in a developing country, although risky, may generate high returns. Indeed, the higher the performance of the project, the higher the return to equity investors. Thus, unlike bonds where income is fixed or loans where the return comes in the form of predetermined interest payments, return on equity could be very high. This potential makes various types of investors, both domestic and international, attracted to this type of investment. Among equity investors, and in addition to the individual investors, there can be investment banks (which can at the same time be part of the loan syndicate), life insurance companies (although very cautious), multilateral government agencies (such as IFC) and special investment funds. However, in any BOT project, lenders expect the sponsors to hold equity in their project. Walker and Smith (eds., 1995) cite two reasons why this is the case: one, if the debt service takes a considerable part of the cashflow, their loans will be at risk; and two, they want the sponsors to have some of their own funds in the project which will further motivate them to ensure a successful operation of this project.
Another financing source for infrastructure projects is what is known as quasi-equity or mezzanine finance. Benoit (1996) describes this type of investment as one that “frequently takes the form of debt, but enjoys many of the qualities of equity” (p.9). An example of this type of equity is the convertible unsecured loan stock which is a loan stock that pays fixed interest but gives its holder the right to convert it into common stock sometime in the future. Walker and Smith observe that this type of financing is attractive to both investors and project sponsors. For investors, the appeal is in the rate of return which is several percentage points higher than the cost of senior debt. For project sponsors, the advantage of such financing is that it allows the share of equity in the capital structure of the project to remain low which makes the return on equity higher.