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The 16 Risks -Risk
Mitigation
To get the Full Description of each of the 16 Risks, there is a large web page that can be accessed. This is a 'headings' version suited as a quick introduction/summary. Navigation is as follow: Consultants and engineering companies follow a fairly well-defined path that leads to a feasibility study (with an accuracy of plus or minus 5-20% depending on the depth of the analysis) which, with some financial analysis and perhaps market study(s), is translated into a "bankable" document. This is stated as being adequate to attract investors and financiers into putting up the development funds. If the company or state agency is strong enough, it can use its internal funding sources. Frequently an infrastructure development requires cash to be raised from investors (domestic or more often foreign), "majors" (that is other large construction, equipment, or operating companies), or via project financing from the banking community, the capital markets, or multilateral agencies.
A financier will undertake to absorb the consequences of certain risks and whenever it agrees to do so without further recourse to the other assets or financial strength of the sponsors, the finance is often called non-recourse financing.
The categories of risk sharing in an infrastructure project financing are as follows:
The operating risk has interrelated components: Technical, Management, and Costs. The ability to economically achieve the desired operating rate depends on the engineering, experience, and quality of staff applied to the project. Technical Component: As a general rule if:
then the financiers will take the Technical risk.
Cost Risk Component: A key element in the cash flow projections, which are the basis of assessing project financing, is the operating-cost projection.
A number of risk mitigants can be structured here such as:
Management Component: The experience of the management in efficiently applying the given technology is crucial when considering the projected operating performance of any project. The availability of sufficient trained workforce may also need close examination in some locations. The financiers may seek an employment contract or "key-man" insurance to ensure the continued involvement of the company and of strategic individuals. A management agreement may be needed to cover this risk component. Besides high skills and a proven track record, financiers may seek comfort from:
It is difficult to define the dividing line separating these three overlapping components of Operating Risk, but all are generally under the control of sponsors and are easier to absorb if the sponsors have a successful history of building and operating similar projects. (Navigation Return) Sponsor-Participant risk (This is sometimes called the Credit risk).The stature of the other companies/entities in the project may have an impact on the project financing especially if other participants are weak financially or technically. If there is a weak or inexperienced participant in a joint venture, the lenders may require cross guarantees. It is very important to study the concession agreement or the joint venture agreement (JVA) since its structure may seriously inhibit project financing. The cancellation, abandonment, and force majeure clauses may be crucial to the project finance document, which, after all, has its roots in the concession/JVA itself. No amount of project finance skill or structuring can overcome deficiencies in these agreements. Close scrutiny of the JVA will concentrate on provisions for forfeiture, dilution of interest, and compulsory contribution by the other joint venturers. A financially strong company will choose to project finance less often since it can access other funding source on a corporate basis and at a lower cost and with less hassle compared with documenting the complex risk-sharing mechanisms and supports in a project financing. Some large companies feel that they cannot "talk a walk" from a project that is project financed since it has their name associated with it; some financiers and ratings agencies depend on these companies feeling that way; and consequently the credit basis is essentially the corporation and not just the project. The main support structures to handle sponsor/participant risk in a project financing are as follows: Engineering risk (Also known as Design risk). This poorly understood risk is often counted as part of Completion Risk since engineering and design flaws become quickly noticeable as the project encounters difficulty in construction or startup. The risk here revolves around the poor quality of the engineer/design work which can also have a crippling impact on the cash flow stream well after the (excess) capital has been spent pre-completion to counter the hardware problem. This risk can arise from poor professional advice or selection of an inappropriate or inexperienced firm for the technology or location involved. Flaws in capital budgeting or poor design estimates are only coverable by outsiders under: Completion risk (Also called the Construction, Development, or Cost-Overrun risk). Broadly speaking, a lender expects the loan proceeds to be spent on building a project which is on time, at budget, and is capable of producing sufficient cash flow after completion of construction and commissioning to repay the loan comfortably. The Completion Risk is usually not taken by financiers in project lending and other financial support is necessary prior to completion. The usual format is to structure an objective completion test which, when satisfied, signals the pre-completion supports and undertakings are released and the project has commenced its limited-recourse status. This project-finance completion test is usually more extensive than the engineering/construction completion used by the construction contractor in standard turnkey contracts. There are two main types of completion tests. One calls for the construction to be finished by a certain date and the loan is immediately due if completion has not occurred by that fixed date. A more common test is a ‘performance’ completion test which might have all or some of the following types of components:
Completion tests are becoming more complex as project financiers become more experienced in sizing up acceptable levels of risk and as companies realise the possibilities of risk shedding while limiting the impact on their balance sheets. Additional completion test categories now seen include the following:
The implication of a sponsor accepting the Completion Risk is that cost overruns must be met by the company and, in the case of completion not being attained by a certain date, not achieving a project financing at all and the loan remains a corporate credit. In most Project Financing, this is certain to be the risk the financiers do not (hate to) take. Numerous devices have been structured to package this risk more tolerably and the author can identify at least eight major varieties of completion support:
Outside the company's control Supply risk Supply risk (This may also be known as the Traffic/Reserve risk).The financiers can almost always accept the Supply/Traffic risk. Extensive (independent) studies are needed to cover this risk and it is common for the financier to commission check/audit studies to verify the Sponsor(s) estimates on traffic/throughput. If supply is believed to be insufficient, the financiers may ask for a warranty. The following can be used:
Market risk (Sometimes called the Sales or Price risk). This risk is distinguished from the Traffic/Supply risk by its prime characteristics of price and sales volume, not just the volume/throughput. Market Risk occurs when:
This is one of the most critical areas of risk absorption by the financiers. The best coverage of Market Risk comes from long-term contracts extending beyond the end of the loan life, although sales contracts are not often feasible or desirable for certain infrastructure projects. The competitive position is examined in detail. A structured monopoly or technical link with a consumer is deemed highly desirable. Sometimes a sales completion test will be required as well as the performance completion test (See Completion Risk above) before the financiers assume the marketing risk. As a general rule of thumb, the financiers aim for the net present value of the sales proceeds net of operating costs to be at least 1.3 times the amount of loan outstanding -- for an infrastructure project 1.15 to 1.3 is the general rule of thumb. This key risk in project financing is the most difficult to cover and usually has the weakest support overall within the project's collection of risks. Supports and structures applicable here include: Infrastructure risk (Also called the Transportation risk). Infrastructure (other than that being developed in an infrastructure project itself) is a very important component of many infrastructure projects (e.g. access ramps/telephones/electricity supply) and financiers will need to be assured that the chosen infrastructure will remain technologically and economically competitive especially in comparison with other existing or potential infrastructure competitors. The materials handling required to deliver or export the production can sometimes equal or exceed the project’s operating and capital costs. Moreover, port capacity may be the limiting factor in remote projects. If the sales price is on a f.o.b. basis, the ability to pass through transportation costs in any sales arrangements means that the buyer absorbs this risk. In some locations, the government builds and operates the rail and port, but one must be careful that the operator is not "taxed" through higher freight rates or user rates. In general, the financiers will wish to review closely the transportation studies and perhaps to inspect the existing facilities or the proposed sites. Independent certification will assist the financier's absorption of this risk component. The types of supports available here are:
Environmental risk This risk must be addressed for projects in all locations of the world. A project financing cannot proceed without favourable assurance of environmental compliance from the local regulatory bodies with which the sponsors must deal. This risk category can also arise due to location of the project e.g. near towns or highway or in proximity to wilderness, heritage, native reserve, or scenic areas. This is not simply a sub-set of political risk but a distinct risk aspect of project financing today. Some multilateral agencies will not even let a project finance application in the door until it gets an environmental ‘tick’ first.
POLITICAL RISK (Actually a mix of risk categories such as nationalisation, currency inconvertibility, regulatory, and tax risks). Each Bank has a continuing review process of country risk based on evaluation of the political and economic outlook. Financiers are then willing to take some degree of the political risk for certain countries. Loans to sovereign borrowers in the country establish the market "price" for the country itself. In the event financiers decide they cannot absorb Political Risk, then some of the risks may be covered by government-sponsored export credit agencies; organisations like the OPIC for US companies or financiers; or through insurance from groups such as Lloyd of London or private insurance sources. Some surprisingly advantageous Political Risk insurance is now being written by large insurance groups; however, the amount is quite limited at the present. If the project financing parallels a World Bank/IFC or export-credit financing, then some (but not complete) comfort may be derived from the potential leverage from these government agencies. The risk of currency inconvertibility is usually due to arbitrary government action caused by serious balance-of-payment problems, which should have been identified in the country-economic analysis process. A mechanism will usually be set up to accrue the local currency in the operation that remittance will be permitted at a future date. Debt:equity swaps can also remobilise this inconvertible pool of funds. The more difficult areas which must be judged on a case-by-case basis concern the following:
The development agreement with the government can be subject to direct change or cancellation, or to the exercise of other government powers. It is not uncommon for project lenders to seek a direct guarantee from the government not to subvert the development agreement. In the case of war and insurrection, the financiers may, for example, share an individual risk component after a pre-agreed level of damage has been done. Guarantee mechanisms would otherwise be required in certain countries. A large project is a wide-open target for creeping nationalisation through a noose of continually changing tax or royalty regimes. Financiers will try to anticipate the impact of tax changes on the ability of the project to stand on its own and may not accept more than a defined portion of this risk. The most difficult aspect of Political Risk assessment is the impact of non-government political activists. It is quite common to see additional loan repayment time made available to a project where strikes are expected. In fact, force majeure coverage may be very important in such an insurance. This risk is one that the banks in their wisdom used to feel most equipped to handle, that is until the LDC debt mountain started to cast a shadow over bank loan portfolios everywhere. This is a prime motivation to invoke project financing since it brings a wider constituency to the forefront of a government's thinking on a project. Some of the main structures and supports are listed below:
Force Majeure risk Force majeure concerns events outside of the control of either the borrower or the lender. Some element of political risk may be included in the definition of force majeure. Financiers can usually absorb temporary Force Majeure Risk during both the construction and operating phases of the project due, for example, to a strike or unavoidable delay in the delivery of a crucial equipment part. But lenders are naturally cautious about permanent force majeure which is irreversible. Many force majeure events coincide with the other risk categories such as technical risk (water inflow) or political risk (government regulations), but lenders can often accept some of the permanent Force Majeure Risk through project financing. The expectation of such risk will lead to a requirement for a flexible transaction. Business interruption insurance is becoming more prevalent and is another way, favourably viewed by the financiers in a project financing, to cover Force Majeure Risk. However, it is not yet available amounts exceeding about $500 million. This is one of the risks which seems to affect almost every project at some stage of its development or operation. Supports can come from:
Foreign Exchange risk Besides currency inconvertibility (a Political risk), foreign exchange exposure can occur when project revenues differ from the currency of the project loan. Lenders usually avoid Foreign Exchange Risk in project financing. The best hedge is to match the loan currency to the (underlying) currency in which the price/tariff is set. A further step is to match equipment purchases to the sales revenue currency. However, if a large loan is required, the available loan currencies may be limited. Structures that can be applied include: (Navigation Return)Barter (Navigation Return) Within The Financiers’ Control Syndication risk. (May be called the Financing or Underwriting risk).Once of the terms and conditions of the project financing have been negotiated and documented, the actual funding has some risks which should be understood. Of course, if the loan is only given by one financier then this risk category does not apply. However, by a virtue of the usually large amounts involved, most projects involve a layering of financing or a syndicate of banks which has its own conventions. The arranger or lead managers (1-3 banks) carry the negotiating responsibility with the borrower and the participating banks. The agent bank (usually one of the lead managers) arranges the documentation and loan disbursements. The lead managers arrange a syndicate of banks, first choosing the managers (2-6 banks) and the co-managers (3-10 banks) whose ranking depends on the amounts of the loan; and finally the participating banks. The types of bank syndicates vary from fully underwritten or club deals among the lead managers to best-efforts commitment to raise money over and above the amount committed by the lead managers. A fully underwritten financing requires a slightly higher interest margin than a best-efforts financing. If it is decided to arrange a project financing in a number of sequential borrowings, then the borrower takes the risk that the interest margin may increase. This risk arises when the banking syndicate is being arranged. It is covered by:
Funding-Interest Rate risk Most bank project financings are funded on a floating-rate basis due to the necessity for flexibility in drawdowns and repayment. If interest rates escalate uncontrollably, the available cash flow can be correspondingly reduced and may not be sufficient to repay principal when due. Financiers usually accept this risk indirectly in a project financing. The longer term fixed rate capital markets have been aggressively chasing long-term infrastructure and power projects. Co-financing from government or quasi-government entities such as export credit agencies or the World Bank may help to introduce fixed-rate funding as well as longer maturities. This risk that interest rates will get out of hand is difficult to cover off through supports and guarantees, although some techniques can be applied.
Legal risk The burden of legal documentation (which in the end apportions the risks among the lenders, insurers, governments, buyer and sponsors) usually rests on the financier and its advisers. There is some risk that professional advisers will create risks in the document which can affect the tax position, tenure, security, enforcement and other attributes so heavily negotiated in the risk-sharing process embodied in the project financing in the first place. Second opinions, judgement, and experienced staff and advisers are perhaps the only way to mitigate this final risk category. The risk of professional advisers creating unworkable, faulty or unenforceable documentary structures is difficult to mitigate overtly but some supports are available such as:
A full understanding of who takes what risk and the general rules applied by project financiers can result in remarkably good project finance agreements without too much difficulty. An early dialogue with the financiers will serve to validate the company's expectations of risk sharing in a project financing. A firm understanding of these objectives should be established, perhaps with the assistance of a financial adviser. Matching these objectives to the structures in a project financing is heavily driven by the specific risk to be covered and the balance sheet and tax objectives of the sponsor(s). The large number of supports described above should not become a checklist since project financing requires sophisticated judgements to arrive at the trade-off in these various supports to achieve both the lender's and the borrower's objectives and risk to match comfort levels - no mean documentary feat! Yet the complexity of supports demonstrates the flexibility that has needed to be developed in order to make this source of funds attractive. Project financings are live documents and one can expect changing conditions to have to be accommodated. (Navigation Return) |
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© IAF 2006 email: iaf AT iaf.biz |
