CAP.

1
WHAT IS PROJECT FINANCE?

Project finance:= Structured finance of a specific entity the SPV. Financing that as a priority does not depend
on the soundness and creditworthiness of the sponsors. 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 projects
ability to repay the debt contracted and remunerate the capital invested at a rate consistent with the degree of
risk inherent with the venture concerned.

KEY FEATURES

1. The debtor is a project company set up on an ad hoc basis that is financially and legally independent
from the sponsors
2. Lenders have only limited recourse to the sponsors
3. Project risks are allocated equitably to the contractual parties 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 repayments and interest
5. Collateral is given by sponsors to lenders as security for receipts and assets tied up in managing the
project

FACTOR CORPORATE FINANCING PROJECT FINANCING

Accounting treatment On-balance sheet Off-balance sheet
Main variables underlying the Customer relations Future cash flows
granting of financing Solidity of balance sheet
Profitability
Guarantees for financing Assets of the borrower Project assets
Effect on financial elasticity Reduction on financial elasticity for No or reduced effect for sponsors
the borrower
Degree of leverage utilizable Depends on effects on borrowers Depends on cash flows generated
balance sheet by the project (leverage is usually
much higher

PROJECT FINANCING DISADVANTAGES PROJECT FINANCING ADVANTAGES

Lot of time needed to evaluate the project and High level of risk allocation among participants > high
negotiate the contract terms D/E > impact of return for sponsors
High cost of monitoring The loans only collateral refers to assets that serve to
carry out the initiative
Lenders are expected to pay significant costs for Sponsors are completely isolated from events
taking on greater risks involving the project if financing is done on a no -
recourse basis
SPONSORS OF A PF DEAL

1. INDUSTRIAL SPONSORS: sponsors who see the initiative as upstream or downstream integrated or in some
way as linked to their core business

2. PUBLIC SPONSORS: (central or local governments, municipalities or municipalized companies) whose aims
center on social welfare

PPP (public-private partnership): private sector participation in realizing public works, based on a
concession agreement with the public administration
the private party constructs works that will be used directly by the public administration itself, which
therefore paus for the product or service made available [hospitals, schools, prisons]
construction of works in which the product/service will be purchased directly by the general public. The
private party will receive the operating revenues and, possibly with an injection in the form of a public
grant, it will be able to repay the investment made [toll roads, cell phone networks, supply of water and
sewage plants]

3. CONTRACTORS/ SPONSORS WHO DEVELOP BUILD OR RUN THE PLANT

3.1. Initial phase builder: highly motivated to finish the plant on time, within budget and in accordance with the
performance specifications. If operations can be activated as planned, the project will begin to generate cash
flows and, as a shareholder, the contractor will start earning dividends after having collected down payments for
construction

3.2. Operational phase plant manager: has a clear interest in sponsoring a PF deal because they would benefit
both from cash flows deriving from the O&M contract as well as from dividends paid out by the SPV during the
operational phase

4. FINANCIAL INVESTORS

4.1. INFRASTRUCTURE FUNDS

a. Greenfield funds: invest in an infrastructure from the beginning of its development

>bear construction and technology risks
> high risk high return profile : IRR 15%

b. Brownfield funds: invest in projects that have already successfully passed the construction phase
> bear risks linked to the operational phase
> lower risk return profile: IRR 10 12%

> buy out equity stakes of other sponsors

> recapitalize the SPV
> involved in privatization process
 c. Infrastructure funds of funds: whose asset allocation is based on the purchase of stakes of other
infrastructure funds that invest directly in industrial projects

4.2. SOVEREIGN WEALTH FUNDS (SWFs) : special investment vehicles created by governments mainly in
developing countries in order to manage the surplus of balance of payments or proceeds coming
from the exploitation if natural resources, with the declared objective to increase the welfare of their
countries

4.3. MULTILATERAL DEVELOPING BANKS

4.4. PRIVATE BANKS

OVERVIEW OF CONTRACTS

Who? Contract Notes

Builder Company Fixed-price turnkey Penalty fees (liquidated damages) if
Consortium of contract (EPC minimum performance standards not
companies contract) respected or delays in construction
Early completion bonus
O&M contractor Already-in-place O&M Agreement
company (or sponsor)
Joint venture
Purchasers Retail market Offtakers: long-term Retail market: supply of drinking water,
Off-takers purchase contract traffic flow on toll road, tourist flow in
often signed on a hotel or leisure park; public services:
take-o-pay basis cemeteries, parking lots, sports facilities

Offtakers: cogeneration plants, oil and gas

and mining sector; PPP sector: hospital
services
Suppliers Usually only one Long-term RMSAs
supplier, often
sponsor

PF AND RISK MGMT TECHNIQUE

1. Risk identification: ascertain the impact of projects CFs

2. Risk analysis
3. Risk transfer and allocation of risk to the actors best suited to ensure coverage against these risks:
create an incentivizing tool
4. Residual risk mgmt
 Residual risk borne
Allocation to SPV
Allocation to insurers by the SPV
counterparties
(insurance policies)
through operating
Final loan/bond
contracts
pricing

TOTAL RISK

Risk identification and analysis

SEPARATE INCORPORATION AND AVOIDANCE OF CONTAMINATION RISK

CORPORATE FINANCING PROJECT FINANCING

Existing firm Existing firm (sponsor)

Assets in place Share Capital Assets in place Share Capital

Existing Debt Existing Debt

New project New Debt
New Share Capital
SPV

New project New Debt

New Share Capital

A new investment project concerning the companys core business will cost it a weighted average of the cost of
debt and cost of equity

= + (1 )
+ +

CORPORATE FINANCING

soundness and profitability of the venture that mgmt. intends to launch

Project launched if: r > WACC

soundness and profitability of the company that will realize the new venture
ELEMENTS OF PF DEALS

1. The project is very large compared to the company size

Contamination risk: the possibility that the results from a new project could impact the companys
overall solvency

2. Higher degree of risk than the average risk level for the asset portfolio in the balance sheet

3. The project is linked to the companys core business

no diversification effect : the correlation between existing assets and new assets is very strong and
positive

Financers and shareholders perceive projects high risk > ask for higher cost of debt and equity
WACC r < WACC financing the new venture on-balance sheet will reduce the value of the company!

Conclusion: large and risky projects are isolated by sponsors in and ad hoc vehicle company, that is, off-balance
sheet. Separation avoids the risk that the new project contaminates existing projects, thereby increasing the
weighted average cost of capital for both. Because project finance is indeed an off-balance sheet solution, it
achieves this important result.

Trade off between contamination risk and coinsurance effect := the phenomenon whereby a surplus of cash
flow from one or more assets or divisions is used to cover the financial cash shortage of another asset or
division within the same firm.

While from a purely theoretical standpoint it will always be useful for sponsors to separate new projects from
existing companies, if a new venture defaults it will have a significant impact of sponsors reputation and could
lead to negative consequences with regard ti the cost of new debt contracted to finance additional new
projects. In certain situations the coinsurance effect might be preferable rather than company-project
separation.
CAP. 3 PROJECT CHARACTERISTICS, RISK ANALYSIS AND RISK MANAGEMENT

RISK DEFINITION REMEDY CONTRACT

ACTIVITY Risk that the structure on which the Mapping out timing
PLANNING RISK SPV depends on to generate cash and resources of
flows during the operational phase project activities
may not be available because of
delays in one activity in the
construction phase
TECHNOLOGICAL Risk that the technology may be - Wrapping or
RISK valid in theory but inapplicable in a wraparound
PRECOMPLETION working plan responsibility Turnkey (EPC)
RISKS - (Independent contract
technical advisor
opinion)
- (Penalties)
CONSTRUCTION Noncompletion or delayed
RISK completion
Completion with cost overruns
Completion with performance
deficiencies
SUPPLY RISK Risk that arises when the SPV I not Put-or-pay agreements (or throughput
able to obtain the needed agreements)
production input for operations or
when input is supplied in a less than
optimal quantity or less than the
quantity needed for the efficient
utilization of the structure. Or the
SPV might find output, but a higher
price than expected
OPERATING RISK Risk that arises when the plant O&M agreements:
POSTCOMPLETION
functions but technically - Fixed-price contract
RISKS
underperforms in postcompletion - Pass-through contract
testing
DEMAND RISK Risk that revenues generated by the RETAIL MARKET:
SPV are less than anticipated - Sensitivity analyses
- Contract that ensures minimum use of
the structure
- Public body as wholesale buyer in a
variable market

OFFTAKE AGREEMENTS
 RISK DEFINITION REMEDY CONTRACT
INTEREST RATE The impact on project cash flows from - Self protection of cash
RISK higher-than-expected interest costs flows
- Swap contract on the
true interest rate
- Contracts that cover
inflation risk
EXCHANGE RATE Risk of significant fluctuations in the - Currency matching
RISK projects financial flows that are stated - Forward agreements for
in a different currency than that of the buying or selling
SPV - Futures on exchange
rates
- Options on exchange
rates
- Currency swaps
INFLATION RATE Risk that emerges when the inflation Consumer price index
RISK rates used for cash flow calculations in swap
the business plan are different from
actual values recorded during the life of
the project
ENVIRONMENTAL Risk related to any potential negative - Increasing self-regulation
RISK impact the building project could have - Insurance policies
on the surrounding environment
Change in law to introduce
restrictive legislation to safeguard
the environment Derivative
RISK
contracts
COMMON Lack of government support
TO BOTH because of public opposition
Insurance
PHASES REGULATORY RISK Risk related to inefficiency in the public
policies
administration or the complexity of the
bureaucracy
Delay or cancellation of permits
Unexpected renegotiation or
revocation of concessions
POLITICAL AND Investment risks: limitations of - Government support
COUNTRY RISK currency convertibility, agreement
governments expropriation or - Insurance policies
nationalization, breakout of war,
revolt or civil war
Change-in-law risk
Quasi-political risk: disputes and
interpretation regarding contracts
already in place due to default of
the public counterparties, creeping
expropriation
LEGAL RISK Risk that a party to a contract will not be - Meticulous drafting of
able to enforce security arrangements, contracts
enforce foreign judgments, have a - Support of the host
choice of law, or refer disputes to government
arbitration
CREDIT RISK Risk that one the parties involved in a Due diligence process
project finance initiative cannot fulfill its
commitments
RISK ALLOCATION WITH CONTRACTS STIPULATED BY THE SPV
ALLOCATION OF CONSTRUCTION RISK THE TURNKEY (EPC) CONTRACT

Elements of the contract:

Completion date
Cost of the work
Plant performance
Warranty period
+ Early completion/overperformance bonus
+ Performance bond posted in deposit by contractor until construction is complete clauses that limit
contractor responsibility for paying damages

Commercial Operating Date (COD):

deadline for completion of the
structure and delivery of the facility

Breach of contract: theoretically projects

MPSs met? NO default renegotiation of completion +
liquidated damages

YES

Optimal
perf. met?

NO

Liquidate: contractor pays the SPV Make good: the contractor payes the
buydown damage = 100% yeald actual cost to bring the plant up to 100%
revenue output

NB: the contractor is not in breach of contract if plant completion is delayed due to force majeure
ALLOCATION OF SUPPLY RISK PUT-OR-PAY AGREEMENTS

The supplier sells the SPV preset volumes of input at pre-agreed prices (adjusted according to predicted trend
of a given price index)

If the supplier is not able to supply good or service:

Indexed payments
SPV Input supplier

Supply
of input

Alternative
supplier
Finds input from alternative source
+ input supplier bears the
difference in price paid by the SPV

NB: same revision mechanism for input price and sale price > sales revenues and supply costs are synchronized

ALLOCATION OF OPERATIONAL RISK OPERATIONS AND MAINTENANCE AGREEMENTS

FIXED PRICE CONTRACT

Fixed period O&M fee Operator

SPV

Operating costs

PASS-THROUGH CONTRACT

Fixed compensation Operator

SPV
+ performance bonus

Operating costs
ALLOCATION OF MARKET RISK

RETAIL MARKET

Sensitivity analyses
Contract that ensures minimum use of the structure
Public body as wholesale buyer in a variable market

OFFTAKE AGREEMENTS

Long-term contracts in which one counterparty (the SPV) commits to delivering certain volumes/quantities of a
good or service. The other, called offtaker, agrees to pay predefined sums of money or a set fee for a certain
period of time.

Usually set up on a take-or-pay basis

Indexed payments
SPV Offtaker
Pay the alternative
supplier
Bear the difference
in prices
Alternative
supplier
Good/service supply

OFFTAKE CONTRACTS IN THE POWER SECTOR

1. POWER PURCHASE AGREEMENT (PPA) STRUCTURE

Electric power
Supplier FSA SPV Offtaker

Minimum purchase
+
PPA rate = CAPACITY CHARGE + ENERGY CHARGE

Fixed cost Fuel costs

+ Debt service + Variable
+ sponsor O&M costs
reimbursement
 American model

Independent Power supply Utilities

producers if Pip > Pu (distributors)

British model

2. TOLLING STRUCTURE
The energy producers - a SPV or an independent power producer (IPP) generate sufficient cash flows
to repay initial investments. At the same time, this setup allows for more efficient and rational risk
allocation

Bears market risk

Bears only
(toller must provide
operational risk
Fuel for free sufficient
(tolling fee does
SPV + Tolling fee Toller technical/professional
not depend on
skills)
fluctuations in
the power
market and in Delivers
the fuel price) energy

Energy
offtaker
Energy sale agreement

Financial approach: Tolling fee = Ds + Rs + Foc + Voc NB: fuel costs component is absent, because
fuel is provided for free by the toller
Industrial approach: Tolling fee = Am + Rci + Foc + Voc
 3. TAKE AND PAY CONTRACTS or MERCHANT PLANTS (most used before financial crisis)
The project company does not enter into any long-term contract guaranteeing fuel supply within a set
price bracket or the sale of electricity generated by the plant. The offtake pays for only what it actually
buys the SPV bears operational, supply and market risks!

OFFTAKE AGREEMENTS IN PPP INITIATIVES

A PPP is a way to transfer most of the risks of providing services to a retail public of end users to private
parties, leaving the public sector only the role of director and supervisor of service provision to taxpayers.
Sponsors usually ask the public administration to cover at least part of the market risk and to contribute in the
form of a subsidy, improving the projects attractiveness and profitability for sponsors.

OFFTAKING CONTRACTS IN THE ROADWAYS SYSTEM THE SHADOW TOLL SYSTEM

During concession:

Variable toll (on traffic volumes)*

Citizens Taxes Public Private
administration operator
BOT or DBFO

*Example: banding system

HIGH

NO SHADOW TOLL PAID

Dividends Band 3
# of vehicles

Subordinated debt service + Voc Band 2

LOW

Senior debt service + Foc Band 1

Incentives for concession holder: payments based on traffic volumes

Limitation of traffic risk
Advantage for public administration: cap on costs for PA and revenue for sponsors
 After concession:

Variable toll (on traffic volumes)

Public Private
administration operator
Roadway

OFFTAKING CONTRACTS IN THE HOSPITAL AND HEALTHCARE SERVICES SECTOR

English model: the public body makes no down payment until the hospital actually opens. At this point,
a single payment is based exclusively on services rendered and consists of:

Fee Based on Penalties (<fees review Risk borne by private

mechanism) party
Availability fee Availability of the facility Availability deductions Operating risk related
to efficiency
Service fee Service provision Performance deductions Operating risk related
to quality
Volume fee Number of services Market risk
provided
CAP. 4 THE ROLE OF LEGAL ADVISOR IN A PF DEAL

It is for the legal advisor to guarantee that there is a sound link between current risks and future income/cash
flows. They do so by constructing a contractual system that creates a reliable expectation as regards the
effective achievement of the forecasted income for the project and its distribution as indicated in the financial
model.

PROJECT FINANCING DEVELOPMENT STAGES AND IMPACTS ON THE ROLE OF LEGAL ADVISORS

STAGE ACTIVITY REQUIRED LAWYERS INVOLVED

Organizing the project company Sponsors lawyers

Preparing the articles of

incorporation

1. Forming group of sponsors Negotiating the arrangements

between sponsors

Check on bankability of the Sponsors lawyers

venture on a without or limited Project companys lawyers
recourse basis
Drafting of project documents Project companys lawyers
Sponsors lawyers (when sponsor
is counterpart of the project
company)
Due diligence report: report Arrangers lawyers
2. Industrial development of the prepared by the arrangers lawyers for
project their clients giving a summary of the
project and its bankability
Legal opinions: conclusive Sponsors lawyers
documentation in the setup phase of a Arrangers lawyers
financing that certifies the legal
validity of the key features of the
project (condition to get financing)
Finance Documents Arrangers lawyers
- mandate documents Project companys lawyers
- credit agreement
- security documents
- intercreditor agreement
3. Project financing - equity contribution agreements
- hedging agreements
- direct agreements
Assistance during syndication Arrangers lawyers
phase
4. Maintenance of project Periodic contacts with agent bank Sponsors lawyers
financing and sponsors Arrangers lawyers
CAP. 6 FINANCING THE DEAL

ADVISORY AND ARRANGING ACTIVITIES FOR PF FUNDING

SERVICE WHAT? WHO? REQUIREMENTS NOTES

ADVISORY Soft services used to define the risk Consulting Organizations No commitment for
SERVICES profile for a deal, its time schedule, firms, auditing reputation, lending
and its size to make it bankable, that firms, large- competitive standing,
is, to model the deal so that it can be scale expertise in specific
proposed to potential lenders. constructors, sectors/geographical
Preliminary valuation of the financial engineering locations, relations
feasibility of a project and outline an firms, with the sponsors
initial assumption as to how the individual
funding required to sustain an SPV professionals,
can be obtained. sponsors
FINANCING / Granting loans and providing equity Commercial Experience, Underwriting
ARRANGING based on indications in the feasibility banks and reputation and track guarantee of
SERVICES study prepared by consultants. large financial record, flexibility as availability of funds
conglomerates regards unforeseen
Arranging:= a mandate from the SPV events and
borrower to structure and manage refinancing, cost of
the financing contract. the financing

Syndication:= The mandated lead

arranger (MLA) must therefore be
able to contact the widest possible
number of banks in participating in
the deal and must then be the
coordinator representing all lenders.

INTEGRATION OF ADVISORY AND ARRANGING SERVICES

ADVANTAGES DISADVANTAGES
SPECIALIZATION MODEL Reducing potential conflict of interests: Banks may fear that the advisor is trying to
Arranger Advisor the advisor has no interest in setting a sell them an excessively risky deal
price for the financial package that
would be more remunerative in the The advisor may handle the mandate in a
absence of competitive offers prudent manner, offering a deal in favor of
lenders but not profitable for sponsors

More costly because of duplication of roles

INTEGRATION MODEL Banks have credible point of reference Potential conflict of interest and non-
Arranger = Advisor (underwriting commitment) impartiality of the service

Less costly solution

HYBRID MODEL
The borrower allows the advisor
to compete with others for the
role of arranger
TYPES OF SYNDICATION

SINGLE STAGE SYNDICATION

To proceed immediately with a general syndication without an underwriting group. The MLA will lead a
syndicate where banks do not share the underwriting commitment on the loan with it

TWO STAGE SYNDICATION

To gather a restricted number of banks in an underwriting group and then resell part of the loan in a general
syndication

How many banks to invite in the underwriting group?

FEW BANKS MANY BANKS

Better solution for the borrower Deter strategic default

Confidentiality is better safeguarded Better solution for the MLA

Lower coordination costs and decisions time Higher coordination costs and decisions time

Which banks to invite?

Final take:= the portion of the loan the MLA keep on its balance sheet
MLA faces trade-off between higher return on capital employed and negative signal to the market
(not confidence in future prospects of the borrower)

CLUB DEAL

A restricted pool of banks (4 to 6) jointly proposes a financial package to the borrower with a full financial
commitment. No other bank will be invited to join the group and all the funds needed for the SPV will be
provided by the restricted group of lending banks.

Faster deal-making process, avoid the exposure to interbank market volatility

(!) All the banks of the club share the same role of arranger. Fees will then be distributed on an equal basis
without the possibility for the MLA to yield extra returns compared to other members for the club
FEE STRUCTURE

FEE FOR ADVISORY SERVICES

Sums reimbursed for expenses incurred

+ Retainer fee: covers advisory costs during the study and preparation phase of the deal (15000
25000 euros on a lump-sum basis)

+ Success fee: incentive = (0.5% - 1%) x debt value incentive to plan deals with highest D/E
project size percentage
innovation percentage
bearish market condition: percentage

FEE FOR ARRANGING SERVICES = (0.7% - 1%) x syndicated debt

Pure arranging fee best-effort basis

Fee for underwriting and arranging services commitment basis (more costly)

Coarranging fee: part of the arranging fee given to coarrangers = (0.5% - 0.8%) x part of the
loan underwritten

FEES TO PARTICIPANTS AND THE AGENT BANK

Up-front management fee = (20 40 bps) x amount lent lead managers, managers and comanagers

Commitment fee
The SPV pays lenders interest calculated at the agreed rate on that part of the loan effectively used,
whereas it pays a commitment fee on the amount committed but not used.
The SPV pays the commitment fee periodically to the agent bank, which then returns it to banks
participating in the pool based on funds each of them has committed.

= ( )
360

CL = maximum committed loan to the borrower

cf = % of annual commitment fee
Et = cumulative amount disbursed at the beginning of period t
t = number of days calculating the reference period

NB!!! Commitment fees due during the construction phase are capitalized at the interest rate of the
respective loan tranche until the SPV starts the operational phase

Agency fee : fixed annual payment to agent bank = 40000 100000 euros
FUNDING OPTIONS: EQUITY

1. Equity contribution before starting to draw on the loan granted by banks: higher financing cost +
backup guarantee

2. Equity contribution after the loan facility has been fully utilized: lower financing cost + opportunity cost
of alternative forgone investments

3. Pro-rata payments (stage payment clause): each payment will be subdivided into borrowed capital and
risk capital in a proportion corresponding to the weight of each source in total financing

FUNDING OPTIONS: MEZZANINE FINANCING OR SUBORDINATED DEBT

Financing whose features are hybrid, neither pure equity nor pure senior debt. Usually mezzanine financing is
subordinated debt (debt that is paid only after senior debt complete amortization), with possible equity kicker
in the form of warrants or option to convert debt into equity. Mezzanine financing may be an attractive
solution for lenders who are more open to risk but whose investment guidelines or articles of incorporation do
not allow them to contribute equity.

Reasons for which subordinated debt may be preferred than equity contribution:

a subordinated loan requires payment if interest after senior debt service but before dividends

tax deductibility of interest paid on subordinated debt

dividend trap can be avoided

The dividend trap is the situation where net income is lower than the free cash flow available to sponsors. This
may happen when depreciation generates loss, though not affecting the cash flow account. Dividends cannot
be distributed if the company makes a loss, even if there are positive cash flows available for shareholders.

Resorting to subordinated debt avoid the dividend trap, given that interest on subordinated debt is deductible
in the income statement and is paid before dividends.

NB!!! The subordinated debt can cause the problem of negative equity: a problem arising when the use of
subordinated debt results in more substantial interest payable, lower profits/higher losses, and thus greater
erosion of the sponsors equity capital
FUNDING OPTIONS: SENIOR DEBT

Tranches of senior debt made available by the pool of banks:

Base facility: finances construction and will be repaid from cash flows the project generates in the
operational phase

NB: each repayment reduces the SPVs debt to the pool, so the base facility is not a revolving credit

Working capital facility: earmarked for financing the cash deficit that can emerge from the cash
collection cycle

NB: it is a revolving credit, every repayment made by the SPV means this credit line granted to the
borrower is again available

Stand-by facility: covers contingencies arising during the projects life cycle
> riskiest part of the loan, higher spread requested

NB: in case of stage payments, a stand-by equity clause states that if the stand-by facility is used then
more shareholders equity must be paid in so that the SPVs debt-to-equity ratio remains unchanged

VAT facility: finances VAT paid on construction and development costs and will be repaid from VAT
receipts during the operational phase

LOAN REMUNERATION

fixed
Cost of financing = interbank market rate + spread

variable (usually increasing)

> time
> cover ratios

REPAYMENT OPTIONS

Tailor-made repayment plan : the advisor estimates operating cash flows and then establishes a
timetable for loan repayments (possible percentages revision and repayments reallocation)

Dedicated percentage loan repayment plan: the capital repayment is in proportion to operating cash
flow for the year because a constant % is established at the outset constant DSCR

Mini perm: a loan covers the period of construction and is granted to constructor as a bridge until
the project is completed. At that time, the venture is suitable to be financed on permanent (perm)
 basis because it is able to generate revenues.

> hard mini perm: the duration of the loan is set on a time horizon of 7 to 8 years and forces the SPV to
refinance the loan before maturity of the mini perm. If it is not able to do so, the SPV goes bankrupt.

> soft mini perm: the loan maturity remains long, but the loan agreement includes incentives to the
borrower that encourage it to refinance the loan before the final maturity.

REFINANCING LOANS ALREADY GRANTED TO THE SPV

SOFT REFINANCING (WAIVER)

Renegotiating conditions (amendments to the financing agreement) to:

Free up cash from the debt service reserve account: replaced by a bank guarantee

Reduce spreads paid on the loan

renegotiations with all the banks in the
pool, carried out by the arranger
Reduce restrictions imposed by covenants

working fee (or waiver fee) paid to the arranger = 10-20 bps

HARD REFINANCING

Change in the level of leverage (regearing)

Worthwhile if minimizes 2 effects:

>tax costs
>claw back action

Takeover
Acquisition of the loan by a new pool of lenders, who replace the old pool as regards relations with the
SPV

New financing (or new lending)

A pool of new lenders advances a sum to the SPV that is sufficient to repay creditors in the old pool
completely. The new lenders grant a new loan tranche to increase the leverage level, guaranteeing this
increased funding with a lower level of seniority. The SPVs sponsors immediately draw down the
additional cash.

Bond issue at the end of the construction phase

The funds raised by the bond issue can be used to repay the banks that funded the project during the
construction phase. Issue of bonds usually means that better conditions can be achieved in terms of
 extended tenor and lower interest rate

Mixed solution new lending and bond issue

CAP. 5 VALUING THE PROJECT AND PROJECT CASH FLOW ANALYSIS

ANALYSIS OF OPERATING CASH FLOWS

Advisors must first identify the cash flow components of the project, that is they must determine the
difference between inflows and outflows before taking financial items into account (principal and interest
payments, reserve account contributions, and dividends to sponsors) = operating cash flow, OCF(or unlevered
free cash flow, UFCF)

WATERFALL STRUCTURE OF OCF

Revenues from sales

- Raw materials and operating costs
- O&M fees
- Insurance costs
- Taxes
- Increase in working capital
- Capex
= Operating Cash Flow net (UFCF)

DYNAMIC OF OCF

tail

Construction phase: the project cannot generate revenue or cash flows and must pay capex. Consequently,
cash flows are negative, and cash requirements have to be covered by bank lenders or bond investors and by
sponsors who begin to confer equity an subordinated debt.
Operating phase: the project starts generating revenues (and therefore cash flows) earmarked for paying
operating costs. After the first few years in which operating cash flows are negative, the curve of cumulative
flows reverses its course: OCFs become positive, and this helps curtail the overall financial requirement.

INPUTS FOR CALCULATING CASH FLOWS

1. The timing of the investment

Length of plant construction period interest and commitment fees capitalization
Penalties, delay liquidated damages

2. Initial investment cost

Turnkey contract cost Direct investments

Purchase of the land
Owners costs
Development costs
VAT on direct investments Indirect investments
Capitalized interests and fees
Cost of guarantees and insurance during construction

Timing of installments: concentration of costs in the construction phase, interest

3. VAT dynamic

4. Grants
Testing grant: paid out at the end of the construction period + bridge financing
Milestone grant: loans are used on the basis of the milestones achieved, net of the portion of
the grant received and the portion of equity conferred

5. Sales revenues, purchasing costs and operating costs during the operating life of the project
During the designing of the financial model, sales and purchasing contracts are usually in the
drafting stage
Standard prices and conditions applied by the market for similar initiatives
Prices escalation mechanism in accordance to inflation
Dummy item: cushion to cover changes in costs or additional costs

6. Changes in working capital: represents and outlay or a source of cash

7. Taxes
Depreciation policy of the plant is a key variable for optimizing tax burden

8. Macroeconomic variables
DEFINING THE OPTIMAL CAPITAL STRUCTURE FOR THE DEAL

WATERFALL STRUCTURE ON THE POSSIBLE USES OF OCFs DURING OPERATIONS

Operating Cash Flow net (UFCF)

- Interest on senior loan
- Interest on subordinated loan
- Senior loan repayment
- Subordinated loan repayment
- Debt reserve provisions
- O&M reserve provisions
= Dividends to sponsors

ELEMENTS OF THE FINANCIAL MODEL

1. Equity
The degree of economic soundness of the project: break-even point for indebtedness
The level of risk lenders are willing to accept: contractual structure and counterparties
Precedents on the domestic or international financial market
Timing of equity contribution
How to confer equity: pure equity or subordinated loan

2. Senior debt
Tenor: benchmark = tail
Average loan life (ALL)

=
=1
3. VAT facility

VAT paid VAT facility VAT facility

repayment

Interest Principal

OCFs VAT on sales

or VAT refund

4. Stand-by facility
When drawdowns are made, sponsors deposit additional equity at the same time keep D/E constant
IDENTIFYING SUSTAINABLE D/E MIXES FOR SPONSORS AND LENDERS

OPERATING CASH FLOW > DEBT SERVICE

or
DEBT SERVICE CAPACITY > DEBT SERCVICE REQUIREMENTS

ARRANGERS WORK FLOW IN CHOOSING A FINANCIAL STRUCTURE

OFC

Capital Structure Proposal

Change in D/E mix or modification in the terms of the loan agreement

Revision in the variables that determine OFC

D/E consistent NO
NO
with sponsors
IRR?

YES

NO D/E consistent
NO
with lenders
IRR?

YES

NO D/E satisfies NO
cover ratios?

YES
Optimal Capital Structure
OPTIMAL CAPITAL STRUCTURE FOR PROJECT SPONSORS

Projects IRR := the interest rate that makes the NPV of a projects positive OCFs equal to the NPV of its
negative OFCs



=
(1 + ) (1 + )
=0 =

Sponsors IRR : the lower the better

=
(1 + ) (1 + )
=0 =

IRR accepts if:

_
[ (1 ) + ( ) ]
+ +
=1

Payback period: the moment in time when then projects outflows and inflows are equal

: | = 0
=0

: | =0
(1 + )
=0

OPTIMAL CAPITAL STRUCTURE FOR LENDERS

Net Present Value

+

=

(1 + _) (1 + _)
= =0

Lenders IRR: the higher the better

+ +

=
(1 + ) (1 + )
=0 =+1
Problem: in accordance to Basel II and III rules, there is absorption of equity capital (risk capital) for every loan
that banks give to borrowers. Equity has a much higher opportunity cost than the cost of funding!

Solution 1: in NPV formula, substituting c_funding with the weighted marginal cost of funding

= (1 8%) (1 ) + 8%

Solution 2: IRRproject > WMCF ?

Solution 3: annual return on banks equity absorbed by the project > cost of bank equity ?

+
>
8% + 6%

Solution 4: risk-adjusted return on banks capital > cost of bank equity?

= >

COVER RATIOS

Cover ratios are indicators of financial sustainability of the capital structure and the most important examples
of financial covenant

Debt Service Cover Ratio DSCR

= 1
+

DSCR = 1 not acceptable

>for sponsors: the flow of dividends would fall to 0
>for lenders: they need a safety margin

Average DSCR

=1
+
=

Loan Life Cover Ratio

The quotient of the sum of the operating cash flows produced by the project until the lasts scheduled year of
debt repayment (s+n) discounted to the moment of valuation (s) plus the available debt service (DR) and the
outstanding debt (O) at the time of valuation. Lenders uses this ratio to evaluate the debt servicing capacity of
the projects OFCs.

+
= +
(1 + )
=

+

=
(1 + )
=

An LLCR greater than 1 can be interpreted as surplus of cash freely available t project sponsors if they were to
opt to liquidate the initiative immediately. They could reimburse the entire outstanding debt with the net
revenue generated during the remaining loan repayment period.

NB: if i = iloan and all the DSCRs have the same value during the loan amortization period, then AVDSCR = LLCR

SENSITIVITY ANALYSIS AND SCENARIO ANALYSIS

Variations in: Sensitivity Analysis: Results:

Tariffs/unit revenues Impact on OCFs SCENARIO 1

Provisioning costs SCENARIO 2
Other operating costs SCENARIO 3

Debt Service capacity

>
Debt service requirements?
CAP. 7 LEGAL ASPECTS OF PROJECT FINANCE
THE PROJECT COMPANY

Project company usually refers to a legal entity, that is, the company that is formally responsible for a specific
project finance deal. This company is a newly organized entity which does nothing but develop, build and
operate the project.

REASONS FOR INCORPORATING THE PROJECT IN A PROJECT COMPANY

Defensive/protective reasons

Principle of general liability of any person/legal entity > Contamination risk and co-insurance effect
Ring-fencing: protecting the project company from external factors that could distort the correlation
between the financial model and the project companys legal relationships. The company has to be protected
against any possible external interference and liabilities not-related to the project that might jeopardize the
economic, financial or legal management of the project.

Positive reasons

The SPV coincides with the project itself, in the sense that the entire cash flow related to the project has to be
entirely attributed to the company. The purpose of the project is essentially to make the project and its cash
flow coincide as much as possible with the entity that is liable for servicing the debt toward lenders. This
ensures that cash flow generated by the project will be channeled in the order of priority set down in the
financial model.

OUTSOURCING THE CORPORATE FUNCTIONS OF THE PROJECT COMPANY: HOW THE COMPANY/PROJECT IS
ACTUALLY RUN

Every effort is made to embed the project in the project company from the financial and legal standpoints. The
project company is the point where legal responsibilities for all financial relationships relating to the project
converge.

At the same time, the company contracts out all activities pertaining to its operations to third parties. The
reasons underlying outsourcing are:

- Transforming variable internal costs into fixed costs or costs that vary within preset parameters
- Predetermining objectives in terms of economic results and performance targets

A project company is therefore a box to make money move. First it comes in (money from bans loan and
equity/subordinated loan contributions from the sponsors); then it goes out (money is spent to finance the
development and construction of the plant); finally it comes in again (revenues from the project plant are
collected by the project company from the beginning of the commercial operations), with binding obligations
established to give priority to servicing the loan.
SECURITY DOCUMENTS SECURITY PACKAGE

Security interests have the purpose of segregating a given asset as security for a credit. The asset in question is
still the ownership of its grantor (the security provider), whether this person is the borrower itself or a third
party. The lender acquires the following rights over the secured asset:

- The right to have it sold to a third party and to cover the asset into cash
- The right of pre-emption: the right to obtain priority over other potential creditors of the same
borrower to collect the amount owed from the sale of the asset
- The right to enforce the security over an asset even if said asset is purchased by a third party. In other
word, the security interest follows the secured asset, and secures is throughout all its later sales until
the debt is repaid in full

FUNCTIONS OF THE SECURITY PACKAGE:

Defensive function: protecting the project and its property from the rights of third parties, who may be
sponsors creditors claiming settlement from their loans on the project companys corporate capital,
which is actually pledged in favor of project lenders.
Positive function: to make it possible to repay a loan in case of default, limiting the loss given default.

ELEMENTS OF THE SECURITY PACKAGE

1. PLEDGE ON PROJECT COMPANY SHARES/QUOTAS

2. SECURITY ON THE COMPANYS RECEIVABLES

a. Special privilege
b. Assignment of receivables

3. PLEDGE ON THE PROJECT COMPANYS BANK ACCOUNT

NB: All the project companys bank accounts are pledged, the only exception being the account where
cash available for distributions to sponsors is credited

4. MORTGAGE ON THE PROJECTS PROPERTY

5. SECURITY ON OTHER PROJECT COMPANY ASSETS

In this case the defensive function is more relevant than the positive one
DIRECT AGREEMENTS

Direct agreements are contracts executed directly by the lenders and the key counterparties to the project
agreement. They are legal instruments that lenders use to reserve the right to interfere directly in the
relationship between the project company and third parties.

Though direct agreements do not technically constitute security interests, the function of these agreements is
strictly related to that of security interests and to the remedies available to lenders in case of a crisis of the
project.

Functions of direct agreements:

To safeguard the project agreements and its bankability

Provisions mitigating the risk of termination
Right to lenders to be informed on any circumstances that would justify terminating the
contract
Lenders faculty to intervene to remedy the situation of breach
Possibility of nominating an additional party who would assist the SPV or take on contracts
obligations

Enforcement of step-in rights: under certain conditions, lenders can replace the project company with
a third party as counterparty to the project agreement

ENFORCING SECURITY INTEREST AND LENDERS STEP-IN RIGHTS

Unlike corporate finance, project finance, by definition, does not own assets that have value comparable to the
project finance loan. Project assets have value only if the project is up and running and can generate revenues,
this value shrinks when the project defaults.

Therefore the aggregate value of the secured assets is not enough to ensure acceptable coverage for financing.
Hence. In fact, this is their only hope that the loan will be reimbursed.

Step-in rights are entitled to lenders, so that they use security interest to take possession of the entire project
and continue to run it. This is achieved by

- Appropriating voting rights relating to secured shares and replacing the board of directors
- Enforcing the security on the shares themselves
- Taking ownership of the project companys share capital

Only after very possibility for re-establishing an acceptable profit level for the project has been exhausted, will
security interests be used the way they are traditionally intended. At this point, these are likely to be enforced
on an individual basis to get the highest possible sale price on every single asset.