UNIT 4: PROJECTS AND THEIR LIFE CYCLE/

INTRODUCTION TO PROJECT FINANCE

In order to understand project finance first we have to understand Projects and

their life cycle.
A project is a unique endeavour to produce a set of deliverables within clearly
specified time, cost and quality constraints. Projects are different from standard
business operational activities as they:
• Are unique in nature. They do not involve repetitive processes. Every project
undertaken is different from the last, whereas operational activities often
involve undertaking repetitive (identical) processes.
• Have a defined timescale. Projects have a clearly specified start and end date
within which the deliverables must be produced to meet a specified customer
requirement.
• Have an approved budget. Projects are allocated a level of financial
expenditure within which the deliverables are produced, to meet a specified
customer requirement.
• Have limited resources. At the start of a project an agreed amount of labour,
equipment and materials is allocated to the project.
• Achieve beneficial change. The purpose of a project is typically to improve an
organization through the implementation of business change.
• Involves an element of risk. Projects entail a level of uncertainty and therefore
carry business risk. Project risks are unique and take three forms:
 Symmetric risk – This is the probability of loss that occurs when there is
movement in underlying asset. For example, if the price of an asset
dropsby $10then the loss will also be $10. Symmetric risks can also be
broken down into:
- Demand, price risks;
- Input/ supply risks;
 - Currency, interest rates, inflation risks.
 Asymmetric downside risk which can be further broken down into:
- Environmental;
- Creeping expropriation.
 Binary risk –The risk to either the upside or the downside movement
which can be broken down into:
- Technology failure;
- Counterparty failure.
The above mentioned risks will be discussed in detail in later units.
What is project management?
Project finance cannot be discussed without having a clear understanding of
project management. Project Management is the skills, tools and management
processes required to undertake a project successfully. The components of
project management are highlighted in the figure below.

Fig. 10.1 Project management components

• A set of skills. Specialist knowledge, skills and experience are required to

reduce the level of risk within a project and thereby enhance its likelihood of
success.
• A suite of tools. Various types of tools are used by project managers to
improve their chances of success. Examples include document templates,
registers, planning software, modelling software, audit checklists and review
forms.
• A series of processes. Various processes and techniques are required to
monitor and control time, cost, quality and scope on projects. Examples include
time management, cost management, quality management, change management,
risk management and issue management.
The project life Cycle
The project life cycle consists of four phases as shown in the figure below.

Fig. 10.2 Project Life Cycle

(i) Project initiation
The first phase of a project is the initiation phase. During this phase a business
problem or opportunity is identified and a business case providing various
solution options is defined. Next, a feasibility study is conducted to investigate
whether each option addresses the business problem and a final recommended
solution is then put forward. Once the recommended solution is approved, a
project is initiated to deliver the approved solution. Terms of reference are
completed outlining the objectives, scope and structure of the new project and a
project manager is appointed. The project manager begins recruiting a project
team and establishes a project office environment. Approval is then sought to
move into the detailed planning phase.
 (ii) Project planning
Once the scope of the project has been defined in the terms of reference, the
project enters the detailed planning phase. This involves creating a:
• project plan outlining the activities, tasks, dependencies and timeframes;
• resource plan listing the labour, equipment and materials required;
• financial plan identifying the labour, equipment and materials costs;
• quality plan providing quality targets, assurance and control measures;
• risk plan highlighting potential risks and actions to be taken to mitigate those
risks;
• acceptance plan listing the criteria to be met to gain customer acceptance;
• communications plan describing the information needed to inform
stakeholders;
• procurement plan identifying products to be sourced from external suppliers.
At this point the project will have been planned in detail and is ready to be
executed.
(iii) Project execution
This phase involves implementing the plans created during the project planning
phase. While each plan is being executed, a series of management processes are
undertaken to monitor and control the deliverables being output by the project.
This includes identifying change, risks and issues, reviewing deliverable quality
and measuring each deliverable produced against the acceptance criteria. Once
all of the deliverables have been produced and the customer has accepted the
final solution, the project is ready for closure.
(iv) Project closure
Project closure involves releasing the final deliverables to the customer,
handing over project documentation to the business, terminating supplier
contracts, releasing project resources and communicating the closure of the
project to all stakeholders. The last remaining step is to undertake a post-
implementation review to quantify the level of project success and identify any
lessons learnt for future projects.

INTROUDUCTION TO PROJECT FINANCE

A huge body of literature is available today on the subject of structured finance
in general and project finance in particular. The majority of authors agree on
defining project finance as financing that as a priority does not depend on the
soundness and creditworthiness of the sponsors, namely, parties proposing the
business idea to launch the project. Approval does not even depend on the value
of assets sponsors are willing to make available to financers as collateral.
Instead, it is basically a function of the project’s ability to repay the debt
contracted and remunerate capital invested at a rate consistent with the degree
of risk inherent in the venture concerned. Project finance is the structured
financing of a specific economic entity—the SPV, or special-purpose vehicle,
also known as the project company—created by sponsors using equity or
mezzanine debt and for which the lender considers cash flows as being the
primary source of loan reimbursement, whereas assets represent only collateral.
Project finance is also used to refer to a non-recourse or limited recourse
financing structure in which debt, equity and credit entrancement are combined
for the construction and operation, or refinancing of a particular facility in a
capital-intensive industry.
 Non-recourse project financing – means that there is no recourse
(claim) to the projects sponsors assets for the debts or liabilities of an
individual project.
 Limited recourse (limited claim to asset) –means that there are limited
obligations and responsibilities of the project sponsor.
 Corporate sponsor (organizers) – invest in a legal independently called
the special purpose vehicle (SPV) created specifically to undertake the
project.
  Repayment of recourse and limited recourse – financing is from the
project itself.
The following five points are, in essence, the distinctive features of a project
finance deal.
(i) The debtor is a project company set up on an ad hoc basis that is financially
and legally independent from the sponsors.
(ii) Lenders have only limited recourse (or in some cases no recourse at all) to
the sponsors after the project is completed. The sponsors’ involvement in the
deal is, in fact, limited in terms of time (generally during the setup to start-up
period), amount (they can be called on for equity injections if certain economic-
financial tests prove unsatisfactory), and quality (managing the system
efficiently and ensuring certain performance levels). This means that risks
associated with the deal must be assessed in a different way than risks
concerning companies already in operation.
3. Project risks are allocated equitably between all parties involved in the
transaction, with the objective of assigning risks to the contractual
counterparties best able to control and manage them.
4. Cash flows generated by the SPV must be sufficient to cover payments for
operating costs and to service the debt in terms of capital repayment and
interest. Because the priority use of cash flow is to fund operating costs and to
service the debt, only residual funds after the latter are covered can be used to
pay dividends to sponsors.
5. Collateral is given by the sponsors to lenders as security for receipts and
assets tied up in managing the project.
Difference between project and corporate finance
A sponsor can choose to finance a new project using two alternatives:
1. The new initiative is financed on balance sheet (corporate financing).
2. The new project is incorporated into a newly created economic entity, the
SPV, and financed off balance sheet (project financing).
The table below shows the main differences between project and corporate
finance.
Table 11.1 The main differences between corporate and project financing

Alternative 1 means that sponsors use all the assets and cash flows from the
existing firm to guarantee the additional credit provided by lenders. If the
project is not successful, all the remaining assets and cash flows can serve as a
source of repayment for all the creditors (old and new) of the combined entity
(existing firm plus new project).
Alternative 2 means, instead, that the new project and the existing firm live two
separate lives. If the project is not successful, project creditors have no (or very
limited) claim on the sponsoring firms’ assets and cash flows. The existing
firm’s shareholders can then benefit from the separate incorporation of the new
project into an SPV. One major drawback of alternative 2 is that structuring and
organizing such a deal is actually much more costly than the corporate financing
option. The small amount of evidence available on the subject shows an average
incidence of transaction costs on the total investment of around 5–10%. There
are several different reasons for these high costs.
Sectors where project financing is used
Project finance techniques have enabled projects to be built in markets using
private capital. These private finance techniques are a key element in scaling
back government financing. Such agendas make project financing a key method
of using private capital to achieve private ownership of public services such as
energy, transportation and other infrastructure development initiatives. The goal
ultimately is to make government irrelevant and achieve a two-tier society
where government panders to the marginalized and infrastructure development
and exploitation are handed over to private capital, free from the encumbrances
of electoral mandates. Therefore project finance is used in large infrastructure
projects like:
(i) Energy. Project finance is used to build energy infrastructure in
industrialized countries as well as in emerging markets.
(ii) Oil. Development of new pipelines and refineries are also successful
uses of project finance. Large natural gas pipelines and oil refineries
have been financed with this model. Before the use of project finance,
such facilities were financed either by the internal cash generation of
oil companies, or by governments.
(iii) Mining. Project finance is used to develop the exploitation of natural
resources such as copper, iron ore, or gold mining operations in
countries as diverse as Chile, Ghana and Australia.
(iv) Highways. New roads are often financed with project finance
techniques since they lend themselves to the cash flow based model of
repayment.
(v) Telecommunications. The burgeoning demand for
telecommunications and data transfer via the Internet in developed and
developing countries necessitates the use of project finance techniques
to fund this infrastructure development.
(vi) Other sectors targeted for a private takeover of public utilities and
services via project finance mechanisms include pulp and paper
projects, chemical facilities, manufacturing, hospitals, retirement care
facilities, prisons, schools, airports and ocean-going vessels.
Real examples
 1. CASE: BP AMOCO
Background -In 1999 BP AMOCO the largest shareholder in A10C, the 11 firm
consortium formed to develop the Caspian oilfields in Azerbaijan had to decide
the mode of financing for its share of the $10billion second phase of the project.
For this project the SPV specifically formed was A10C. The size of project was
$10 billion. The risks involved were:
-Political risks involved with investing in Azerbaijan a new country formed
after the collapse of the Soviet Union.
-Risk of transporting the oil through unstable and hostile countries.
- Industry risks: price of oil and estimation of reserves.
-Financial risks: The project fell just after the Asian and Russian default of
1996-1998 years.
2. The Eurotunnel between the United Kingdom and France
To finance the tunnel connecting the United Kingdom and mainland Europe,
project finance was used. Two companies were incorporated in France and the
UK specifically to build the project. Syndicate loans involving more than 220
banks were used to finance the project.
THE ADVANTAGES AND DISADVANTAGES OF PROJECT
FINANCE
Advantages
The following are the advantages of using project finance to finance a business:
■ Non-recourse/limited recourse financing Non-recourse project financing
does not impose any obligation to guarantee the repayment of the project debt
on the project sponsor. This is important because capital adequacy requirements
and credit ratings mean that assuming financial commitments to a large project
may adversely impact the company’s financial structure and credit rating (and
ability to access funds in the capital markets).
■ Off balance sheet debt treatment The main reason for choosing project
finance is to isolate the risk of the project, taking it off balance sheet so that
project failure does not damage the owner’s financial condition. This may be
motivated by genuine economic arguments such as maintaining existing
financial ratios and credit ratings. Theoretically, therefore, the project sponsor
may retain some real financial risk in the project as a motivating factor,
however, the off balance sheet treatment per say will effectively not affect the
company’s investment rating by credit rating analysts.
■ Leveraged debt. Debt is advantageous for project finance sponsors in that
share issues (and equity dilution) can be avoided. Furthermore, equity
requirements for projects in developing countries are influenced by many
factors, including the country, the project economics, whether any other project
participants invest equity in the project, and the eagerness for banks to win the
project finance business.
■ Avoidance of restrictive covenants in other transactions Because the
project financed is separate and distinct from other operations and projects of
the sponsor, existing restrictive covenants do not typically apply to the project
financing. A project finance structure permits a project sponsor to avoid
restrictive covenants, such as debt coverage ratios and provisions that cross-
default for a failure to pay debt, in the existing loan agreements and indentures
at the project sponsor level.
■ Favourable tax treatment Project finance is often driven by tax efficient
considerations. Tax allowances and tax breaks for capital investments etc. can
stimulate the adoption of project finance. Projects that contract to provide a
service to a state entity can use these tax breaks (or subsidies) to inflate the
profitability of such ventures.
■ Favourable financing terms Project financing structures can enhance the
credit risk profile and therefore obtain more favourable pricing than that
obtained purely from the project sponsor’s credit risk profile.
■ Political risk diversification Establishing SPVs (special purpose vehicles)
for projects in specific countries quarantines the project risks and shields the
sponsor (or the sponsor’s other projects) from adverse developments.
■ Risk sharing Allocating risks in a project finance structure enables the
sponsor to spread risks over all the project participants, including the lender.
The diffusion of risk can improve the possibility of project success since each
project participant accepts certain risks; however, the multiplicity of
participating entities can result in increased costs which must be borne by the
sponsor and passed on to the end consumer –often consumers that would be
better served by public services.
■ Collateral limited to project assets Non-recourse project finance loans are
based on the premise that collateral comes only from the project assets. While
this is generally the case, limited recourse to the assets of the project sponsor is
sometimes required as a way of incentivizing the sponsor.
■ Lenders are more likely to participate in a workout than foreclose
The non-recourse or limited recourse nature of project finance means that
collateral (a half-completed factory) has limited value in a liquidation scenario.
Therefore, if the project is experiencing difficulties, the best chance of success
lies in finding a workout solution rather than foreclosing. Lenders will therefore
more likely cooperate in a workout scenario to minimize losses.
Disadvantages of project finance
■ Complexity of risk allocation Project financings are complex transactions
involving many participants with diverse interests. This results in conflicts of
interest on risk allocation amongst the participants and protracted negotiations
and increased costs to compensate third parties for accepting risks.
■ Increased lender risk Since banks are not equity risk takers, the means
available to enhance the credit risk to acceptable levels are limited, which
results in higher prices. This also necessitates expensive processes of due
diligence conducted by lawyers, engineers and other specialized consultants.
■ Higher interest rates and fees Interest rates on project financings may be
higher than on direct loans made to the project sponsor since the transaction
structure is complex and the loan documentation lengthy. Project finance is
generally more expensive than classic lending because of:
■ the time spent by lenders, technical experts and lawyers to evaluate the
project and draft complex loan documentation;
■ the increased insurance cover, particularly political risk cover;
■ the costs of hiring technical experts to monitor the progress of the project and
compliance with loan covenant;
■ the charges made by the lenders and other parties for assuming additional
risks.
■ Lender supervision In order to protect themselves, lenders will want to
closely supervise the management and operations of the project (whilst at the
same time avoiding any liability associated with excessive interference in the
project). This supervision includes site visits by lender’s engineers and
consultants, construction reviews, and monitoring construction progress and
technical performance, as well as financial covenants to ensure funds are not
diverted from the project. This lender supervision is to ensure that the project
proceeds as planned, since the main value of the project is cash flow via
successful operation.
■ Lender reporting requirements Lenders will require that the project
company provides a steady stream of financial and technical information to
enable them to monitor the project’s progress. Such reporting includes financial
statements, interim statements, reports on technical progress, delays and the
corrective measures adopted, and various notices such as events of default.
■ Increased insurance coverage The non-recourse nature of project finance
means that risks need to be mitigated. Some of this risk can be mitigated via
insurance available at commercially acceptable rates. This however can greatly
increase costs, which in itself, raises other risk issues such as pricing and
successful syndication.
■ Transaction costs may outweigh the benefits The complexity of the project
financing arrangement can result in a transaction whose costs are so great as to
offset the advantages of the project financing structure. The time-consuming
nature of negotiations amongst various parties and government bodies,
restrictive covenants, and limited control of project assets, and burgeoning legal
costs may all work together to render the transaction unfeasible.
Common misconceptions about project finance
There are several misconceptions about project finance:
■ The assumption that lenders should in all circumstances look to the project as
the exclusive source of debt service and repayment is excessively rigid and can
create difficulties when negotiating between the project participants.
■ Lenders do not require a high level of equity from the project sponsors. This
may be true in absolute terms but should not obscure the fact that an equity
participation is an effective measure to ensure that the project sponsors are
incentivized for success.
■ The assets of the project provide 100% security. Whilst lenders normally look
for primary and secondary sources of repayment (cash flow plus security on
project assets), the realizable value of such assets (e.g. roads, tunnels and
pipelines which cannot be moved) are such that the security is next to
meaningless when compared against future anticipated cash flows. Security
therefore is primarily taken in order to ensure that participants are committed to
the project rather than the intention of providing a realistic method of ensuring
repayment.
■ The project’s technical and economic performance will be measured
according to pre-set tests and targets. Lenders will seek flexibility in
interpreting the results of such negotiations in order to protect their positions.
Borrowers on the other hand will argue for purely objective tests in order to
avoid being subjected to subjective value judgements on the part of the lenders.
■ Lenders will not want to abandon the project as long as some surplus cash
flow is being generated over operating costs, even if this level represents an
uneconomic return to the project sponsors.
■ Lenders will often seek assurances from the host government about the risks
of expropriation and availability of foreign exchange. Often these risks are
covered by insurance or export credit guarantee support. The involvement of a
multilateral organization such as the World Bank or regional development
banks in a project tends to ‘validate’ a project and reassure lenders’ concerns
about political risk.

SOURCES OF FUNDS FOR PROJECT FINANCING

Because of limited and non-recourse financing nature of project financing,
raising funds can be difficult. In assembling a project financing deal, all
available sources should be evaluated.
These are three categories of project financing providers:
(i) Public sector
These providers can provide debt and equity and include. They include:
- Government department and agencies (treasury)
- Special funds.
(ii) Private sector
The following are public sector project financing providers:
- Commercial Bank – it is rare for banks to hold equity. Most of the time banks
hold debt by forming syndicated loans.
- Development Banks like the African development bank, Asian development
bank, World Bank, etc.
- Islamic Banks – note that Islamic banking is different from normal banking.
- International investors like pension funds and other fund managers.
(iii) Project participants
Project participants who provide funding include the SPV, Suppliers and
Contractors.
Types of project financing instruments
There are two types of project financing instruments:
(i) Equity
(ii) Debt
Equity
The SPV is a corporation or limited partnership in which sponsors put up
equity. The law in many countries requires a minimum amount of initial capital
that sponsors must confer when SPV is formed, but this a small amount. There
are 3 alternatives to pay in the majority of equity which must be negotiated
beforehand with pool of lenders:
(i) Paying in the remaining capital before starting to draw on the loan granted by
banks;
(ii) Paying in the remaining capital after the loan facility has been fully utilized;
(iii) A clause establishing pro-rata payments.
It is important to know that shares of the SPV can be issued on the stock
markets. This is mainly done 5-6 years after the venture becomes operational so
that institutional investors can launch a secondary offer to sell the securities in
their portfolio.
Equity is subordinate to debt. Debt will be repaid first then equity hence high
capital risk exists.
Debt
There are 4 types of debts extended to projects:
- Bank loans
- Bonds
- Subordinated loans
- Project leasing
1. Bank loans (senior debt)
This accounts for a bulk of financing for privately owned projects. Bank loans
are provided by commercial banks in 4 ways:
- The base facility – this is debt granted to the SPV to finance construction and
will be repaid from cash flows the project generates in the operating phase.
- Working capital facility – this is the second tranche of debt that banks make
available to the borrower and is intended to finance any cash deficit arising as a
result of the cash collection cycle, that is, the difference between the average
collection period for trade receivables plus average age of inventories and be
average payment period for supplier accounts payable.
- Standby facility – this is a tranche of additional debt made available to the
SPV to cover contingences arising during the project's life cycle. The tranche
can only be used if specific events occur and these are:
 A standby loan only utilizable to cover additional costs to those estimated
in the budget.
 A standby loan utilizable to cover additional costs compared to those
budgeted after the base facility has been completely used.
Note that loans can be disbursed in the currency of the SPV's home country or
in one or more foreign currencies. The latter is called multicurrency agreement.
- The VAT facility – this is the loan given to the SPV with VAT refunds acting
as collateral.
2. Bond financing
A project bond issue is an alternative that an SPV can use to obtain funding. As
in the case of bank loans, the principal and interest on project bonds are also
repaid to investors from project cash flows. A bonds is a debt facility that an
entity issues. The bonds pays interest (coupon) during the duration or life of
bond and pay face value at maturity.
Bonds are issued by SPV and are suitable for project finance because they are
long term. They are issued on the capital market.
Project bonds can be classified based on different characteristics:
 Nationality of the issuer in terms of issue currency;
 Target investors (domestic, foreign);
 Surbodination clauses (Junior, senior);
 Existence of capital and interest payment guarantees or otherwise
(collateralized bonds, monoline bonds).
 Interest calculation method (fixed rate bonds, free floating).
 Capital repayment method (total repayment or bullet payment)

3. Subordinated loans
Subordinated loans also called Mezzanine financing or quasi-equity loans. They
are senior to equity capital but junior to senior debt and secured debt.
Subordinated loans are loans given out to the SPV by equity sponsor or other
interested parties of the project. There are a number of reasons why sponsors
prefer subordinated loans.
 A subordinated loan requires payment of interest after senior debt service
but before dividends. This means the sponsors remuneration is more
certain than just relying on dividends and also reduces volatility of
returns on total funds contributed to the project.
 Interest paid on subordinated debt is tax deductible in many countries.
 Especially during the initial years of the project's life, recourse to
subordinated debt means the so called «dividend trap» can be avoided.
4. Project leasing
A lease is a contract calling for the lessee (user) to pay the lessor (owner) for
use of an asset. A lease is a financial rent of assets with an option that the lessee
will buy out the asset at the end of the lease contract at a reduced fee. In a
project leasing contract, the leasing company (lessor) provides the assets to the
SPV (lessee) after purchasing it from the manufacturer (supplier). In turn the
SPV commits to pay the lessor installments (either fixed or floating) for a given
period of time according to a pre-established timetable.
While the project lease contract does not differ from a regular leasing contract,
some differences exist, which include:
 The type of asset obtained in leasing by the SPV.
 Relations with lenders are regards to debt (essentially with the pool of
banks that materially disburses funding to complete the structure to be
assigned in leasing).
Advantages of leasing
1. Getting syndicated loans can be expensive as SPV has no credit history and
also because of the non-recourse nature of project financing. Leasing can be
cheaper because the leasing company might be long in the business hence has
knowledge of risk mitigation.
2. Leasing has some tax incentives in a lot of countries.
MAIN SOURCES OF EQUITY AND DEBT FOR PROJECTS
The main sources of equity and debt can be divided into two groups of lenders
and sponsors.
Group 1 – commercial lenders, include:
1. Banks;
2. Institutional lenders;
3. Commercial finance companies;
4. Leasing companies;
5. Individuals;
6. Investment management companies;
7. Money market funds.
Groups 2 – commercial sponsors, include:
1. Companies requiring the product or service;
2. Companies supplying products or raw materials to the project;
3. International agencies;
4. Government export financing agencies, and national interest lenders;
5. Host government;
6. Contractors;
7. Trade creditors;
8. Vendor financing equipment.
We now look at the sources in detail:
1. The World Bank and area development banks
These provide debt or a mixture of debt and equity.
Advantages
1. The loans tend to be for longer terms than might otherwise be available.
2. Possibly offered at fixed interest rates.
3. Interest rates tend to be lower than would otherwise be possible.
4. Participation of the World Bank endorses the credit for other potential
lenders.
Disadvantages
1. A lengthy approval process, which may delay the project for months or years.
2. The funds provided may be in currencies difficult to hedge and create
significant currency risks.
2. Government export financing and national interest lenders
This is generally available from two sources or a combination of both:
- From Export and Import banks (EXIM banks)
- Foreign aid which comes into two forms:
1. from the private sector of the country where government is providing aid.
2. Sources from the recipient of the purchases of goods and services.
Types of finance extended by government export financing and national interest
lenders include:
1. Loans and guarantees.
2. Supplier credit - a loan is made to the supplier and the supplier quotes
financing terms to the purchaser. Usually requires the supplier to assume some
portion of the risk of financing.
3. Buyer credit- the loan is made to the buyer instead of the supplier.
Typical terms of the loans
1. Five to ten years;
2. Low interest compared to commercial sources;
3. Currency normally in the currency of supplying country;
4. Fees: A fee of 0.5 -1% is typically required;
5. Security – satisfactory corporate guarantees or montages.
Advantages
1. A fixed rate of interest often available;
2. A lower rate of interest than would otherwise be available;
3. A loan for a longer term than would otherwise be available;
4. The quasi – government expropriation or interference in the project.
Disadvantages
1. Delays in procedures to obtain such loans.
2. The project may not generate the currency needed to repay the loan, thereby
creating a currency exposure.
3. The equipment available from the countries supplying the credit may not be
the best suited for the project.
4. The quality of services performed may not be as satisfactory as those
available from other sources.
5. Additional equipment or services may be needed which are not covered by
the export financing.
6. The equipment used may require expensive maintenance.
3. Host government
The host government provides the following direct and indirect assistance:
- Equity investment by government investment companies;
- Investment grants;
- Government subsidized loans to support new enterprises;
- Income tax concessions;
- Subsidized energy costs, transportation, communications etc.
4. Commercial banks
These tend to limit commitments from five to ten years with floating interest
rates. Loans often arranges as syndicated bank loans.
5. Institutional lenders
These include insurance companies, pension funds, charitable foundations etc.
6. Money market funds
These concentrate their investments in short-term debt such as certificates of
deposit, short-term notes and commercial paper.
7. Leasing companies
These use tax benefits associated with equipment ownership to offer attractively
priced leases for equipment.
8. Suppliers of raw materials
A supplier seeking a market for a product or a by-product which it produces is
sometimes willing to subsidize construction, or guarantee debt of a facility
which will use that product.
9. New product buyers or service users
A corporation requiring a product or a service may be willing to provide
financial help in getting the project built.
10. Contractors
These provide support in the form of fixed price contracts and at the same time
guarantees to build a project facility at a certain price. Contractors can also
provide advice on the financing of the projects, having had considerable
expertise in dealing with lenders.
11. Trade creditors
These extend short-term credit linked to the sale of goods and services.
12. Sponsor loans and advances
This may not be a very satisfactory method of financing. It is necessary only in
case of cost over-runs and is preferable to capital contribution since a loan is
easily repaid. It is usually at a lower rate of interest.
SYNDICATE LOANS AND THEIR STRUCTURES
The large size of projects being financed often requires the syndication of the
financing. For example, the Eurotunnel project financing involved some 220
banks. The syndicated loan, exists because often any one lender individually
does not have the balance sheet availability due to capitalization requirements to
provide the entire project loan. Other reasons may be that it wishes to limit its
risk exposure in the financing or diversify its lending portfolio and avoid risk
concentration. The solution is to arrange a loan where there are several lenders
forwarding funds under a single loan agreement. Such a group of lenders is
often called a syndicate. A syndicate of banks might be chosen from as wide a
range of countries as possible to discourage the host government from taking
action to expropriate or otherwise interfere with the project and thus jeopardize
its economic relations with those countries. The syndicate can also include
banks from the host country, especially when there are restrictions on foreign
banks taking security in the country.
What is a syndicate loan?
A syndicated loan is a loan that is provided to the borrower by two or more
banks, known as participants, which is governed by a single loan agreement.
The loan is arranged and structured by an arranger and managed by an agent.
The arranger and the agent may also be participants. Each participant provides a
defined percentage of the loan, and receives the same percentage of repayments.
There are various categories of lenders in loan syndication, typically:
■The arranger The bank that arranges the syndication is called the arranging
bank or lead manager. The bank typically negotiates the term sheet with the
borrower as well as the credit and security documentation.
■The managers The managing bank is typically a title meant to distinguish the
bank from mere participants. In other words, the bank may take a large portion
of the loan and syndicate it, thus assuming some of the underwriting risk.
Managers can therefore broaden the geographic scope of the syndication. This
role is reflected in the title which then features in the facility tombstones and
any other publicity relating to the facility.
■The facility agent exists to administer the administrative details of the loan on
behalf of the syndicate. The facility agent is not responsible for the credit
decisions of the lenders in entering into the transaction. The agent bank is
responsible for mechanistic aspects of the loan such as coordinating
drawdowns, repayments, and communications between the parties to the finance
documentation, such as serving notices and disseminating information. The
Facility Agent also monitors covenant compliance and, when necessary, polls
the bank group members in situations where a vote is needed (such as whether
to declare a default or perfect security arrangements) and communicates these
decisions to the borrower.
■Technical/engineering bank as the name implies monitors the technical
progress and performance of the project and liaise with the project engineers
and independent experts. As such, the bank is responsible for identifying
technical (engineering) events of default.
■Account bank The account bank is the bank through which all project cash
flows pass and are monitored, collected, and disbursed.
■Insurance bank The insurance bank undertakes negotiations in connection
with project insurances, to ensure that the lender’s position is fully covered in
terms of project insurance.
■The security trustee exists where there are different groups of lenders or
other creditors interested in the security and the coordination of their interests
will call for the appointment of an independent trust company as security
trustee.
We have analysed the roles of financial advisors and arrangers separately. It is
now time to clarify if the same bank (whether an investment bank or
commercial bank)can simultaneously be both the financial advisor and the
arranger of the deal, provided, of course, that the advisor has the financial
strength to take on the task of organizing the pool of lenders. As for the SPV-
borrower, there are three alternatives (i.e. there are three main models in which
a syndicate is done):
1. The first is to maintain a clear-cut division between the roles of financial
advisor and arranger: The borrower decides not to allow its financial
advisor to participate in the loan pool once this is structured
(specialization model).
2. The second alternative is exactly the opposite, in which case the borrower
decides beforehand that the chosen financial advisor will also be the
arranger in the second phase (integration model).
3. The third situation lies somewhere between the previous two, namely,
where the borrower decides to allow its financial advisor to compete with
others for the role of arranger.
Benefits and drawbacks of the models:
1. Separating roles has a benefit of potential conflict of interests.
2. A pure advisor never invests money so other banks might be scared that
the project offered is risky.
3. Specialization brings duplication of duties.
Bank advisory services
Task of advisor include:
- To understand fully the sponsor's objectives and then to identify solutions to
achieve them.
- To identify risks and find ways of mitigation them.
- To assist sponsors in preparing the information memorandum.
- To assist sponsors in preparing and negotiating mayor contracts.
- To highlight problems sponsors have not consider, but need to be resolved.
- To assist sponsors as regard certification of permits, authorizations etc.
Arranging services
- Arranging consists of the mandate from the borrower to structure and manage
the financing.
- The arranger must have the capacity to contract a large number of banks
interested in taking part in the deal.
- Sponsors select arrangers based on some of the following factors:
1. Experience;
2. Reputation and track record;
3. Flexibility;
4. Cost of financing.
The international loan syndicate market
The syndicated lending market is international by nature, that is to say, many of
the borrowers and projects being financed are international taking place in
Europe, Eastern Europe, Africa, the Middle East, etc. Furthermore, in order to
place these large loans (e.g. up to several hundred million dollars) in the market,
sometimes several banks are needed to participate in these loans.
The factors which account for the size and spectacular growth of this market are
several:
■ The market is international rather than being confined to a particular country,
and new debt issues can avoid a great deal of national regulation which may
involve onerous registration requirements. This can lead to a significant
reduction in the cost of the issue.
■ The international syndicated lending market has evolved a very fast, efficient
and flexible distribution network which can place deals in large volumes and for
the most part can ensure that they are launched successfully and in an orderly
fashion.
■ This is because syndicated loans are managed, underwritten and sold by
syndicates. These syndicates are dominated by the London based Swiss,
American, European, and Japanese banks which have access to large client
bases.
■ The international marketplace gives borrowers access to a greater number and
diversity of investors than would be possible within their own marketplace. This
ability to tap different sources of finance can reduce overall interest costs.
■ The most important European banking markets are based in the UK. The
effect of London being the UK’s capital city should not be overestimated. The
large volume of activities, the variety and innovation of banking products, the
large number of people employed in the UK banking industry is significantly
influenced by the strength of the London trading and capital market activities.
The syndicated loan market was initially developed in London by a relatively
small number of merchant banks which had small balance sheets but large and
important customers. It would not have been possible for these merchant banks
to provide the full amounts of loans needed by their customers and so other
banks were asked to provide parts of the loans on the same terms and
conditions, with the merchant bank taking a fee to arrange the loan and
administer it once it was drawn. In today’s terms, the merchant bank was acting
as arranger and agent.
During the 1960s many North American and other foreign banks opened
branches in London, attracted by the growth of the new Eurodollar market.
These new branches could gain assets quickly and easily by participating in
syndicated loans to borrowers with which they would not otherwise have had a
relationship. The American and Japanese banks in particular began targeting
large companies with the specific intention of arranging syndicated loans in
order to maximize their fee income. In recent years in the London market, the
part played by Japanese banks as arrangers has lessened and some of the UK
clearing banks have become increasingly active. Today the syndicated loan
market is a major part of the operations of banks throughout the world, with
major centres in London, New York and Hong Kong. They are typically used to
finance large projects such as the JorfLasfar Power Station in Morocco – one of
the largest syndicated loans.