The challenges of infrastructure and recent trends in project finance: some remarks on the Brazilian experience
by Júlio César Bueno
With the loss of capability of investment by the public sector, there was a global tendency in 80’s and 90’s to diminish the role of the State, with the privatization and concession of public services to the private sector. In Brazil, The Brazilian Privatization Program – PND, was instituted under the Law No. 8,031, of 04/12/1990, when the concept of privatization became an integral part of the economic reforms initiated by the Federal Government. At that time, all effort was concentrated on the sale of productive state owned companies, tied to strategic sectors, which allowed the inclusion of steel manufacturers, petrochemical and fertilizer companies in the PND.
Between 1990 and 1994, the Federal Government privatized 33 companies, 18 of which were controlled companies and 15 minority shareholder participations of Petroquisa and Petrofertil. Other eight auctions of minority shareholdings were held under Decree No. 1,068. Through these operations the Government obtained receipts of US$ 8.6 billion that, along with the US$ 3.3 billion in debt transferred to the private sector, brought the total to US$ 11.9 billion.
Due to the large amount of funds needed for the viability of infrastructure projects, private companies were incapable of compromising their budgets during the long course of maturation of such projects. The transfer of part of the infrastructure to private initiative, demanding substantial investments in its planning, development and operation, began to be financed by other agents and other sources, due to the integration of the partners in the respective projects.
Commercial banks, multilateral agencies, export credit institutions, pension funds, insurance companies and participants in international capital markets became important financiers of infrastructure projects in Brazil through Project Finance. As a financial model which adapts itself to the need of funds for projects developed by the private sector, Project Finance represents an important instrument to make investments in infrastructure viable in developing countries viable.
The Practical Use and Importance of Project Finance
Project Finance is usually defined as the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project. In this context, it represents a financing technique which generally allows a company to raise funds to set up a project based on the feasibility of such a project and its ability to generate revenues at a level sufficient to cover construction and operational costs, as well as debt service and a return for the investor (cf. FINNERTY, John D. Project Financing: Asset-Based Financial Engineering. London: John Wiley and Sons, 2007, p. 4).
Projects like power plants, toll roads or airports share a number of characteristics that make their financing particularly challenging. Large-scale projects might be too big for any single company to finance on its own. On the other hand, widely fragmented equity or debt financing in the capital markets would help to diversify risks among a larger investors’ base, but might make it difficult to control managerial discretion in the allocation of free cash flows, avoiding wasteful expenditures. Project Finance is than used to strike a balance between the need for sharing the risk of sizeable investments among multiple investors and, at the same time, the importance of effectively monitoring managerial actions and ensuring a coordinated effort by all project-related parties.
Project Finance transactions require joint efforts from lenders, investors, suppliers, off takers and sponsors of the project in order to make feasible the implementation of a project, dealing with special challenges, such as:
(1) They require large indivisible investments in a single-purpose asset: Project Finance than deals have contemplated the creation of a special purpose vehicle with bankruptcy remoteness features, as a ring fencing technique, which usually results in credit enhancement for financiers and cost reductions for sponsors, although the creation of a project company is not necessarily a rule inherent to project finance;
(2) Projects usually undergo two main phases (construction and operation) characterised by quite different risks and cash flow patterns: Construction primarily involves technological and environmental risks, whereas operation is exposed to market risk (fluctuations in the prices of inputs or outputs) and political risk, among other factors. Most of the capital expenditures are concentrated in the initial construction phase, with revenues instead starting to accrue only after the project has begun operation; and
(3) The success of large projects depends on the joint effort of several related parties so that coordination failures, conflicts of interest and free-riding of any project participant can have significant costs: From the construction company to the input supplier, from the host government to the off-taker, all parties have substantial discretion in allocating the usually large free cash flows generated by the project operation, which can potentially lead to opportunistic behaviour and inefficient investments.
Trends of Project Finance Structures in Brazil
A. Detailed Financial Structure
In project finance, several long-term contracts such as construction, supply, off-take and concession agreements, along with a variety of joint-ownership structures, are used to align incentives and deter opportunistic behaviour by any party involved in the project. The definition of the advantages and limits of a Project Finance structure requires a detailed analysis of the various aspects must be made by those interested, involving, amongst others:
(1) A study of the structure that comprises Project Finance, detailing the advantages, the disadvantages and limits of each model;
(2) The criteria of evaluation and requirements established by the agents in charge of classification of credit and the respective impact on the composition of the interest rate of the financing;
(3) Identification, allocation and development and implementation of the criteria and methods to manage the risks involved;
(4) Formulation of an accurate economic-finance model to obtain the resources on the international market;
(5) Techniques and implications of the necessary due diligence; and
(6) Monitoring the project during its building and operational phases and respective management of financial documents, also contemplating the securitization of the receivables.
In Project Finance equity is held by a small number of sponsors and debt is usually provided by a syndicate of a limited number of banks. Concentrated debt and equity ownership enhances project monitoring by capital providers and makes it easier to enforce project specific governance rules for the purpose of avoiding conflicts of interest or suboptimal investments. The use of non-recourse debt in project finance further contributes to limiting managerial discretion by tying project revenues to large debt repayments, which reduces the amount of free cash flows. Moreover, non-recourse debt and separate incorporation of the project company make it possible to achieve much higher leverage ratios than sponsors could otherwise sustain on their own balance sheets.
Nonrecourse debt can generally be deconsolidated, and therefore does not increase the sponsors’ on-balance sheet leverage or cost of funding. From the perspective of the sponsors, non-recourse debt can also reduce the potential for risk contamination. In fact, even if the project were to fail, this would not jeopardise the financial integrity of the sponsors’ core businesses. One drawback of non-recourse debt, however, is that it exposes lenders to project-specific risks that are difficult to diversify. In order to cope with the asset specificity of credit risk in project finance, lenders are making increasing use of innovative risk-sharing structures, alternative sources of credit protection and new capital market instruments to broaden the investors’ base.
Hybrid structures between project and corporate finance are being developed, where lenders do not have recourse to the sponsors, but the idiosyncratic risks specific to individual projects are diversified away by financing a portfolio of assets as opposed to single ventures. Public-private partnerships are becoming more and more common as hybrid structures, with private financiers taking on construction and operating risks while host governments cover market risks.
There is also increasing interest in various forms of credit protection. These include explicit or implicit political risk guarantees, credit derivatives and new insurance products against macroeconomic risks such as currency devaluations. Likewise, the use of real options in project finance has been growing across various industries. Examples include: refineries changing the mix of outputs among heating oil, diesel, unleaded gasoline and petrochemicals depending on their individual sale prices; real estate developers focusing on multipurpose buildings that can be easily reconfigured to benefit from changes in real estate prices.
Finally, in order to share the risk of project financing among a larger pool of participants, banks have recently started to securitize project loans, thereby creating a new asset class for institutional investors. Collateralised debt obligations as well as open-ended funds have been launched to attract higher liquidity to project finance.
B. Partnering Construction Contractual Structure
Within time and the more use of Project Finance structures, parties have evolved to the use of Engineering Procurement Construction (EPC) – the favourite contract model for the lenders – and Engineering Procurement Construction Management (EPCM). Nevertheless, because the EPC contract approach shifts all the risk of project completion cost and performance onto the contractor’s shoulders, it tends to trigger an adversarial project team relationship, potentially leading to a breeding ground for conflict, contractual disputes and major claims that undermine the project’s financials and its ultimate successful outcome. Therefore, the challenge in Project Finance has been the adoption of the Alliance contracting as a viable, proven alternative to adversarial business-as-usual contracts.
Alliance contracting offers a unique system of project delivery whereby risks are shared between owner and contractor. They are incentive-based relationship contracts in which the parties agree to work together as one integrated team in a relationship that is based on the principles of equity trust, respect, openness, no dispute and no blame. Alliance contracting can relieve the pressure of the short-term demands on the industry and set the foundation for longer term structural improvement in the way the industry works. Also, significantly reduces, the risk of claims and disputation between the parties through the use of inclusive and collaborative legal and commercial arrangements. These arrangements enable the parties to work together in an open and generative manner and to strive to achieve the business goals of everyone in the relationship and can provide a bankable project delivery method even for project financing.
C. Submission to the Equator Principles
Project Finance transactions may encounter social and environmental issues that are both complex and challenging, particularly with respect to projects in the emerging markets. Large industrial and infrastructure projects, such as for power generation, are becoming increasingly conditioned to social and environmental risk assessments in order to be approved. In this context, Brazil is following the international trend to adopt the Equator Principles for Project Finance transactions.
Equator Principles represent a set of socioenvironmental guidelines adopted by 61 banks worldwide for financing projects amounting to US$10 million or more and are intended to serve as a common baseline and framework for the implementation by each lender of its own internal social and environmental policies, procedures and standards related to its project financing activities.
Today, 7 banks are signatories of the Equator Principles in Brazil. They work to ensure that the projects they finance are developed in a manner that is socially responsible and reflect sound environmental management practices. By doing so, negative impact on project-affected eco-systems and communities should be avoided where possible, and if this impact is unavoidable, it should be reduced, mitigated or compensated for, or both, appropriately.
The success in the financing of an infrastructure project, by means of Project Finance, depends on all the parties involved satisfactorily complying with their various contractual obligations under the Project Finance Documentation. Lenders, as well as the other participants, in accordance with the level of risk being assumed and in proportion to the benefits received from the implementation of the project, will undertake the due diligence needed to adequately measure the risks involved.
The viability of the Project Finance model, in short, is based on the consistency and efficiency of its network of agreements. Such documents must be structured and negotiated in a consistent manner with the respective legislation applicable in the jurisdictions involved, and be constructed in such a way as to allow full implementation of their respective terms and conditions, notwithstanding the natural complexity of the same, in a form which will satisfactorily identify, mitigate, allocate and allow the adequate management of the various risks involved in the Project Finance.
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