← A COMPARATIVE ANALYSIS OF MUTUAL

FUNDS WITH SPECIAL EMPHASIS ON SIP AND

LUMPSUM INVESTMENTS

←← A PROJECT REPORT

←← Submitted by

←

← SAKET AGARWAL

←← in partial fulfillment for the award of the degree

←← of

←← BACHELOR OF COMMERCE

←← In

←← FINANCE

←← ST. XAVIERS COLLEGE (AUTONOMOUS),KOLKATA

←

1

← MARCH, 2010

←

← ST. XAVIER’S COLLEGE(AUTONOMOUS),

KOLKATA

←

←← BONAFIDE CERTIFICATE

← Certified that this project report “A COMPARATIVE ANALYSIS OF

MUTUAL FUNDS WITH SPECIAL EMPHASIS ON SIP & LUMPSUM

INVESTMENTS” is the bonafide work of “SAKET AGARWAL” who carried

out the project work under my supervision.

←

←

← SIGNATURE SIGNATURE

←

← HEAD OF THE DEPARTMENT SUPERVISOR

←

DEPT. OF COMMERCE (EVE.) DEPT. OF

COMMERCE (EVE.)

←

← 30 MOTHER TERESA SARANI 30 MOTHER TERESA

SARANI

←

← KOLKATA 700 016 KOLKATA 700 016

2

←

3

ACKNOWLEDGEMENT

←←← First and foremost, I would like to extend my deepest gratitude to

my guide Professor Kaushik Chatterjee for his support. His constant

encouragement motivated me to perform to the best of my ability.

←← I am sincerely thankful to my teachers, without whose supervision

and guidance this project would not have been completed.

← Also, I would like to convey my gratitude to Mr. Sanjay Saraf of

SSEI Ltd. Who gave me valuable knowledge on the subject.

←← Also, I would like to speacially thank Mr. Basant Maheshwari,

Director of www.theequitydesk.com for providing and guiding me on

the various regulations governing the stock market.

4

ABSTRACT

←← Finance is the lifeblood of business. Finance is indispensable, it is

rightly said that finance is the lifeblood of an enterprise. This is because in

modern money oriented economy, finance is one of the basic foundations of

all kinds of economic activities. It is needed to convert ideas into reality.

It may be arranged in many ways – and project finance is one such way. It is

the raising of funds on a limited recourse or non-recourse basis to finance an

economically separable capital investment project in which the providers of

the funds look primarily to the cash flow from the project as the source of

funds to service their loans and provide a return on their equity invested in

the project.

As an effective alternative to conventional direct financing, project financing

has become one of the hottest topics in corporate financing. It’s being used

more and more frequently on a wide variety of high profile corporate

projects.

Through this project I have highlighted on the rationale of project finance,

the characteristics and scheme of project finance, and the security

arrangements, project structure, project risks and its mitigation. Financial

modelling calculations are also shown and the various sources of project

funds have also been highlighted.

The presented case study involves a peep into Enron scandal and the way it

has impacted project finance, as after Enron project finance was widely

criticized.

5

Table of Contents PAGE NO.

1. INTRODUCTION

1.1 Rationale of Project Finance 1-2

1.2 Characteristics of Project Finance 3

1.3 Basic Scheme of Project Finance 4-5

2. LITERATURE REVIEW

2.1 Definition of Project Finance 6-7

2.2 Project Financing Arrangements 8-9

2.2.1 Build Own Operate Transfer

2.2.2 Build Own Operate Structure

2.2.3 Build Lease Transfer Structure

2.3 Project Viability and Financial Modelling 10-23

2.3.1 Technical Feasibility

2.3.2 Project Construction Cost

2.3.3 Economic Viability

2.3.4 Adequacy of Raw Material Supplies

2.3.5 Creditworthiness

2.3.6 Financial Modelling

2.4 Project Finance Risk 24-34

2.4.1 Risk Minimization Review

2.4.2 Types Of Risks

2.5 Security Arrangements 35-39

2.5.1 Security Arrangements Covering Completion of Project

2.5.2 Direct Security Interest in Project’s Facilities

2.5.3 Security Covering Debt Service

2.5.4 Purchase And Sale Contract

2.5.5 Raw Material Supply Agreement

2.5.6 Supplemental Credit Support

6

2.5.7 Financial Support Agreement

2.5.8 Cash Deficiency Agreement

2.5.9 Escrow Fund

2.5.10 Insurance

2.6 Legal Structure 40-44

2.6.1 Undivided Joint Interest

2.6.2 Corporations

2.6.3 Partnerships

2.7 Sources Of Funds 45-49

3. CASE STUDY: HOW ENRON HAS AFFECTED PROJECT FINANCE

3.1 The Enron Story 50-51

3.2 Caution among Lenders and Investors 52-53

3.3 Project Finance And Enron Factor 53-64

3.3.1 Effect on Traditional Project Finance

3.3.2 Effect in Structured Project Finance

3.3.3 Sources of Free Cash Flow

3.3.4 Security Interests

3.3.5 How Companies Have Responded

3.3.6 Increased Transparency and Disclosure

3.3.7 Regulatory Issues

3.4 Other Lessons Learned 65-66

4. CONCLUSION 67

BIBLIOGRAPHY 68

7

←←←

8

9

10

←←← CONTENTS

← PARTICULARS PAGE NO.

←← 1. INTRODUCTION 4

←← 2. LITERATURE REVIEW 6

←← 3. METHODOLOGY 17

←← 4. HYPOTHESIS 26

←← 5. RESULTS 27

←← 6. CONCLUSION 28

←← 7. EXECUTIVE SUMMARY 30

←← ANNEXURE

← BIBLIOGRAPHY

←←←←←←←←←←

11

←

← 1.

INTRODUCTION

←

← 1.1 Rationale of Project Financing

←

← There is a growing realization in many developing countries of the

limitations of governments in managing and financing economic activities,

particularly large infrastructure projects, Provision of infrastructure

facilities, traditionally in the government domain, is now being offered for

private sectors investments and management. This trend has been

reinforced by the resource crunch faced by many governments.

Infrastructure projects are usually characterized by large investments, long

gestation periods, and very specific domestic markets.

← In project financing the project, its assets, contracts, inherent

economic and cash flows are separated from their promoters or sponsors in

order to permit credit appraisal and loan to the project, independent of the

sponsors. The assets of the specific project serve as a collateral for the

loan, and all loan repayments are made out of the cash of the project. In

this sense, the loan is said to be of non-resource to the sponsor.

12

←

←

13

← Thus, project financing may be defined as the scheme of ‘financing

of a particular economic unit in which l lender is satisfied in looking at the

cash flows and the earnings of that economic unit as a source of funds,

from which a loan can be repaid, and to the assets of the economic unit as a

collateral for the loan. In the past, project financing was mostly used in oil

exploration and other mineral extraction through joint ventures with

foreign firms. The most recent use of project financing can be found in

infrastructure projects, particularly in power and telecommunication

projects. Project financing is made possible by combining undertakings and

various kinds of guarantees by parties who are interested in a project. It is

built in such a way that no one party alone has to assume the full credit

responsibility of the project. When all the undertakings are combined and

reviewed together, it results in an equivalent of the satisfactory credit risk

for the lenders. It is often suggested that the project financing enables a

parent company to obtain inexpensive loans without having to bear all the

risks of the project. This is not true, in practice, the parent company is

affected by the actual plight of the project, and the interests on the project

loan depend on the parents stake in the project. The traditional form of

financing is the corporate financing or the balance sheet financing. In this

case, although financing is apparently for a project, the lender looks at the

cash flows and assets of the whole company in order to service the debt and

provide security.

←

14

←

← 1.2 Characteristics of Project Finance

←

← The following are the characteristics of project financing:

← • A separate project entity is created that receives loans from lenders

and equity from sponsors.

← • The component of debt is very high in project financing. Thus,

project financing is a highly leveraged financing.

← • The project funding and all it’s other cash flows are separated from

the parent company’s balance sheet.

← • Debt services and repayments entirely depend on the project’s cash

flows. Project assets are used as collateral for loan repayments.

← • Project financers’ risks are not entirely covered by the sponsor’s

guarantees.

← • Third parties like suppliers, customers, government and sponsors

commit to share the risk of the project.

← Project financing is most appropriate for those projects, which

require large amount of capital expenditure and involve high risk. It is

used by companies to reduce their own risk by allocating the risk to a

number of parties.

← It allows sponsors to :

← • Finance large projects than the company’s credit and financial

capability would permit.

15

← • Insulate the company’s balance sheet from the impact of the

project.

← • Use high degree of leverage to benefit the equity owners.

← 1.3 Basic Scheme of Project Finance

←

The basic scheme of project finance has been explained with an example:

← Acme Coal Co. imports coal. Energen Inc. supplies energy to

consumers. The two companies agree to build a power plant to accomplish

their respective goals. Typically, the first step would be to sign a

memorandum of understanding to set out the intentions of the two parties.

This would be followed by an agreement to form a joint venture.

← Acme Coal and Energen form an SPV (Special Purpose Vehicle)

called Power Holdings Inc. and divide the shares between them according to

their contributions. Acme Coal, being more established, contributes more

capital and takes 70% of the shares. Energen is a smaller company and takes

the remaining 30%. The new company has no assets.

← Power Holdings then signs a construction contract with Acme

Construction to build a power plant. Acme Construction is an affiliate of

Acme Coal and the only company with the know-how to construct a power

plant in accordance with Acme's delivery specification.

16

← A power plant can cost hundreds of millions of dollars. To pay Acme

Construction, Power Holdings receives financing from a development bank

and a commercial bank. These banks provide a guarantee to Acme

Construction's financier that the company can pay for the completion of

construction. Payment for construction is generally paid as such: 10% up

front, 10% midway through construction, 10% shortly before completion,

and 70% upon transfer of title to Power Holdings, which becomes the owner

of the power plant.

← Acme Coal and Energen form Power Manage Inc., another SPV, to

manage the facility. The ultimate purpose of the two SPVs (Power Holding

and Power Manage) is primarily to protect Acme Coal and Energen. If a

disaster happens at the plant, prospective plaintiffs cannot sue Acme Coal or

Energen and target their assets because neither company owns or operates

the plant.

A Sale and Purchase Agreement (SPA) between Power Manage and Acme

Coal supplies raw materials to the power plant. Electricity is then delivered

to Energen using a wholesale delivery contract. The cash flow of both Acme

Coal and Energen from this transaction will be used to repay the financiers.

FIGURE - I

17

2. LITERATURE REVIEW

←

←

← 2.1 Definition of Project Finance

←

18

There is no single agreed upon definition for project finance. 

For example, Finnerty defines project finance as:

 The raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.

While Nevitt and Fabozzi defines it as:

A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.

And the International Project Finance Association (IPFA) defines project finance 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. 

Although none of these definitions uses the term “nonrecourse debt” explicitly (i.e., debt repayment comes from the project company only rather than from any other entity), they all recognize that it is an essential feature of project finance.[1] 

The following definition, albeit slightly more cumbersome, allows one to distinguish project finance from other financing vehicles, something the previous two definitions cannot do:

Project finance involves the creation of a legally and 19

economically independent project company financed with nonrecourse debt (and equity from one or more corporate sponsors) for the purpose of financing a single purpose, capital asset usually with a limited life.

--------------------------------------------------------------------------------------------

[1] Limited recourse debt—debt that carries a repayment guarantee for a defined period of time, for a fraction of the total principal, or until a certain milestone is achieved (e.g., until construction is complete or the project achieves a minimum level of output)—is a subset of nonrecourse debt.  The distinguishing feature is that at least some portion of the debt becomes nonrecourse at some point in time.

20

2.2 Project Financing Arrangements

←

← The project financing arrangements may range from simple

conventional type of loans to more complex arrangements like the build-

own-operate-transfer (BOOT).

← The typical arrangements include:

← 2.2.1 ‘The build-own-operate-transfer (BOOT) structure

← 2.2.2 The build-own-operate (BOO) structure

← 2.2.3 The build-lease-transfer (BLT) structure

←

←

← 2.2.1 ‘The build-own-operate-transfer (BOOT) structure

← It is a special financing scheme, which is designed to attract private

participation in financing constructing and operating infrastructure projects.

In BOOT scheme, a private project company builds a project, operates it for

a sufficient period of time to earn an adequate return on investment, and then

transfers it to the host government or its agency. Quite often, the value of

efficiency gain from private participation can outweigh the extra cost of

borrowing through a BOOT project, relative to direct government

borrowing. The private group usually consists of international construction

contractors, heavy equipment suppliers, and plant and system operators

along with local partners.

←

←

21

← 2.2.2 The Build-Own-Operate (BOO) Arrangement

← The issue of “transfer”(the T in BOOT projects) is ambiguous because

most of the BOOT projects under operation or consideration have the

transfer dates quite far away and, therefore, they are not a real concern as

yet. One problem with the transfer provision is the likelihood of the capital

stock of the project being run down as the date of transfer draws bearer.

←

←

← 2.2.3 Build-Lease-Transfer arrangement

← In the build lease transfer arrangement, the control of the project is

transferred from the project owners to a lease. The shareholders retain the

full ownership of the project, but, for operation purposes, they lease it to a

lessee. The host government agrees with the lessee to buy the output or

service of the project. The lesser receives the lease rental guaranteed by the

host government.

←

←

←

←

←

←

←

←

←

22

← 2.3 PROJECT VIABILITY AND FINANCIAL MODELLING

←

← Investors are concerned about all the risks a project involves, who will

bear each of them, and whether their returns will be adequate to compensate

them for the risks they are being asked to bear. Both the sponsors and their

adviser must be thoroughly familiar with the technical aspects of the project

and the risks involved, and they must independently evaluate a projects

economics and its ability to service project related borrowings.

←

←

← 2.3.1.Technical Feasibility:

← Prior to the start of construction, the project sponsors must undertake

extensive engineering work to verify the technological processes and design

of the proposed facility. If the project requires new or unproven technology,

test facilities or a pilot plant will normally have to be constructed to test the

feasibility of the process involved and to optimize the design of full scale

facilities. A well-executed design will accommodate future expansion of the

project; often, expansion beyond the initial operating capacity is planned at

the outset. The impact of project expansion on operating efficiency is then

reflected in the original design specifications and financial projections.

←

←

←

←23

← 2.3.2 Project Construction Cost:

← The detailed engineering and design work provides the basis for

estimating the construction costs for the project. Construction costs should

include the cost of all facilities necessary for the project’s operation as a

freestanding entity. Construction costs should include contingency factor

adequate to cover possible design errors or unforeseen costs. Project

sponsors or their advisers generally prepare a time schedule detailing the

activities that must be accomplished before and during the construction

period. A quarterly breakdown of capital expenditures normally

accompanies the time schedule.

← The time schedule specifies

← (1) Time expected to be required to obtain regulatory or

environmental approvals and permits for construction.

← (2) The procurement lead time anticipated for major pieces of

equipment and

← (3) The time expected to be required from pre-construction activities-

performing detailed design work, ordering the equipment and building

materials, preparing the site and hiring the necessary manpower.

← The project sponsor examines the critical path of the construction

schedule to determine where the risk of delay is greatest and then assesses

the potential financial impact of any projected delay.

24

2.3.3 Economic Viability:

← The critical issue concerning economic viability is whether the

project’s expected net present value is positive. It will be positive only if the

expected present value of the future free cash flows exceeds the expected

present value of the project’s construction costs. All the factors that can

affect project cash flows are important in making this determination.

Assuming that the project is completed on schedule and within budget, its

economic viability will depend primarily on the marketability of the projects

output (price and volume). To evaluate marketability, the sponsors arrange

for a study of projected supply and demand conditions over the expected life

of the project. The marketing study is designed to confirm that, under a

reasonable set of economic assumptions, demand will be sufficient to absorb

the planned output of the project at a price that will cover the full cost of

production, enable the project to service its debt, and provide an acceptable

rate of return to equity investors.

← The marketing study generally includes:

← 1) A review of competitive products and their relative cost of

production;

← 2) An analysis of the expected life cycle for project output, expected

sales volume, and projected prices; and

← 3) An analysis of the potential impact of technological obsolescence.

25

← An independent firm of experts usually performs the study. If the

project will operate within a regulated industry, the potential impact of

regulatory decisions on production levels and prices—and, ultimately, on the

profitability of the project –must also be considered. The cost of production

will affect the pricing of the project output. Projections of operating costs are

prepared after project design work has been completed. Each cost element,

such as raw materials, labor, overhead, taxes, royalties, and maintenance

expense, must be identified and quantified. Typically, this estimation is

accomplished by dividing the cost element into fixed and variable cost

components and estimating each category separately. Each operating cost

element should be escalated over the term of the projections at a rate that

reflects the anticipated rate of inflation. From a financing standpoint, it is

important to assess the reasonableness of the cost estimates and the extent to

which the pricing, and hence the marketability, of the project output is likely

to be affected by estimated cost inflation rates. In addition to operating costs,

the project’s cost of capital must be determined. The financial adviser

typically is responsible for this task. He develops and tests various

financing plans for the project in order to arrive at an optimal financing plan

that is consistent with the business objectives of the project sponsor.

←

←

← 2.3.4 Adequacy of raw material supplies:

26

← The project should have sufficient supplies of raw materials to enable

it to operate at design capacity over the term of the debt. Independent

consultants may be summoned to evaluate the quantity, grade, and rate of

extraction that the mineral reserves available to the project are capable of

supporting. The project should have the ability to access the raw materials

through contractual agreements like direct ownership, lease, purchase

agreement etc.

← 2.3.5 Creditworthiness:

← A project has no operating history at the time of its initial debt

financing. Consequently, the amount of debt the project can raise is a

function of the project’s expected capacity to service debt from project cash

flow- or more simply, its credit strength.

← A project’s credit strength derives from

← (1) The inherent value of the assets included in the project,

← (2) The expected profitability of the project,

← (3) The amount of equity project sponsors have at risk,

← (4) The pledges of creditworthy third parties or sponsors involved in

the project.

Thus,

27

← To arrange financing for a stand-alone project, prospective lenders

must be convinced that the project is technically feasible and economically

viable and that the project will be sufficiently creditworthy if financed.

Establishing technical feasibility requires demonstrating that the

construction can be completed on schedule and within budget and that the

project will be able to operate at its design capacity following completion.

Establishing economic viability requires demonstrating that the project will

be able to generate sufficient cash flow so as to cover its overall cost of

capital. Creditworthiness will be established by demonstrating that even

under reasonably pessimistic circumstances, the project will be able to

generate sufficient revenue to cover all operating costs and to service project

debt in a timely manner. The loan terms have an impact on how much debt

the project can incur and still remain creditworthy.

2.3.6 Financial Modelling

EXAMPLE: To illustrate how financial modeling is done a 50MW power

plants calculation is shown below:

28

2.4 PROJECT FINANCE RISK

2.4.1 Risk Minimization Process 

Financiers are concerned with minimizing the dangers of any events that

could have a negative impact on the financial performance of the project, in

particular, events that could result in:

(1) The project not being completed on time, on budget, or at all;

(2) The project not operating at its full capacity;

(3) The project failing to generate sufficient revenue to service the debt; or

(4) The project prematurely coming to an end.

29

The minimization of such risks involves a three-step process. The first step requires the identification and analysis of all the risks that may bear upon the project. The second step is the allocation of those risks among the parties. The last step involves the creation of mechanisms to manage the risks.

If a risk to the financiers cannot be minimized, the financiers will need to build it into the interest rate margin for the loan.

STEP 1 - Risk identification and analysis

30

← The project sponsors will usually prepare a feasibility study, e.g. as to

the construction and operation of a mine or pipeline. The financiers will

carefully review the study and may engage independent expert consultants to

supplement it. The matters of particular focus will be whether the costs of

the project have been properly assessed and whether the cash-flow streams

from the project are properly calculated. Some risks are analyzed using

financial models to determine the project's cash flow and hence the ability of

the project to meet repayment schedules. Different scenarios will be

examined by adjusting economic variables such as inflation, interest rates,

exchange rates and prices for the inputs and output of the project. Various

classes of risk that may be identified in a project financing will be discussed

below.

←

← STEP 2 - Risk allocation

← Once the risks are identified and analyzed, they are allocated by the

parties through negotiation of the contractual framework. Ideally a risk

should be allocated to the party who is the most appropriate to bear it (i.e.

who is in the best position to manage, control and insure against it) and who

has the financial capacity to bear it. It has been observed that financiers

attempt to allocate uncontrollable risks widely and to ensure that each party

has an interest in fixing such risks. Generally, commercial risks are sought to

be allocated to the private sector and political risks to the state sector.

←

31

← STEP 3 - Risk management

← Risks must be also managed in order to minimize the possibility of the

risk event occurring and to minimize its consequences if it does occur.

Financiers need to ensure that the greater the risks that they bear, the more

informed they are and the greater their control over the project. Since they

take security over the entire project and must be prepared to step in and take

it over if the borrower defaults. This requires the financiers to be involved in

and monitor the project closely. Such risk management is facilitated by

imposing reporting obligations on the borrower and controls over project

accounts. Such measures may lead to tension between the flexibility desired

by borrower and risk management mechanisms required by the financier.

←

←

← 2.4.2 TYPES OF RISKS

Of course, every project is different and it is not possible to compile an exhaustive list of risks or to rank them in order of priority. What is a major risk for one project may be quite minor for another. In a vacuum, one can just discuss the risks that are common to most projects and possible avenues for minimizing them.

However, it is helpful to categorize the risks according to the phases of the project within which they may arise:

(i) The design and construction phase;

(ii) The operation phase; or

(iii) Risks common to both construction and operational phases.

32

It is useful to divide the project in this way when looking at risks because the nature and the allocation of risks usually change between the construction phase and the operation phase.

(i) Construction phase risk –

33

← Completion risk:

← Completion risk allocation is a vital part of the risk allocation of any

project. This phase carries the greatest risk for the financier. Construction

carries the danger that the project will not be completed on time, on budget

or at all because of technical, labour, and other construction difficulties.

Such delays or cost increases may delay loan repayments and cause interest

and debt to accumulate. They may also jeopardize contracts for the sale of

the project's output and supply contacts for raw materials.

← Commonly employed mechanisms for minimizing completion risk

before lending takes place include:

← (a) Obtaining completion guarantees requiring the sponsors to pay all

debts and liquidated damages if completion does not occur by the required

date;

← (b) Ensuring that sponsors have a significant financial interest in the

success of the project so that they remain committed to it by insisting that

sponsors inject equity into the project;

← (c) Requiring the project to be developed under fixed-price, fixed-time

turnkey contracts by reputable and financially sound contractors whose

performance is secured by performance bonds or guaranteed by third parties;

← (d) Obtaining independent experts' reports on the design and

construction of the project.

34

← Completion risk is managed during the loan period by methods such

as making pre-completion phase drawdown’s of further funds conditional on

certificates being issued by independent experts to confirm that the

construction is progressing as planned.

←

←

← (ii) Operation phase risk

←

← Resource / reserve risk  

← This is the risk that for a mining project, rail project, power station or

toll road there are inadequate inputs that can be processed or serviced to

produce an adequate return.

← For example, this is the risk that there are insufficient reserves for a

mine, passengers for a railway, fuel for a power station or vehicles for a toll

road. Such resource risks are usually minimized by:

← (a) Experts’ reports as to the existence of the inputs (e.g. detailed

reservoir and engineering reports which classify and quantify the reserves

for a mining project) or estimates of public users of the project based on

surveys and other empirical evidence (e.g. the number of passengers who

will use a railway);

← (b) Requiring long term supply contracts for inputs to be entered into

as protection against shortages or price fluctuations (e.g. fuel supply

agreements for a power station);

35

← (c) Obtaining guarantees that there will be a minimum level of inputs

(e.g. from a government that a certain number of vehicles will use a toll

road); and

← (d) "Take or pay" off-take contacts, which require the purchaser to

make minimum payments even if the product cannot be delivered.

← Operating risk

← These are general risks that may affect the cash flow of the project by

increasing the operating costs or affecting the project's capacity to continue

to generate the quantity and quality of the planned output over the life of the

project. The usual way for minimizing operating risks before lending takes

place is to require the project to be operated by a reputable and financially

sound operator whose performance is secured by performance bonds.

Operating risks are managed during the loan period by requiring the

provision of detailed reports on the operations of the project and by

controlling cash-flows by requiring the proceeds of the sale of product to be

paid into a tightly regulated proceeds account to ensure that funds are used

for approved operating costs only.

←

Market / off-take risk

36

← Obviously, the loan can only be repaid if the product that is generated

can be turned into cash. Market risk is the risk that a buyer cannot be found

for the product at a price sufficient to provide adequate cash flow to service

the debt. The best mechanism for minimizing market risk before lending

takes place is an acceptable forward sales contact entered into with a

financially sound purchaser.

←

← (iii) Risks common to both construction and operational phases

←

Participant / credit risk

← These are the risks associated with the sponsors or the borrowers

themselves. The question is whether they have sufficient resources to

manage the construction and operation of the project and to efficiently

resolve any problems that may arise. Of course, credit risk is also important

for the sponsors' completion guarantees. To minimize these risks, the

financiers need to satisfy themselves that the participants in the project have

the necessary human resources, experience in past projects of this nature and

are financially strong.

←

← Technical risk

37

← This is the risk of technical difficulties in the construction and

operation of the project's plant and equipment, including latent defects.

Financiers usually minimize this risk by preferring tried and tested

technologies to new unproven technologies. Technical risk is also minimized

before lending takes place by obtaining experts reports as to the proposed

technology. Technical risks are managed during the loan period by requiring

a maintenance retention account to be maintained to receive a proportion of

cash flows to cover future maintenance expenditure.

←

←

←

← Currency risk

← Currency risks include the risks that:

← (a) A depreciation in loan currencies may increase the costs of

construction where significant construction items are sourced offshore; or

← (b) A depreciation in the revenue currencies may cause a cash-flow

problem in the operating phase.

← Mechanisms for minimizing currency risk include:

← (a) Matching the currencies of the sales contracts with the currencies

of supply contracts as far as possible;

← (b) Denominating the loan in the most relevant foreign currency; and

← (c) Requiring suitable foreign currency hedging contracts to be

entered into.

←

38

← Regulatory / approvals risk

← These are risks that government licenses and approvals required to

construct or operate the project will not be issued (or will only be issued

subject to onerous conditions), or that the project will be subject to excessive

taxation, royalty payments, or rigid requirements as to local supply or

distribution. Such risks may be reduced by obtaining legal opinions

confirming compliance with applicable laws and ensuring that any necessary

approvals are a condition precedent to the drawdown of funds.

←

←

←

←

← Political risk

← This is the danger of political or financial instability in the host

country caused by events such as insurrections, strikes, and suspension of

foreign exchange, creeping expropriation and outright nationalization. It also

includes the risk that a government may be able to avoid its contractual

obligations through sovereign immunity doctrines. Common mechanisms for

minimizing political risk include: (a) requiring host country agreements and

assurances that project will not be interfered with;

← (b) Obtaining legal opinions as to the applicable laws and the

enforceability of contracts with government entities;

← (c) Requiring political risk insurance to be obtained from bodies

which provide such insurance (traditionally government agencies); 39

← (d) Involving financiers from a number of different countries, national

export credit agencies and multilateral lending institutions such as a

development bank; and

← (e) Establishing accounts in stable countries for the receipt of sale

proceeds from purchasers.

←

← Force majeure risk

← This is the risk of events which render the construction or operation of

the project impossible, either temporarily (e.g. minor floods) or permanently

(e.g. complete destruction by fire). Mechanisms for minimizing such risks

include:

← (a) Conducting due diligence as to the possibility of the relevant risks;

← (b) Allocating such risks to other parties as far as possible (e.g. to the

builder under the construction contract); and

← (c) Requiring adequate insurances which note the financiers' interests

to be put in place.

←

← Country Risk

← Country risk includes risks of currency transfer, expropriation, war

and civil disturbances, and breach of contract by the host government. The

multilateral Investment guarantee Agency (MIGA) of the World Bank

provides guarantee against country risk for an appropriate premium. Export

credit agencies also provide such guarantees but they usually seek counter-

guarantees from the host government.

40

←

← Sector Risk

← Sector risk refers to the risk in certain sectors because of the role of

government agencies in those sectors. For example, in the power sector, the

buyer is usually a government utility agency that transmits and distributes

power. The solvency of the utility is critical for the ‘take or pay’ power

purchase agreement to have any value. For selected power projects, the

Indian government has agreed in principle to give counter guarantees to back

up state guarantees for the State Electricity Boards (SEBs), payment

obligations to private generating companies, on a specific request to the state

government concerned and subject to the state government agreeing to

certain terms and conditions. For toll roads, government support may be

necessary to enforce toll collections. Similarly, in the case of municipal

services such as water supply and solid-state disposal, the support of

municipal authorities is important. In each case, the government may

guarantee contract compliance of the respective agencies.

FIGURE 2: TYPES OF RISK

41

2.5 Security Arrangements

←

42

← Arranging sufficient credit support for project debt securities is a

necessary precondition to arranging debt financing for any project. Lenders

to a project will require that security arrangements be put in place to protect

them from various risks. The contractual security arrangements apportion

the risks among the project sponsors, the purchasers of the project output,

and the other parties involved in the project. They represent a means of

conveying the credit strength of going-concern entities to support project

debt.

← 2.5.1 Security arrangements covering completion of project:

The security arrangements covering completion typically involves an

obligation to bring the project to completion or else repay all project debt.

Lenders normally require that the sponsors or creditworthy parties provide

an unconditional undertaking to furnish any funds needed to complete the

project in accordance with the design specifications and place it into service

by a specified date. The specified completion date normally allows for

reasonable delays. If the project is not completed by the specified date, or if

the project is abandoned prior to completion, the completion agreement

typically requires the sponsors or other designated parties to repay all project

debt. The obligations of the parties providing the completion undertaking

terminates when completion of the project is achieved.

←

←

43

←

← 2.5.2 Direct security interest in project facilities:

Lenders require a direct security interest in project facilities, usually in the

form of a first mortgage lien on all project facilities. This security interest is

often of limited value prior to project completion. Following completion of

the project, the first lien provides added security for project loans. The lien

gives lenders the ability to seize the assets and sell them if the project

defaults on its debt obligations. It thus affords a second possible source of

debt repayment apart from cash flows of the project.

←

←

← 2.5.3 Security covering debt service:

After the project commences operations, contracts for the purchase and sale

of the project’s output or utilization of the project’s services normally

constitute the principal security arrangements for project debt. Such

contracts are intended ensure that the project will receive revenues that are

sufficient to cover operating costs fully and meet debt service obligations in

a timely manner.

←

←

←

←

←

←

44

←

← 2.5.4 Purchase and Sale Contracts:

It is of the following types:

← (a)Take-if-offered contract :

← Such a contract obligates the purchaser of the project’s output or

services to accept delivery and pay for the output and services that the

project is able to deliver. It does not require the purchaser to pay if the

project is unable to deliver the product. That is the contract protects the

lenders only if the project is operating at a level that enables it to service its

debt. Lenders would therefore require additional credit support or security

arrangements in order to provide against unforeseen events.

(b) Take-or-pay contract:

A Take-or-pay contract is similar to a Take-if-offered contract; it gives the

buyer the option to make cash payment in lieu of taking delivery, whereas

the take-if-offered contract requires the buyer to accept deliveries. Cash

payments are usually credited against charges for future deliveries. Like the

take-if-offered contract, a take-or-pay contract does not require the

purchaser to pay if the project is unable to deliver the output or services.

← (c) Hell-or-high water contract :

← This is similar to a take-or-pay contract except that there are no ‘outs’

even when adverse circumstances are beyond the control of the purchaser.

The purchaser must pay in all events, regardless of whether any output is

delivered. It therefore provides lenders with tighter security than other

contracts.45

← Step-up provisions:

The strength of these various agreements can be enhanced in situations

where there are multiple purchasers of the output. A step-up provision is

often included in the purchase and sale contracts. It obligates all the other

purchasers to increase their respective participation in case one of the

purchasers goes into default.

←

← 2.5.5 Raw material supply agreements:

A raw material supply agreement represents a contract to fulfill the project’s

raw material requirements. The contract specifies certain remedies when

deliveries are not made. Often both purchase and supply contracts are made

to provide credit support for a project. A supply-or-pay contract obligates

the raw material supplier to furnish the requisite amounts of the raw material

specified in the contract or else make payments to the project entity that are

sufficient to cover the project’s debt service.

←

← 2.5.6 Supplemental credit support:

← Depending on the structure of a project’s completion agreement and

the purchase and sale contracts, it may be necessary to provide supplemental

credit support through additional security arrangements. These arrangements

will operate in the event the completion undertaking or the purchase and sale

contracts fail to provide the cash to enable the project entity to meet its debt

service obligations.

←46

←

←

← 2.5.7 Financial support agreement:

← A financial support agreement can take the form of a letter of credit or

similar guarantee provided by the project sponsors. Payments made under

the letter of credit or similar guarantee are treated as subordinated loans to

the project company. In some cases it is advantageous to purchase the

guarantee of a financially able party to provide credit support for the

obligations of a project company

←

← 2.5.8 Cash deficiency agreement:

← It is designed to cover any cash shortfalls that would impair the

project company’s ability to meet its debt service requirements. The obligor

makes a cash payment sufficient t cover the cash deficiency. Payments made

under a cash deficiency agreement are usually credited as cash advances

toward payment for future services or product from the project.

←

← 2.5.9 Escrow Fund

In certain instances lenders may require the project to establish an escrow

fund that typically contains between 12 and 18 month’s debt service. A

trustee can draw money from the escrow fund if the project’s cash flow from

operations proves insufficient to cover the project’s debt service obligations.

←

←47

←

←

← 2.5.10 Insurance:

Lenders typically require that insurance betaken out to protect against

certain risks of force majeure. The insurance will provide funds to restore

the project in the event of force majeure, thereby ensuring that the project

remains a viable entity. The project sponsors normally purchase commercial

insurance to cover the cost of damage caused by natural disasters. They may

also secure business interruption insurance to cover certain other risks. In

addition lenders may require the sponsors to agree contractually to provide

additional funds to the project to the extent insurance proceeds are

insufficient to restore the operations.

←

←

←

←

48

2.6 LEGAL STRUCTURE

Sponsors of projects adopt many different legal forms for the ownership of

the project. The specific form adopted for any particular project will depend

upon many factors, including:

The amount of equity required for the project

The concern with management of the project

The availability of tax benefits associated with the project

The need to allocate tax benefits in a specific manner among the

project company investors.

One of the most critical questions project sponsors need to address is

whether a legally distinct “ project financing entity” should be employed and

how it should be organized.

2.6.1 Undivided Joint interest:

Projects are often owned directly by the participants as tenants in common.

Under the undivided joint interest ownership, each participant owns an

undivided interest in the real and personal property constituting the project

and shares in the benefits and risks of the project in direct proportion to the

ownership percentage. The ownership interests relate to the entire assets of

the project; no participant is entitled to any particular portion of the property.

49

When the project is organized, the participants choose someone in their

ranks to serve as the project operator. This arrangement is particularly

suitable when one of the owners already has operations in the same industry

that are of a similar nature, or otherwise has qualified employees available.

The duties of the operator and obligations of all other parties are specified in

an operating statement. The joint venture will require each participant to

assume responsibility for raising its share of the project’s external financing

requirements. Each sponsor will be free to do so by whatever means are

most appropriate to its circumstances.

Thus for example,

if a sponsor owns 25 percent of the project, it will be required to provide,

from its resources, 25 percent of the funds necessary to construct the project.

The undivided joint interest has particular appeal when firms of widely

differing credit strength are sponsoring the project. By financing

independently, the higher-rated credits can borrow at a cost that is lower

than the cost at which the project entity can borrow based on its composite

credit. Depending on the sponsor’s ability to take immediate advantage of

the tax benefits of ownership arising out of the project, direct co-ownership

may also provide the project sponsors with immediate cash flow to fund

their equity investments.

50

2.6.2 Corporation

The form of organization most frequently chosen for a project is the

corporation. A new corporation is formed to construct, own, and operate the

project. This corporation, which is typically owned by the project sponsors,

raises funds through the sponsors’ equity contributions and through the sale

of senior debt securities issued by the corporation. The senior debt

securities typically take the form of either first mortgage bonds or

debentures containing a negative pledge covenant that protects their senior

status. The negative pledge prohibits the project corporation from granting a

lien on project assets in favour of other lenders unless the debentures are

secured rate able. The corporate form permits creation of other types of

securities, such as junior debt (second mortgage, unsecured, or subordinated

debt), preferred stock, or convertible securities. The corporate form of

organization offers the advantages of limited liability and an issuing vehicle.

Nevertheless, the corporate form has disadvantages that must be considered.

The sponsors usually do not receive immediate tax benefits from any

Investment Tax Credit (ITC) the project entity can claim or from

construction period losses of the project. Also, the ability of a sponsor to

invest in the project corporation may be limited by provisions contained in

the sponsor’s bond indentures or loan agreements. In particular, the

51

provisions restricting “investments” either by amount or by type may impose

such limitations.

2.6.3 Partnership:

The partnership of organization is frequently used in structuring joint

venture projects. Each project sponsor, either directly or through a

subsidiary, becomes a partner in a partnership that is formed to own and

operate the project. The partnership issues securities (either directly or

through a corporate borrowing vehicle) to finance construction. Under the

terms of a partnership agreement, the partnership hires its own operating

personnel and provides for a management structure and decision-making

process. A partnership is particularly attractive for so-called “cost

companies”; a profit is not realized at the project level but instead is earned

further downstream in the sale of the project’s output. The Uniform

Partnership Act imposes joint and several liabilities on all the general

partners for all obligations of the partnership. They are also jointly and

severally liable for certain other project-related obligations any of the

general partners incurs in the ordinary course of business or within the scope

of a general partner’s apparent authority. A partnership can also have any

number of limited partners. They are not exposed to unlimited liability.

However, there must be at least one general partner who does have such

exposure.

52

FIGURE 3: A PARTNERSHIP STRUCTURE IN PROJECT FINANCE

53

54

100% OWNERSHIP AND PERFORMANCE GUARANTEE

100% OWNERSHIP AND PERFORMANCE GUARANTEE

100% OWNERSHIP AND PERFORMANCE GUARANTEE

X OWNER

SHIP PERCEN

Y OWNER

SHIP PERCEN

Z OWNER

SHIP PERCEN

100%

OWNERSHIP

2.7 SOURCES OF FUNDS

Financing options i.e the various sources of finance are equity, debt, Indian

and international financial institutions, multilateral institutions, export credit

agencies, GDR’s and external commercial borrowings.

(a) Equity finance

Government policy allow a debt equity ratio of 8:2, however lending

institutions advocate a gearing ratio up to 7:3 as a prudent measure of

lending. Specialized infrastructure and mutual funds have come up to bridge

the equity gap in mega projects such as Global Power investment of GE

Caps, the AIG Asian Infrastructure Fund, and the Asian Infrastructure Fund

of Peregrine Capital Ltd. And ICICI.

(b) Debt Financing

In raising debt or financing the power sector projects the list of funds should

be the lowest so that the ultimate cost of electricity will be the lowest for the

end consumer. The decision of the promoter to go in for equity or debt

financing depends on various factors like go guidelines for power projects,

incentives available and return on equity as also the cost of debt vis-a vis

equity.

55

Domestic Capital market Bonds are issued by the Central / State

Government and Publish/private Ltd. Companies t augment the resources of

the power sector in the capital market. Presently, internal rates are regulated

and credit rating is mandatory if the maturity of the instruments exceeds 18

months. NCDs with an option of buy back, debentures with equity warrants,

floating rate bonds and deep discount bonds are some of the innovative

instruments offered in the market.

(c) Indian Financial Institutions

The area of project financing in the Indian context is mainly limited to the

Indian Term Lending Institutions. In addition a large number of state level

institutions, finance projects of smaller size commercial banks also

participate in the term loans to a limited extent, besides meeting the working

capital requirements. As no individual FI can feed to the power sector

because of the huge funds requirements and the long gestation period of the

projects. The concept of loan syndication amongst the FIs is gaining

momentum. This also helps in sharing the risk among the FIs apart from

saving o the efforts and the cost because of the appraisal done by the leading

institution.

56

(d) Sources of international finance

Due to the domestic finance viable for the power projects, the need to tap

international markets has become inevitable which is characterized by the

long tenure of maturities and availability of various modes of finance.

(e) Multilateral Institutions

Institutions like the World Bank, IFC, and ADB etc. Have traditionallybeen

financing infrastructure in developing countries. The financing comer with

restrictive covenants affordable costs, long tenure and in an assured manner.

The co-financing facility extended by some of the multilateral institutions is

gaining popularity. In many of these loans, sovereign guarantee is required.

(f) Export Credit Agencies

ECAs are a common source of bilateral funding. Credit is provided by ECAs

such as the US Exim Bank, Exim Japan, etc. ECAs have a long history of

providing finance for all types of power generation equipment. There are

certain limitations in ECA financing like exposure limits, exchange risk,

transfer to IPP guarantee requirements and cost of insurance etc.

57

(g) External commercial borrowings

These include Yankee bonds, Dragon bonds, Euro Currencysyndicated

loans, US144A private placements, Global Registered Notes, Global Bonds

etc. (J) Syndicated loans The special features of syndicated loans are that

they are for medium to longer period; specific to the requirements of the

borrowers to suite their projects and availability of floating rate of interest.

Most of the investors are Asian/European Banks, FIs, Insurance Companies

and pension funds.

(h) Global Depository receipts (GDRs)

GDRs present an attractive avenue of funds for the Indian companies. Indian

Companies can collect a large volume of funds in foreign currency in Euro

issues. GDRs are usually listed in Luxembourg and are traded in London in

the OTC market or among a restricted group such as Qualified Institutional

Buyers (QIBs) in the USA. The GDRs do not have a voting right; there is no

fear of management control.

58

FIGURE4: SOURCES OF FUNDS

59

60

3. CASE STUDY :

HOW ENRON HAS AFFECTED PROJECT FINANCE

3.1 The Enron Story

Enron Corporation (former NYSE ticker symbol ENE) was an American

energy company based in Houston, Texas. Before its bankruptcy in late

2001, Enron employed approximately 22,000 staff and was one of the

world's leading electricity, natural gas, communications and pulp and paper

companies, with claimed revenues of nearly $101 billion in 2000. Fortune

named Enron "America's Most Innovative Company" for six consecutive

years.

Enron traded in more than 30 different products, including the following:

Products traded on Enron Online

Petrochemicals

Plastics

Power

Pulp and paper

Steel

Weather Risk Management

Oil& LNG Transportation

Broadband

Principal Investments

Risk Management for Commodities

61

Shipping / Freight

Streaming MediaWater and Wastewater

At the end of 2001 it was revealed that its reported financial condition was sustained substantially by institutionalized, systematic, and creatively planned accounting fraud, known as the "Enron scandal". Enron has since become a popular symbol of willful corporate fraud and corruption. The scandal also brought into question the accounting practices of many corporations throughout the United States and was a factor in the creation of the Sarbanes–Oxley Act of 2002. The scandal also caused the dissolution of the Arthur Andersen accounting firm, affecting the wider business world.

Enron filed for bankruptcy protection in the Southern District of New York in late 2001 and selected Weil, Gotshal & Manges as its bankruptcy counsel. It emerged from bankruptcy in November 2004, pursuant to a court-approved plan of reorganization, after one of the biggest and most complex bankruptcy cases in U.S. history. A new board of directors changed the name of Enron to Enron Creditors Recovery Corp and focused on reorganizing and liquidating certain operations and assets of the pre-bankruptcy Enron. On September 7, 2006, Enron sold Prisma Energy International Inc., its last remaining business, to Ashmore Energy International Ltd. (now AEI).

62

3.2 CAUTION AMONG LENDERS AND INVESTORS

← Because lenders may have been stung by PG&E or Enron an because

of other recent market factors such as declining power prices and emerging-

market problems, lenders and investors in early 2002 were approaching all

energy and power companies with increased caution. They were scrutinizing

merchant power and trading businesses with particular care. They were

doing deals mainly with prime names that have proven staying power.

← At the same time, rating agencies were downgrading hitherto fast-

growing independent power companies or requiring them to reduce their

leverage to maintain a given rating. Among the agencies’ concerned in the

current market environment are the exposure of these companies’ merchant

plants to fluctuating fuel and electricity prices and the companies’ reduced

access to equity capital. Of course, having been criticized for not

downgrading Enron soon enough, the rating agencies are particularly

sensitive toward the energy and power sectors. But, it is important to

remember that the fast-growing power companies using innovative

revolving credits to finance the construction of new power plants are single

sponsors with fully disclosed on-balance- sheet debt. Even though Enron is

one of the factors that have discouraged banks from increasing their industry

exposure, most of the restrictions the markets are placing on the growth of

independent power companies are related to other market factors discussed

above that were evident before the Enron bankruptcy.

63

← Similar to lenders and investors, companies that trade with each other

are becoming more concerned with counterparty credit risk. In evaluating

the creditworthiness of a given counterparty, they are looking at the whole

portfolio to see if one risky business such as merchant power or energy

trading—diversification benefits aside— could drag down the others.

← For example, a company with primarily merchant plants is more

vulnerable to an overbuild scenario than one with mainly power purchase

agreements.

3.3 PROJECT FINANCE AND ENRON FACTOR

←

64

← The Enron bankruptcy and related events have changed neither the

nature nor the usefulness of traditional project finance, but they have led to a

slowing down of some of the more innovative forms of structured project

finance. Among the other direct and indirect effects of Enron have been

increased caution among lenders and investors toward the energy and power

sectors; increased scrutiny of off-balance sheet transactions, increased

emphasis on counterparty credit risk particularly with regard to companies

involved in merchant power and trading and deeper analysis of how

companies generate cash flow. There is increased emphasis on transparency

and disclosure even tough disclosure in traditional project finance has been

more robust than in most types of corporate finance. In the current market

environment, for reasons that extend beyond Enron, some power companies

have been cancelling projects and selling assets to reduce leverage and

resorting to on balance financing to fortify liquidity.

←

← The immediate cause of the Enron bankruptcy was a loss of

confidence among investors caused by the company’s restatement of

earnings and inadequate, misleading disclosure of off-balance-sheet entities

and related debt. However, because Enron was a highly visible power and

gas marketer (not to mention far-flung activities from overseas power plants

to making a market in broadband capacity), its failure brought more scrutiny

to all aspects of the energy and power business, particularly the growing

sectors of merchant power and trading.

65

←

← Even before the Enron bankruptcy, the confidence of many power and

gas companies was shaken by other devastating events during 2001

including the California power crisis, the related Pacific Gas and Electric

Company bankruptcy, failing spot power prices in U.S. markets, and the

collapse of Argentina Economy and financial system. The California power

crisis is evidence of a flawed deregulation structure, which caused a global

setback to power deregulation and paralyzed U.S. BANK, markets for much

of the first half of 2001. The falling spot power prices were caused primarily

by overbuilding of new projects for the near term (though probably not for

the longer term), mild weather is most of the United States, and

overdependence on the spot market

← The combination of these events in 2001, accentuated at the end of the

year by the Enron bankruptcy, caused a dramatic change in the perception of

risk among investors, lenders, and rating agencies. In particular, these parties

began to perceive independent power producers (IPPs) riskier than they ever

had before.

66

← They considered trading businesses difficult to evaluate; they

suspected earnings manipulation through the marking to market of power

contracts and off-balance-sheet vehicles; they feared sustained low power

prices in the U.S. market. After problems in countries such as Argentina,

Brazil, India and Indonesia, emerging market IPP projects began to seem

more like a danger than an opportunity. Investors and lenders began to

perceive earnings in the IPP and trading business to be less predictable and

sustainable than they had thought before. They discounted the growth

prospects of these companies and focused on liquidity and leverage in light

of higher perceived risk.

←

← They have bad exposures in foreign markets that have collapsed; they

have had to cancel advance purchase orders for turbines because of a

slowing U.S. power market; their stock prices are tumbling as a result of

reduced growth prospects; and they are facing a credit crunch from lenders,

some of which are gun-shy from recent losses related to PG&E or Enron. So,

as we look at today’s energy and power market, we see some direct effects

of the Enron bankruptcy and other situations caused by a combination of all

the factors discussed above.

← But before going further, let’s look at how Enron has affected pure,

traditional project finance.

← 3.3.1 EFFECT ON TRADITIONAL PROJECT FINANCE

67

←

← “Traditional” project finance is cash flow based; asset-based finance

that has little in common with Enron’s heavily criticized off- balance-sheet

partnerships. The historic elements of project finance are firmness of cash

flow, counterparty creditworthiness, ability to deal over a long time frame,

and confidence in the legal system. It is a method for monetizing cash flows,

enhancing security, and sharing or transferring risks. The Enron transactions

in question generally did not have these characteristics. They were an

attempt to unduly benefit from accounting, tax, and disclosure requirements

and definitions.

← Traditional project finance is based on transparency, as opposed to the

Enron partnerships, where outside investors did not have the opportunity to

do the due diligence upon which any competent project finance investor or

lender would have insisted. Those parties are interested in all the details that

give rise to cash flows. As a result, there is a lot more disclosure in project

finance than there is in most corporate deals.

← In traditional project finance, investors and rating agencies do not

have a problem with current disclosure standards; it is not hidden and it

never has been. First, they know project financing is either with or without

recourse and either on or off the balance sheet.

68

← For example, in the case of Joint venture where a company owns 50%

of a project or less, the equity method of accounting is used for off balance-

sheet treatment. On the income statement, the company’s share of earnings

from the project is included below the line in the equity investment in

unconsolidated subsidiaries.

← When a company owns more than 50% of a project, its debt is

consolidated on the balance sheet and its dividends are included in income.

The minority interest is backed out. The point to remember is that whether a

project is financed on or off the balance sheet, analysts know where to look.

← Also off-balance-sheet treatment may not be the principal reason for

most project financing. It usually is motivated more by considerations such

as risk transfer or providing a way for parties with different credit rating to

jointly finance a project – whereas if all of those parties providing the

financing on their own balance sheets, they would be providing unequal

amounts of capital by virtue of their different borrowing costs. None of these

considerations have anything to do with the Enron partnerships, where 3 %

equity participation from a financial player with nothing at risk was used as

a gimmick to get assets and related debt off the balance sheet.

3.3.2 EFFECT ON STRUCTURED PROJECT FINANCE

←

69

← Even though traditional project finance has not been affected very

much by Enron, there certainly has been a slowing of activity in the more

innovative types of structured finance such as synthetic leasing, structured

partnerships, and equity share trusts – at least for the time being.

Synthetic leases are a mature product, understood by rating agencies and

accountants, in which billions of dollars of deals have been done.

← Even though synthetic lease are transparent and well understood, they

have an off-balance sheet element that creates headlines in today’s

environment, more of them maybe done in a year or two.

← The investor market has overreacted to anything that sounds “like

Enron”. Structured and project financing techniques have been developed

for sound risk management reasons and, in my opinion, must be defended

vigorously on those grounds. I believe a prejudice against such financial

structures could have a real economic and financial cost. However if

sponsors fear that the wider market will punish them for using complex

structures, they will stop using them.

← At the time of Enron scandal several companies had already made

public vows not to use any off – balance sheet structures.

← But, rather than pandering to uninformed sentiment, one should make

greater efforts to clearly delineate the difference between legitimate non-

recourse debt and the Enron structures.

←

←

← 3.3.3 SOURCES OF FREE CASH FLOW70

←

← Immediately after Enron filed for bankruptcy protection, some

questioned whether project and structured finance would survive in its form.

And indeed, some corporations with large amounts of off- balance sheet

financing were subjected to increased scrutiny and sharply red valuations for

both their equity and their debt. In response those companies have expanded

their liquidity and reduced their debt to the extent possible. But, as time

progresses, the main fallout from Enron and the other recent market shocks

have not been so much of a turning away from project finance but rather a

greater stress on bottom-up evaluation of how companies generate recurring

free cash flow and what might affect it over time. In this process, project as

well as structured finance probably will continue to play an important role.

The change, has been that the focus has shifted from not only the project

structures, but also on how they may affect corporate level cash flow and

credit profiles, for example through springing guarantees and potential debt

acceleration, through contingent indemnification and performance

guarantees, and through the potential for joint-venture and partnership

dissolutions to create sudden changes in cash flows.

←

←

← 3.3.4 SECURITY INTERESTS

←

71

← Power business, in part, has shifted from a contract-based business to

a trading, cash flow- based kind of business where the counterparty becomes

critical to the viability of a transaction. The security in the transaction is less

than the asset itself and more what the trading counterparty does with the

asset. That asset has an option value in the hands of a counterparty, but a far

different value if a bask has to foreclose on it—a value you would rather not

find out.

← Enron’s alleged tendency to set its own rules for marking gas,

electricity and various other newer, thinly traded derivative contacts to

market raises some questions about collateral and security. Historically, the

security in a power plant financing has consisted of contracts, counterparty

arrangements and assets. But if a lender’s security depends on marking

certain contracts to market and there is some question as to the objectivity of

the counterparty that is marking them to market, that raises additional

questions as to what is an adequate sale, what is adequate collateral, how a

lender takes an adequate security interest, how a lender monitors the value of

its security interest, and what needs to be done to establish a sufficient prior

lien in the cash flow associated with the transaction. In the case of a

structured project finance transaction, the key question remains just as it

always has been: whether the security is real and whether you can get rely

on it.

←

←

72

← 3.3.5 HOW COMPANIES HAVE RESPONDED

←

← Affected companies respond to the current market environment

rapidly and decisively to strengthen their liquidity through issuing new

equity, canceling projects, selling assets, either unwinding structured finance

deals or putting them on the balance sheet, and increased transparency and

disclosure (discussed further below). During this past December and J alone

five power companies raised $4 billion in equity. During the first quarter of

2002, power projects adding up to 58,000 megawatts of capacity were either

deferred or canceled.

← Some power companies have set up massive credit facilities for doing

so based on their overall corporate cash flow and creditworthiness. Another

option for a company is to borrow against a basket of power projects,

allowing the lenders to diversify their risks, but such a facility is still largely

based on the credit fundamentals of the corporation. But project financing on

an individual plant basis can be preferable to either of these approaches for

both project sponsors and lenders.

73

← For example, say a company is financing ten projects and three run

into trouble. The company can make a rational economic decision as to

which of those projects are salvageable and which ones do not merit

throwing in good money after bad. It might let one go into foreclosure and

be restructured and sold. But if a company is financing ten projects together,

its management may feel compelled to artificially bolster some of its

projects so that the failure of one project does not bring the entire credit

facility down. Making such an uneconomic decision for the near term would

not be in the company’s long-term interests.

←

←

←

←

←

← 3.3.6 INCREASED TRANSPARENCY AND DISCLOSURE

←

74

← The major players generally are releasing much more information

than before about their businesses and financing arrangements. Similarly, an

overriding aura of conservatism in disclosure has been seen, for example, in

conference room discussions while drafting prospectuses for project finance

deals. Bankers are making extra efforts to confirm that details are being

disclosed and explained the right way. Given the current tarnishing of the

merchant power sector, they might explain further than in the past that a

company’s trading is not speculative and that it is using accepted risk

management measures such as value-at-risk (VAR). They also might break

out the percentage of sales from power sales and from “marketing”—a team

that sounds better than trading in today’ environment

← Also strong management actions are needed to restore belief in

honesty of numbers. A company’s management needs to demonstrate the

same passion for integrity as it had for growth in the past. It needs to get rid

of gimmicks and consistently communicate and execute a simple, clear

strategic vision. This involves cleaning up the balance sheet. Transactions

that have significant recourse to the sponsor should be put back on the

balance sheet. Only true non-recourse deals should be left off the balance

sheet. To convey an accurate, fair picture of the business, companies need to

communicate—to the point of obsession —information and assumptions

about how earnings are recognized, including mark-to-market transactions.

← Managing earnings is out and managing cash flow is in—and, that’s

what the rating agencies are looking at anyway.

75

← Companies may need to reexamine their strengths and weaknesses

and refocus and simplify their basic business strategies. Their boards of

directors might become more helpful in this process with the addition of

non-executive members who understand the business.

3.3.7 REGULATORY ISSUES

←

← One of the reasons Enron was left to its own devices in valuing gas,

electricity, and other types of contracts was that it became, in effect the

largest unregulated bank in the world. It was able to avoid regulation of its

activities by the Commodity Futures Trading Commission (CFTC). Partly as

a result of its own lobbying efforts, and the Federal Energy Regulation

Commission (FERC) declined to get involved as well. Therefore, it was able

to duck some of the scrutiny that regulators have directed toward

commercial and investment banks dealing in derivatives. Of course,

securities analysis had long complained about Enron’s opaque financial

reporting, only to be told in return that they just didn’t understand the

business.

76

← FERC will have to become more involved in trading than it has in the

past. FERC’s current emphasis is to avoid the abuse of market power in the

electricity business But today, a power company might have market power

in trading completely unrelated to market power in asset ownership. Enron

proved that they are two different things. A company can dominate trading

market without dominating the asset-ownership market. So regulatory lesson

to be learned from Enron is that today’s electricity market needs more

sophisticated oversight of both the trading function and market power.

←

← Also Sarbanes-Oxley Act was implemented to protect investors by

improving the accuracy and reliability of corporate disclosures made

pursuant to the securities laws, and for other purposes. The Sarbanes-Oxley

Act created new standards for corporate accountability as well as new

penalties for acts of wrongdoing. It changes how corporate boards and

executives must interact with each other and with corporate auditors. It

removes the defense of "I wasn't aware of financial issues" from CEOs and

CFOs, holding them accountable for the accuracy of financial statements.

The Act specifies new financial reporting responsibilities, including

adherence to new internal controls and procedures designed to ensure the

validity of their financial records.

77

3.4 OTHER LESSONS LEARNED

← Among the more general lessonsfrom Enron that go beyond the realm

of structured and project finance are:

← • It is risky to over-invest in businesses sectors such as broadband and

water

← • A power trading business, though potentially profitable, is highly

vulnerable to liquidity crisis and has a low liquidation value.

← •Trading to hedge a power company’s inherent physical position in

power or gas should not be regarded as a suspect business per se, but it can

involve the risk of sudden liquidity crisis—especially for triple-B-minus-

rated companies that don’t want to slip below investment-grade status.

← • Mark-to-market accounting rules can mislead investors, lenders, and

analysts as to the extent of non-recurring earnings, even in the absence of

fraud.

← Among the lessons more directly related to project and structured

finance are the following:

78

← • The transfer of assets, intangible and otherwise, into non-

consolidating vehicles controlled by a sponsor may mislead investors as to

the extent of non-recurring earnings or deferred losses even in the absence of

fraud.

← • There is a risk of low recovery rates on structured transactions

secured by intangible assets (investments, contracts, company stock) or by

tangible assets whose values are net established on an arm’s length basis.

← • Having been badly burned by the Enron bankruptcy, banks and

investors in its structured and project financings, and in the energy sector

generally, will be especially conservative, and this will limit credit and

capital access for many clients in the sector, creating a genera liquidity issue

for these customers.

←

←

← Several recommendations concerning accounting treatment and

disclosure:

←

← • An effort must be made by all in the project finance industry (and

investor relations) to underscore the distinction between true non-recourse

structures and Enron’s activities

79

← • The terms “non-recourse” and “off balance sheet should remain

synonyms. Liabilities that truly have no recourse to a company’s

shareholders can justly be treated as off balance sheet. Enron appears to have

violated this principle since the undisclosed liabilities in the off- balance

sheet partnerships actually had significant recourse to Enron shareholders

through share marketing mechanisms.

← • Many project finance structures are “limited” rather than “non”

recourse, and thus there is a potential grey area in which accounting rules

allow off-balance sheet treatment but there is nonetheless some contingent

liability to the parent company shareholders. Full disclosure of any potential

shareholder recourse was advisable pre-Enron and is absolutely necessary

now.

←

← 4.

CONCLUSION

←

← Two basic tenets of project finance:

← I) The financing of hard assets that have ongoing value through

economic cycles and

← 2) The high level of sponsor expertise and commitment required.

80

← As Enron grew and expanded, it seemed more interested in businesses

or transactions that would generate a certain return than it was in whether or

not those ventures would complement its core businesses. As such, Enron

got into a number of businesses in which it did not have any expertise and

then was not committed to those businesses when expectations were not met.

← To conclude, project finance is alive and well. We just need to remind

a few people of its basic fundamentals. Neither project finance nor sensible

in innovations in structured finance with sound, well explained business

reasons have been shaken by Enron.

← The principle lessons learned from the Enron debacle have to do with

transparency and disclosure. When some of your businesses or your finance

structures become hard to explain, you may begin to question whether they

make sense in the first place.

BIBLIOGRAPHY

Finnerty, J.D., 1996, Project Financing:  Asset-Based Financial Engineering. New York, NY:  John Wiley & Sons.

Hoffman, Scott L., The Law and Business Of International Project Finance, Kluwer Law International, 2008.

Nevitt, P.K., and F.J. Fabozzi, 2000, Project Financing, 7th edition, Euromoney Books (London, U.K.).

81

Brealey, R., and S.Myers, Principles of Corporate Finance, McGraw Hill

Standard & Poor's Corporation, 2003, Project Finance Summary Debt Rating Criteria, by P. Rigby and J. Penrose, in 2003-2004 Project & Infrastructure Finance Review:  Criteria and Commentary, October.

Wikepedia.com - (http://en.wikipedia.org/wiki/Project_finance) (en.wikipedia.org/wiki/Enron)

www.projectfinancemagazine.com/

www.people.hbs.edu/besty/projfinportal/

www.pfie.com

www.projectfinancereview .com

www.time.com/time/2002/enron

www.enronfraud.com/

www.uow.edu.au/~bmartin/dissent/documents/.../citienron.html

←

82