c cc Companies are increasingly using project finance to fund large-scale capital expenditures. The decision to use project finance involves an explicit choice regarding both organizational form and financial structure. With project finance, sponsoring firms create legally distinct entities to develop, manage and finance the project. Borrowing occurs on a limited or non-recourse basis and despite this, projects are highly leveraged entities. Debt to total capitalization ratios average 60-70%. The issue explored in the write up below is why firms use project finance instead of traditional, on-balance sheet corporate finance. The notion/argument that in the right settings, project finance allows firms to minimize the net costs associated with market imperfections such as taxes, transaction costs etc is explored below. At the same time, project finance allows firms to manage risks more effectively and more efficiently. These factors make project finance a lower-cost alternative to conventional corporate finance. Costs and benefits of using project finance, major risks and mitigation of these risks as well as evaluation of debt alternatives are all explored below using the Petrozuata deal as an example. PDVSA should ultimately finance the development of the Orinoco Basin using project finance and a detailed explanation can be found below.
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c c Project Finance involves a corporate sponsor investing in and owning a single purpose, industrial asset through a legally independent entity financed with non-recourse debt. The decision to finance this deal on a project basis was actually a dual decision regarding both financial and organizational structure. Instead of entering into a joint venture with Conoco, PDVSA could have build the project alone and relied on spot market transactions to sell the syncrude. However PDVSA would have needed specialized assets to extract and upgrade the syncrude which would have left it vulnerable to potential opportunistic behavior by its downstream customers. Alternatively Conoco could have decided to build the project itself since it already had the downstream refining capacity. Venezuelan law however would prevent Conoco from going it alone as it prohibits foreign ownership of domestic hydrocarbon resources. So a joint venture with a long-term off-take arrangement was created as a way to encourage investment in specialized assets, limit ex post bargaining costs and deter opportunistic behavior. Structured in this fashion, Petrozuata had all the hallmarks of project finance deals i.e. it was an operating company with a limited life (35 years), it was an economically and legally independent entity and it was funded with non-recourse debt. So Petrozuata could definitely be classified as a project. The three characteristics listed above distinguish project finance from traditional corporate finance. To explain the costs and benefits of using project finance, let¶s start with M&M¶s capital structure irrelevance proposition which holds that firm value should not depend on how a firm finances its investments. So whether a firm uses corporate or project finance to raise funds should be a matter of indifference to its shareholders. A lot of assumptions are baked in here for example, no taxes, no transaction costs, no costs of financial distress. Capital markets however are not perfect so in the real world, in addition to taxes, transactions costs, costs of financial distress, there are costs stemming from incentive conflicts among managers, shareholders and creditors as well as from asymmetric information between corporate insiders and outsiders. Let¶s take each of these factors one by one: Project finance reduces corporate taxes ± The creation of an independent entity allows projects to obtain tax benefits that are not available to their sponsors. In this case, Petrozuata will pay reduced royalty rates on oil revenue and income tax rates in exchange for using local Venezuelan suppliers, contractors etc. Petrozuata will pay income taxes at the rate of 34% and royalty rates at the rate of 1% for the first nine years of operations and no municipal taxes. Now if Maraven (one of PDVSA¶s subsidiaries) had financed the project using conventional on-balance sheet financing, its income tax rate would be 67.7% and its royalty rate would be 16.67%. Tax rate reductions and tax holidays are fairly common in project finance deals. Another tax advantage in a project finance structure is the incremental interest tax shields. Assuming the 60% leverage is twice as high as what either sponsor could have achieved under corporate financing, the incremental tax shields are worth approximately $140 million when discounted at 8% (weighted average cost of debt) Project finance increases transaction costs ± In project finance, negotiating the deal structure including the financial, construction and operational contracts, is expensive, time consuming and is basically the biggest disadvantage of using project finance. Conoco and Maraven spent more than 5 years and $15 million in advisory fees to negotiate this deal. In addition to the structuring expenses, there were financing and issuance costs totaling approximately $17 million. These costs which total $32 million represent a lower bound on the benefits of using project finance instead
of internally generated funds. Many of these costs are relatively fixed in nature so it makes sense to use project finance only for large deals. Project finance reduces the costs of financial distress ± The cost of financial distress is an expected cost equal to the probability of distress times the costs associated with the distress. Project finance adds value by reducing the probability of distress at the sponsor level and by reducing the costs of distress at the project level. If a firm uses conventional finance, it becomes vulnerable to risk contamination i.e. the possibility that a poor outcome for the project causes financial distress for the parent. This cost is offset though by the benefit of coinsurance wherein the project cash flows might prevent the parent from defaulting. So from a parent corporation¶s perspective, when the benefits of coinsurance exceed the costs of risk contamination, traditional corporate finance is preferred and if the coinsurance benefits don¶t exceed the risk contamination costs, project finance is preferred. Risk contamination is more likely when projects are large compared to the sponsor, have greater total risk and have high, positively correlated cash flows. In terms of the costs of financial distress, sponsors use project finance in situations that have low costs of distress. Projects that have tangible assets that do not lose much value during default or restructuring use project finance. The recognition that projects have going concern value makes even senior claimants prefer speedy restructurings to delayed negotiations. The combination of lowering the probability of default and lowering the actual costs of default facilitates the use of high leverage which creates further value by reducing incentive conflicts discussed next. Project finance reduces incentive conflicts ± The inability to write ³complete´ contracts, combined with the fact that it is costly to monitor and enforce contracts, creates the potential for incentive conflicts among the various participants. Most of these conflicts relate to investment decisions or operating efficiency. Most of these investment decisions include overinvestment in negative NPV projects, investment in high-risk negative NPV projects, underinvestment in positive NPV projects, and underinvestment in risky, positive NPV projects due to managerial risk aversion. Project finance helps avert all these investment distortions that would otherwise plague sponsoring organizations using corporate finance. Besides investment decisions, there are important incentive problems that relate to managerial effort. One of the major benefits of project finance is to substitute the private sector for public sector management. To ensure managerial efficiency, there is a board of directors comprising of directors from each sponsor and the compensation contracts of managers are linked to project performance. Project finance reduces asymmetric information costs ± Typically insiders know more about the value of assets in place and growth opportunities than outsiders. This information gap along with agency conflicts creates adverse selection problems mainly a tendency to raise capital when the firm is overvalued and increases the cost of raising capital. These information costs increase with both the type and amount of capital raised. It also explains why firms may not want to finance large projects with corporate debt. These costs are more important in emerging markets than in developed countries like the US. Project finance is used with tangible and relatively transparent assets. Separation of projects from the sponsoring firm facilitates initial credit decisions allowing creditors to analyze the project on a stand-alone basis. Using conventional finance, Petrozuata and its sponsors would be analyzed as a pooled credit. Also with segregated cash flows and dedicated management, there is little room for the kind of intentional or judgmental misrepresentation that is possible with a consolidated firm. These improvements reduce asymmetric information costs and can lower a project¶s cost of capital.
c c Let¶s classify the risks associated with Petrozuata into 4 general categories: Pre-completion risks ± include all risks up to the point when a project passes a detailed set of completion tests. These risks include resource, force majeure, technological and timing risks. The risk that a key resource does not exist in the expected quantity or quality is known as a resource risk. Force majeure risks include both ³Acts of God´ such as earthquakes as well as political risks such as war or terrorism. To mitigate ³Acts of God´ risks, the sponsors purchased a $1.5 billion ³all-risk´ insurance policy during construction and agreed to purchase property insurance as well as business interruption insurance during the operating phase. To mitigate the political risk, the pipelines were underground and loading facilities under water. Also Venezuelan troops guarded the project during construction as a further measure against terrorism. Technological and timing risks are the risks that a project does not work or does not meet scheduled completion. The sponsors took several steps to mitigate these risks such as selecting only proven technologies like horizontal drilling wells and Conoco¶s coking technology used in refineries around the world. Timing risk was mitigated by Petrozuata becoming the general contractor as opposed to hiring a general contractor for all the 3 distinct components of the project.
Operating or Post-completion risks ± Once a project has successfully passed its completion tests, then input, throughput, environmental and output risks become relevant. Definitions for each can be found in a table in the exhibit section. To mitigate input or supply risk as well as throughput risk, an independent consulting firm verified the operations prior to construction. The project was also reviewed carefully to ensure compliance with all applicable domestic and World Bank environmental standards. In addition, there are risks that the demand or price of syncrude falls. Conoco assumed the demand risk through the off-take arrangement guaranteed by DuPont. Failure to lock in a price for the syncrude exposed the project to price risk which Conoco did not want to assume. The sponsors assumed this price risk. In general completion and operational risk can be mitigated through extensive contracting. This will reduce cash flow volatility, increase firm value and increase debt capacity. Sovereign risks ± The one feature that cannot be replicated under conventional corporate financing schemes is project finance¶s use in mitigating sovereign risks. Sovereign risk was one of the biggest concerns about the Petrozuata deal due to Venezuela¶s historical macroeconomic and political instability. The government had restricted currency convertibility between 1994 and 1996 causing several firms to default on foreign currency obligations. Also failed military coups, presidential impeachment, banking crisis etc made investors leery of investing in Venezuela. To mitigate sovereign risks, one of the key features was the decision to keep oil revenues out of the country. Conoco as the purchaser would deposit US dollar proceeds with a trustee in NY who would then disburse the cash. This also eliminated exchange rate risk as the revenues and debt service were both denominated in dollars. Another factor mitigating sovereign risk was making the Venezuelan government as a project sponsor. If the government failed to mitigate sovereign risks, it would lose the monetary benefits from taxes, royalties and dividends as well as increased employment. Another reason why the project structure helps mitigate sovereign risks is that it facilitates participation by local governments, local financial institutions, and bilateral and multilateral agencies. Financial Risks ± There are 3 primary financial risks i.e. interest rate risk, funding risk and credit risk. Interest rate risk refers to the risk that increasing interest rates would reduce cash flows. The funding risk referred to the risk that the project cannot raise the necessary funds at economical rates. Credit risk referred to the risk that the project would be unable to service its debt obligations for any reason. The sponsors and creditors bore all these risks. Evaluation of debt alternatives is explored in the next section. In terms of significance, sovereign risk is probably the most significant. Expropriation, fear of retaliatory government action on expropriation cannot be mitigated in a conventional financing scheme. Resource and technology risks are not significant in this deal. Quantity and price risks are mitigated as noted above. Exhibit 1 presents a comprehensive risk management matrix that identifies the risks and who bears them in this deal.
c c cc ccc The sponsors of the project should use a combination of agency, bank debt and rule 144a bonds debt to finance this deal. Basic features of the various debt alternatives are below: BDA/MDA ± Reduced political insurance, and loan guarantees at higher cost and time delay. Bond Finance ± The idea of using fixed-rate bonds was to transfer the interest-rate risk to insurance companies and other investment fund managers that could use the fixed-rate bonds to offset long-term liabilities. Fewer covenants, greater economies of scale in issuance, and possibly better equity returns are advantages of bond finance. One disadvantage of using bonds is the negative arbitrage. Bonds are issued in a lump sum and the interest cost on unused funds invariably exceeds the interest income. The use of bonds can also result in diminished monitoring; a large group of well-diversified bondholders are less effective monitors than bankers and are potentially less effective at reducing sovereign risks. Another serious issue with bond finance is that the bond market especially for developing country bonds is very fickle. Uncovered Bank Debt ± Greater withdrawal flexibility allowing it to match its cash inflows and outflows. Shorter maturities, restrictive covenants, size and structure restrictions, variable interest rate are key disadvantages of using bank debt. Also no political risk insurance (PRI) needed. Covered Bank Debt ± In addition to the above, PRI would be needed and it could take 12-18 months to arrange. 144A Bond Market ± Includes all the advantages of public bonds with the additional advantage of speed. Could be underwritten within 6 months and did not have restrictive disclosure requirements. Longer term, fixed interest rates, fewer restrictions and larger size. Relatively new and negative carry. The weakest link in the project/to achieving an investment grade rating would be PDVSA¶s B rating. Also the right leverage ratio had to be selected to improve the project¶s DSCR. In our view, the ratings agencies would give the project bonds an investment grade rating but not the highest investment grade rating. The reason is that once all the other Orinoco belt projects are completed, the risk of expropriation rises significantly. Also like the Ras Laffan
project mentioned in the case, we believe that the Petrozuata project would pierce the sovereign ceiling i.e. the project would get an investment grade rating which would be far higher than Venezuela¶s B country rating.
cc c c c Our recommendation would be to keep the leverage ratio at 60%. Increasing the leverage ratio to 70% or higher would adversely affect the project¶s minimum debt service coverage ratios and a possible investment grade rating. Also for the sponsors to show their commitment to the project, 60% seems an appropriate leverage ratio.
c cc In light of recent events like the BP oil spill, financial crisis etc, a reassessment of country and project risks might be in order. The following things could be considered: Increase the number of participants to decrease the relative exposure of each. If the emerging market country is in a particularly hostile part of the world or has hostile neighbors, get sponsors from the major superpowers to detract hostile neighbors from acting opportunistically. Use a staged investment approach where the 2nd phase depends on the outcome of the 1st phase. This improves information availability for the creditors and decreases the cost of debt in the 2nd phase. Special attention has to be given to countries that have UN/US/European sanctions slapped against them or any countries doing business with/in them. The Equator principles also come into play now in this day & age and weren¶t available at the time of this case.
Exhibit 1 ± Project Finance Risk Management Matrix Type of Risk Description of Risk ã Resource Risk Inputs not available in the quantity and quality expected Force Majeure Acts of God such as earthquakes or political risks such as terrorism Technological Risk Technology does not yield the expected output Timing Risk Construction falls behind schedule or is never completed Completion Risk Combination of technological and timing risks ã Input or Supply Risk Throughput Risk Force Majeure Environmental Risk
Market Quantity Risk Market Price Risk Exchange Rates Currency Convertibility Inflation Expropriation Diversion Changing Legal Rules
Funding Risk Interest-Rate Risk Debt Service Risk
Who bears the risk in this case Sponsors (suppliers) 3rd party insurers Sponsors (contractors) Sponsors (contractors) Sponsors (contractors)
Raw materials not available in the quality or quantity expected Output quantities are too low or costs too high See above Project fails to comply with national and international environmental standards Insufficient demand for the output Output prices decline
Changes in exchange rates reduces cash flows Inability to convert and repatriate foreign currency proceeds Nominal contracts become vulnerable to price changes Government seizes assets or cash flows directly or indirectly through taxes Government redirects project output or cash flows Government changes legal rules regarding contract enforceability, bankruptcy etc.
Sponsors, Venezuelan Government
Funds cannot be raised at economical rates Increasing interest rates reduces cash flows Project unable to service its debt obligations
Sponsors 3rd party insurers or sponsors Sponsors
Conoco (off-take) Sponsors (creditors)
Sponsors, Venezuelan Government Sponsors, Venezuelan Government Sponsors, Venezuelan Government Sponsors, Venezuelan Government Sponsors, Venezuelan Government
Acknowledgement ± Papers/White Papers on Project Finance written by Benjamin Esty