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- 1. 1 PF2205 Project Finance Riskmanagement in project finance Dr. Ali Ghahramani Department of the Built Environment National University of Singapore
- 2. 2 Syllabus – Lectures WeekTopic Tutorial 1 Introduction to Project Finance 2 Business model and industry analysis 3 Balance sheet, income statement, statements of retained earnings and cash flow Tutorial 1 odd week 4 Transactions and financial analysis: ratios and returns Tutorial 1 even week 5 Financial proforma Tutorial 2 odd week 6 Time value of money Tutorial 2 even week 7 Project finance model Tutorial 3 odd week 8 Project finance structure Tutorial 3 even week 9 Debt refinancing and secondary equity sales Tutorial 4 odd week 10 Risk management in project finance (ZOOM) Tutorial 4 even week 11 Holiday: Deepavali (31 Oct 24) 12 Contracts/agreements Tutorial 5 even week 13 Case studies, course and exam review
- 3. 3 Lecture overview We willcover • A review of past lecture • Project finance related risks • Risk management Quantitative risk assessment in project finance Theoretical principle of risk allocation Risk control for sponsors and lenders • Default and recovery rates in project finance • Finance model example on real-estate Financial statements & analysis Project finance structure Business model Develop a finance structure • Determine debt/equity validity Optimize the structure • Maximize NPV • Minimize debt/equity ratio Business model • Business model canvas Industry & competitor analysis • Porter's five forces analysis • ESG metrics Develop a financial model • Develop financial scenarios • Develop cash flow statements • Develop income statements • Determine investor NPV • Ensure timely lender payouts • Apply risk/uncertainty to financial model Read and decipher financial statements • Apply transactions • Calculate financial ratios Make investment decisions • Determine IRR Develop financial proforma • Determine break-even point Project finance model
- 4. 4 Reminders on project Pleaseinclude an exit plan, such as sales, absorption by the parent company, etc., as the project company (SVC) is not intended to exist indefinitely The deadline to submit your presentation is November 7 by 11:59 PM. Please email the link to your presentation to Kelly ( kelly_loh_li_ting@u.nus.edu) and me (ghahramani@nus.edu.sg) The deadline for the report is a week later, on November 14 by 11:59 PM You can upload the report here: Project Submission.
- 5. 5 Debt refinancing The processof financial structuring does not stop at Financial Close Opportunities may be open to refinance the debt, usually once higher risky phase (e.g., construction) is complete and the project is operating normally, and revenues are coming in • Reflecting the reduction in risk When all the project and financing agreements have been signed, all conditions on those agreements have been met
- 6. 6 Refinancing possibilities Get anew loan to pay the existing loan and • Reduce the interest rate • Reduce Debt Service Coverage Ratio (DSCR) • Delay loan repayments • Increase debt Increase debt/equity ratio Cash-out refinance Additional closing costs may be due • 1-2% of the remaining loan balance The refinancing may be undertaken by • The original lenders • Other lenders The original debt is paid by new debt We exclude refinancing cost itself, which may be 1–1.5% of the refinanced amount • Some lenders increase interest rate to account for the costs
- 7. 7 Secondary equity sales Investorscome into projects at different stages and with different investment strategies and objectives Any project has various levels of risk over time • There are equity investors whose MARR sits in between high-risk investors and banks
- 8. 8 Windfall issue After refinancing,sponsors will have a limited long-term financial risk in the project • In other words, they don’t care anymore! Project Agreement may require the Offtaker/ Contracting Authority’s consent to be given before refinancing or equity sales can be undertaken
- 9. Risk management Risk control:Remove, reduce, retain risks • Remove Change the project scope • Transfer of risk Via an agreement/ contract/ insurance • Reduce Actions that reduce the probability of an event and overcome the effects of risk o Change in project scope o Change investment plan • Retain: Acceptance of risk (active, passive) o Lead to contingency plans (set of actions in case of occurrence) Risk identification Risk assessment Risk control Risk monitoring and communication Risk Management
- 10. 10 Project finance relatedrisks Project risks • Inherent in the project itself, or the market in which it operates • E.g., construction risks, operating risks, supply risks, environmental risks, uninsured risks, Financial risks • Relate to external economic effects not directly related to the project • E.g., inflation, interest rates, and currency- exchange rates Regulatory and political risks • Changes in law, or risks which relate to the effects of government action or Political Force Majeure events such as war and civil disturbance
- 11. 11 Quantitative risk assessmentin project finance • is the NPV of scenario i • is the probability of scenario i T4 – SGFF: n=3 (worst case, base case, best case) • Given P(worst case) = 0.2, P(base case)=0.6, P(best case)=0.2 P stands for Probability
- 12. 12 The theoretical principleof risk allocation in project finance Project Company’s (SVC) ability to absorb risk is limited • A common error is to leave too much risk with the Project Company Transfer of all risk away from the Project Company to other parties is not viable • Almost any risk can be transferred at a price Value for Money: would a large safety margin to cover risks make sense? Risks should be borne by those who are best able to control or manage them, and to bear their financial consequences • E.g., the risk of late Project Completion and its financial consequences for the project should ultimately be borne by the Construction Contractor, unless late Project Completion arises from events outside the Construction Contractor’s control, in which case insurance may step in to take such risks
- 13. 13 Stakeholders in projectfinance Stakeholder Type Description Project Company/Sponsor Owns and operates project Investor Provides financial resources as Equity Lender/ Financer/ Bank Provides financial resources as Loans/Debt Authority/ Government / Concession grantor Provides law, regulation, and/or financial incentive Constructor/ Contractor Provides engineering, procurement, and construction Operator Provides operations services Purchaser Purchases the outputs Supplier Provides supplies Not all investors are sponsors, as some may be passive equity participants without a management role
- 14. 14 Risk exposure forlender/financing stakeholders Project wins: • Sponsors win, lenders win Project wins a lot: • Sponsors win a lot, lenders win Project loses: • Sponsors lose, lenders may not lose Project loses a lot: • Sponsors lose, lenders lose Risk assessment by lenders is based more on the financial impact • A ‘low probability/ high impact’ risk is one that will usually concern the lenders • Worst case is more important than NPV (at risk) • Sponsors often feel that lenders are too conservative
- 15. 15 Risk control forsponsors Construction phase • Insurance premiums Fixed and usually paid at the beginning of the period • A contingency of around 10% of the Construction Contract cost, or 7–8% of total project costs However well-managed the budget, there is always a risk of unexpected events causing a cost overrun This contingency amount is funded within the total financing package Operation phase • Lenders generally allow the Project Company to assume the operating risks without requiring Sponsor support
- 16. 16 Risk control forlenders Contingent equity commitment • The Sponsors agree to inject a specific additional amount as equity into the Project Company to meet specified cashflow requirements Cost-overrun guarantee • The Sponsors agree to inject additional equity up to a certain limit to cover any cost overruns Completion guarantee • The Sponsors undertake to inject extra funding if necessary to ensure that construction of the project is completed by a certain date, thus taking on the risk that more funding for construction or initial debt payments may be required Performance guarantee • The Sponsors agree to provide additional funding for debt service if the cash flow is reduced by the project not operating to a minimum performance standard Claw-back guarantee • The Sponsors agree to make up any deficiency in the Project Company’s cash flow for debt service, to the extent they have received Distributions from the Project Company
- 17. 17 Project finance defaultrates according to S&P 7% of project-finance companies defaulted on their debt • 65% of the defaults originally received ‘speculative grade’ ratings, i.e., below investment grade. Reasons for failure included: • Technology or design failures that led to failed construction or chronic underperformance during operations • Operational performance consistently below projections • Poor hedging and commodity exposure to variation in fuel and other input prices • Market exposure on project outputs, such as electricity sold in the merchant power market • Structural and financial weaknesses, which were heightened by accidents, court judgments, or an unexpected need for sizable capital spending Often an event will only be terminal for a project that is already vulnerable for other reasons and lacks applicable insurance or adequate liquidity reasons
- 18. 18 Default details accordingto S&P Highest risk industries (% of loans defaulted): • Manufacturing (17%) • Metals & mining (12%) • Media & telecoms (12%). The lowest-risk industries: • Infrastructure (4%) • Oil and gas (8%) • Power (8%) Within infrastructure Public Private Partnerships default rates (2.6%) were lower than those for infrastructure as a whole, illustrating that this sector is probably the safest for project-finance lending
- 19. 19 Lender recovery rateaccording to S&P The average recovery was 75% of the outstanding debt • Loss rates are concentrated at either end of the scale: lenders either recovered almost all or very low of their debt (i.e., 3 lender got the full and 1 didn’t get any back) • The low-recovery cases were mainly in the natural- resources sector Overall, these figures confirm that project-finance is a low-risk business for lenders if organized and structured following market best practices
- 20. 20 Example: real-estate (condo)development All the costs ($150m) are paid as a lump sum to a design-build firm • Design and Construction time: 3 years • 20000 sqm GFA (200 units of 100 sqm) The sales start after construction finishes (COGS=60%) • Year 1: $180,000,000 • Year 2: $70,000,000 SG&A: $5m per year Loans: $100m, DSCR: 1.3 • Interest rate: 5% • Start paying back as soon as possible Equity: $50m • MARR: 15% No working capital needed
- 21. 21 Example: real-estate (condo)development - sales All the costs ($150m) are paid uniformly at the end of each year • Design and Construction time: 3 years The sales start after construction finishes (COGS=60%) • Year 1: $180,000,000 • Year 2: $70,000,000 SG&A: $5m per year Loans: $100m (raised uniformly over 3 years) • Interest rate: 5% • Start paying back as soon as possible Equity: $50m (raised uniformly over 3 years) • MARR: 10% No working capital needed
- 22. 22 Example: real-estate (condo)development - rent All the costs ($150m) are paid uniformly at the end of each year • Design and Construction time: 3 years The rent income is ($5000/month per unit x 200 units x 12 months x 0.95 vacancy rate) $11.4m/year and expected to grow by 3% per year • After 30 years, it will be absorbed by the parent company Operational costs: $2m per year and expected to grow by 2% per year SG&A: $1m per year and expected to grow by 2% per year Loans: $100m (raised uniformly over 3 years) • Interest rate: 5% • Start paying back as soon as possible Equity: $50m (raised uniformly over 3 years) • MARR: 15% No working capital needed (monthly rents cover short-term needs)
- 23. 23 Example: real-estate (condo)development – rent and cash-out refinance All the costs ($150m) are paid uniformly at the end of each year • Design and Construction time: 3 years The rent income is (5000/month per unit x 200 units x 12 months x 0.95 vacancy rate) $11.4m/year and expected to grow by 3% per year • After 30 years, it will be absorbed by the parent company Operational costs: $3m per year and expected to grow by 2% per year SG&A: $1m per year and expected to grow by 2% per year Loans: $100m (raised uniformly over 3 years) • Interest rate: 5% • Start paying back as soon as possible • Cashout-refinance at 1st , 5th , 10th , 15th , and 20th years with appraised values $250m, $350m, $400m, $500m, and $600m with an LTV of 75% - interest rate = 4%, DSCR = 1.2 Loan could remain at the time of absorption Equity: $50m (raised uniformly over 3 years) • MARR: 15% No working capital needed (monthly rents cover short-term needs)
- 24. 24 Example: real-estate (condo)development – NOT IN THE EXAM All the costs ($150m) are paid uniformly at the end of each year • Design and Construction time: 3 years The sales start after construction finishes (COGS=60%) • Year 1: $180,000,000 • Year 2: $70,000,000 SG&A: $5m per year Loans: $100m (raised uniformly over 3 years) • Interest rate: 5% • Start paying back as soon as possible Equity: $50m (raised uniformly over 3 years) • MARR: 15% No working capital needed Potential buyers put in deposits and get their units during 1st year • Year 1: $10,000,000 • Year 2: $40,000,000 • Year 3: $60,000,000 + up to 50% of deposits could be paid as dividends per year
- 25. 25 Lecture overview We covered •A review of past lecture • Project finance related risks • Risk management Quantitative risk assessment in project finance Theoretical principle of risk allocation Risk control for sponsors and lenders • Default and recovery rates in project finance • Finance model example on real-estate Financial statements & analysis Project finance structure Business model Develop a finance structure • Determine debt/equity validity Optimize the structure • Maximize NPV • Minimize debt/equity ratio Business model • Business model canvas Industry & competitor analysis • Porter's five forces analysis • ESG metrics Develop a financial model • Develop financial scenarios • Develop cash flow statements • Develop income statements • Determine investor NPV • Ensure timely lender payouts • Apply risk/uncertainty to financial model Read and decipher financial statements • Apply transactions • Calculate financial ratios Make investment decisions • Determine IRR Develop financial proforma • Determine break-even point Project finance model
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