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Navigator Flood Appeal – Analysing Extreme Events
Analysing Extreme EventsRaising awareness of low frequency, high impact events
An initiative by Navigator Project Finance in partnership with Allens Arthur Robinson
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Analysing Extreme Events
Introduction
• Catastrophic events occur more frequently than commonly believed
• If the return period of an event is 30 years, your project has a 1/30 (~ 3%) probability of occurring every year
• The longer the project life, the greater the chance of a major disaster affecting your project
• Many sponsors and banks are not prepared for a catastrophic event
• It is essential to be prepared – don’t be caught out
“By failing to prepare, you are preparing to fail” - Benjamin Franklin
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Analysing Extreme Events
Why this seminar ?
• To share our knowledge and experience in best practice structuring, the force of nature and its impact on people, projects and markets
• To show our support for Australia’s flood victims.
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Analysing Extreme Events
How can you help?
We encourage you to donate:
www.qld.gov.au/floods/donate.html
The Premier’s Disaster Relief Appeal
• Launched by the Queensland Premier, Anna Bligh, to help those affected by the wide-spread flooding
• The Queensland Government had made a contribution of $1 million to start the appeal
• To date over $120 million has been raised by private, corporate and government donors
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Analysing Extreme Events
Australian Floods 2010
• Affected an area the combined size of France and Germany
• 200,000 people affected
• Estimated reduction in Australia’s GDP of A$30 billion ~ CPI down 0.5%
• Insurance claims in excess of A$1.5 billion
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Analysing Extreme Events
Navigator Project Finance
Navigator is a global project finance
consultancy firm. Navigator provides
a full range of project finance
services for investors, sponsors and
lenders, specialising in project
advisory, financial modelling and
training services globally.
With offices in Sydney, London and
Singapore Navigator’s clients and
projects are distributed globally. Our
consultative approach has made us a
natural choice for project bankers
and developers seeking dedicated
project services.
Allens Arthur Robinson
Allens Arthur Robinson is a
leading international law firm, with
more than 800 lawyers, including
189 partners. They have staff on
the ground in 14 cities and
eight countries across Greater
China, South East Asia and
Australia, and one of the most
extensive legal networks in the
Asia Pacific region. They are
committed to providing excellent
service; combining technical
excellence with commercial insight
to provide the clearest of answers.
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Analysing Extreme Events
Assumptions
• In presenting this session we are making the assumption that the audience understands the broad concept of Project Finance and the process involved.
• Debt financing where the primary source of repayment is the cashflow generated by the project
• Reduced or no cashflows will result in covenant breaches and ultimately default on loans.
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Analysing Extreme Events
Overview
• Introduction and recent events
• Project Finance - Basics
• Risks and mitigants
• Case study and impacts to project
• Monte Carlo simulation
• Summary
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Analysing Extreme Events
Extreme Events
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Analysing Extreme Events
Catastrophic Events – Force Majeure?
Varieties
• Acts of nature, such as fire, flood and earthquake
• Acts of man, such as war, terrorism and riots
• Acts of government, such as a general strike
• Impersonal acts, such as collapse of a financial system
• Disease outbreaks
What’s not force majeure
• Project specific strikes
• Anything within control of management
Major events are often easily forgotten and seen as “one-off”. They’re not limited to floods and have major impacts on cashflow.
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Analysing Extreme Events
A glance at just the last decade….
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
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Analysing Extreme Events
Project Finance Basics
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Analysing Extreme Events
A reminder
Projects are evaluated based using strict debt ratios
• Debt Service Cover Ratio (DSCR)
• Loan Life Cover Ratio (LLCR)
• Project Life Cover Ratio (PLCR)
Project finance is generally long term financing based only upon the projected cashflows of a project.
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Analysing Extreme Events
Debt Service Cover Ratio (DSCR)
• Usually calculated on a per period basis
• Depending on the project, DSCR is typically in the range of 1.25x – 2.00x
• Calculated asDSCR = Cashflow Available for Debt Service (CFADS)
Scheduled Senior Debt Service (P + I)
Calculation of the ability of the project to meet its interest and principal repayments
For more information
www.navigatorpf.com/tutorials/dscr-debt-service-coverage-ratio
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Analysing Extreme Events
Loan Life Cover Ratio (LLCR)
• LLCR at commercial operations date (COD) is important as it reflects the project’s ability to repay its obligations when the debt amount is at its maximum
• Typically, it is in the range of 1.25x – 2.50x
• Calculated asLLCR = NPV (r, CFADS over remaining life of loan)
Opening balance of the debt in the period
Calculation of the project’s ability to repay its outstanding debt over the loan tenor
For more information
www.navigatorpf.com/tutorials/llcr-loan-life-coverage-ratio
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Analysing Extreme Events
Project Life Cover Ratio (PLCR)
• Generally higher than LLCR due to the longer evaluation period
• PLCR could be less than LLCR, particularly in resource projects because of rehabilitation costs at the end of the project
• Typically, it is in the range of 1.50x – 3.00x
• Calculated asPLCR = NPV (r, CFADS over remaining life of project)
Opening balance of the debt in the period
Calculation of the project’s ability to repay its outstanding debt over the life of the project
For more information
www.navigatorpf.com/tutorials/plcr-project-life-cover-ratio
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Analysing Extreme Events
Risks and Mitigants
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Analysing Extreme Events
Risks
Some of a few factors which face a project over its life
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Analysing Extreme Events
Mitigants
Common methods to mitigate project finance risks include
•Insurance
•Force majeure clauses in contracts
•Establishment of debt service reserve account
•Hedging with options rather than forwards
•Management initiatives
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Analysing Extreme Events
Insurance
• Typically required by banks before approval of funding
• The different types of insurance cover include
• Construction and Erection All Risks (CAR/EAR) – covers damages and delays during construction
• Business Interruption – pays for running costs during disruption periods
• Debt Insurance – covers debt repayments during disruptions
• Loss of Profits (usually not required by banks) – covers potential profits that would have been received if there was no disaster
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Analysing Extreme Events
Force Majeure
• Frees both parties from liability or obligation when a disaster happens
• A force majeure clause is usually included in contracts between the SPV and a number of parties (eg shipping companies, banks and off-takers)
• Not typically included in forward contracts
• Seek good legal advice to ensure a well constructed force majeure clause and coverage for all contracts
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Analysing Extreme Events
Establishment of DSRA/c
• Banks often require a sponsor to set up a Debt Service Reserve Account (DSRA/c)
• Typically, it holds two quarters of future debt service (Principal + Interest)
• In the event where cashflows do not cover debt service, the DSRA/c will fund the shortfall
For more information :
www.navigatorpf.com/tutorials/dsra-debt-service-reserve-account
Establishing a DSRA/c at the end of construction ensures that limited shortfalls in the future can be serviced
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Analysing Extreme Events
Hedging with Options
• Options give the user the right to exercise when price is favourable (ie when the option is in the money)
• Options require an upfront premium – they come at a cost
• Can be exchange traded in some instances
• In contrast, forwards must be exercised – product available or not!!
For more information :
http://www.navigatorpf.com/blog/gold-price-hedging
Options help avoid losses when sellable product is not available
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Analysing Extreme Events
Management Initiatives
• Maintain a good relationship with bankers, key offtakers and suppliers
• Banks may readjust repayment schedule in the event of a disaster to match revised cashflows
• Plan ahead by assuming that a disaster will happen during the life of the project
• Constant project monitoring and risk review through full project life
• Source alternative suppliers in the event of a disaster
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Analysing Extreme Events
Case Study: Impact to a Project
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Analysing Extreme Events
The Situation
Our case study is based on an Australian greenfield gold mine. The following is key information relating to the project
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Analysing Extreme Events
The Situation
Funding assumptions for the project are laid out below
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Analysing Extreme Events
Project Diagram
BorrowerBanks
SPV
EPC Contractor
Operating Contractor
Offtaker 1Long term sales contract
Offtaker 2Long term sales contract
Shareholders
Insurance
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Analysing Extreme Events
Gold Mine Metrics
In the base case, the project is showing these key metrics
Note the following
• No covenant breaches in Base and Bank Case
• Base Case geared post-tax IRR at 26.32%
• Base Case geared post-tax NPV at 56 M
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Analysing Extreme Events
Base Case
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Analysing Extreme Events
Disaster Strikes!
Flooding occurs “unexpectedly”
Consequences of flood include
• Widespread damage
• Ore stockpile partially washed away
• Production halted temporarily until water
recedes
• Mine to port infrastructure damaged
• Financial obligations cannot be met
• Offtake contracts cannot be met
• Working capital reserves used up
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Analysing Extreme Events
Commercial Impact?
• Disruption to operations
• Variable cost decreases
• Insurance claims
• Debt repayments are not met (out of CFADS)
• Potential losses on hedging
• Reduction in value to all parties
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Analysing Extreme Events
Disruption to Operations
• Revenue to the project is reduced/removed due to limited or halted production
• Unable to deliver against contracted volumes
• Affected party will have to negotiate with offtakers
• Alternative is to purchase product from a third party producer, which is likely to result in losses as spot prices will rise during catastrophic event
Production halt removes revenue.
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Analysing Extreme Events
Variable Cost Decreases
• Variable costs are no longer incurred because of halted production and the exercise of the force majeure clause
• Fixed costs continue to be paid (eg. Overheads, wages)
• Business Interruption Insurance pays for fixed costs, likely with a delay of receipts of claims
Fixed costs are paid but
variable costs are very low
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Analysing Extreme Events
Insurance Claims
• Depending on the type of insurance in place, the affected party can claim to recover construction cost and/or operating costs
• Insurance receipts tend to be delayed due to the nature of the business/claims process
Insurance pays for fixed
operating costs but there may be delays in receipt
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Analysing Extreme Events
Use of DSRA/c
• No or limited revenue during delays
• Can apply for principal relief from banks
• With bonds, renegotiation is difficult due to the number of parties involved
• Rely on Debt Service Reserve Account (DSRA/c) to service debt. This is default, however banks may provide some relief.
DSRA/c releases cash to fund shortfall during the delay period
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Analysing Extreme Events
Potential Hedging Losses
• Forwards may incur losses in the event of non-delivery
• Catastrophic events will reduce supply of products and drive prices up
• Payout the difference in prices
• The affected party may negotiate with the financial institution to roll over forwards to a future period
• Difficult/costly to reverse position
Forwards no longer act as hedges since there are no sales
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Analysing Extreme Events
Reduction in Value for All Parties
• Financial ratios are badly affected due to minimal/no revenue
• Project and equity returns are reduced significantly
One quarter of delay results in covenant breaches which may lead to default
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Analysing Extreme Events
Disaster Case (Without Insurance)
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Analysing Extreme Events
Scenario Comparison
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Analysing Extreme Events
Monte Carlo Simulation
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Analysing Extreme Events
Monte Carlo Simulation
What is it?
• A technique that involves using random numbers and probability to solve problems
• A type of spreadsheet simulation which randomly generates values for uncertain variables repeatedly
• Calculates multiple scenarios of a model by repeatedly sampling values from the probability distribution for the uncertain variables
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Analysing Extreme Events
Log Normal Distribution
• Assumes a small chance of the unexpected event happening
• Typically used for
• Stock prices
• Survival rates
• Failure rates
• Disasters
Probability distribution of a random variable whose logarithm is normally distributed
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Analysing Extreme Events
Assumptions
• Input: Reduction in production in one quarter
• Distribution : Log-normal
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Analysing Extreme Events
Result
• Range of IRR with different probabilities as a result of the simulation
• Pink area represents scenarios below the hurdle rate of 25%
• A disaster (which is recovered from) can severely damage a whole of life IRR
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Analysing Extreme Events
Summary
When analysing a project, it is important to understand
• Return period of potential disasters
• Probability of the disaster happening during the life of the project
• The likely impact to the project and overall market
• Need for robust model to test downside scenarios
• Knowing the above, informed decisions can be made as to the structures required for your project
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Analysing Extreme Events
Useful resources
For ongoing resources, training or to have us assess your project for its ability to withstand extreme events.
•www.navigatorPF.com
•Book onto Navigator’s International Project Finance course.
•Call us on +61 2 9229 7400