DUE DILIGENCE: A PRACTICAL OVERVIEW OF TYPICAL DELIBERATIONS IN A PROJECT FINANCE STRUCTURE
Due diligence is at the heart of every financial transaction. For parties to evaluate the critical success of a project, due diligence must be up held high. This article is purposed to help readers understand generally what project finance entail and the important role of due diligence in the whole interplay of the finance cycle of a project. This is also meant for the writer to put his experience in the subject-matter to the fore, to inform and equip readers, investor or interested parties with knowledge on the subject-matter. The main parties or stakeholders in project finance are the project sponsor (initial investors), lenders (financial institutions), Project Company (special purposed vehicle), government, project developers and beneficiaries of the project.
In order for a lender to affirm and or appraise the variability of a project documentation, due diligence is a very essential element of the financing structure.
This article further brings to the understanding of readers the meaning of project finance and structure, the main components of project finance and the risk matrix associated with project finance. The article further discusses the typical deliberation issues that stakeholders need to discuss or are discussed in project finance. The aim of this write up is to help readers who have little or no knowledge of project finance to understand the basics of this transaction. It is further to aid in knowledge acquisition but not suffice for a legal advice.
2.0. PROJECT FINANCE IN PERSPECTIVE
Infrastructure is categorized as one of the denominators in economic growth and development of a country. Building infrastructure in a country requires strong funding. These infrastructural projects could be big or small, example, construction of highways, railways, hydro-dams, power plants etc. Any attempt to put some of these aforementioned projects into implementation means the project sponsors needs to secure funds from finance institutions to augment the initial funds contributed by the sponsor.
Project finance is financing long term projects with limited recourse. That is where the debt and equity are paid back to the lenders from the cash flow generated from the project. In fact, project finance is the analysis of the complete life-cycle of a project. In the analysis of the life-cycle of the project, cost and benefits analysis are carried out to determine whether the economic costs will be beneficial or worth investing in since it is a long term project.
2.1. COMPONENTS OF PROJECT FINANCE
a. Financing long-term infrastructure.
Project finance generally covers both public and private interest projects. Thus, any project that has a long-term span can be categorized under long-term financing. These include oil and gas extraction, power production, railways etc. It is estimated that sometimes the risk levels of these project are low, when the project has a reasonable predictable market, but not exhaustive.I must point out that in project finance the project sponsors create a Special Purpose Vehicle (SPV) as the legal entity through which the project will be implemented. By this same entity, financial structures will be created towards the implementation of the project. In the financial structure the project sponsors use the project assets and predicted cash flow as the basis for raising funds. The sponsors should have sufficient capitalization to the project company before turning to lenders to raise equity.
It is my basic advice by experience and best standards that in such transactions project sponsors albeit project companies should issue debt at a reasonable cost, with equity, averaging 10% to 30% of the total capital required for the project.
b. Limited Recourse Financial structure
Where project developers’ or sponsors seek to develop a project it is mostly advised that a Special Purpose Vehicle (SPV) should be created to serve as the legal entity through which the project would be carried out. The SPV is a limited liability company that can sue and be sued and can acquire assets.
It is based on the assessment of assets and cash-inflow of the SPV that the lender bank will grant the loan to the project company. This is contained in a detailed project report that is presented to the lender. The report should be able to lay out the financial structure of the project to be. The lenders make decisions to invest in the project based on the report and whether its content of analysis is realistic and viable to invest in. The lenders must further consider whether the assets, cash-inflow, guarantees and off-takers will be enough security to repay the loan yet to be granted to the project company.
2.3. CASH-INFLOW FROM Special Purpose Vehicle (SPV)
The cash-inflow from the SPV must be enough to meet the operating cost of the project company. Further to this, the cash flow must be sufficient the loan repayment and interest. The residual cash-inflow after repayment of the loan becomes profits to the company. This is shared on pro rata basis to shareholders per the share structure.
3.0. RISK MATRIX
Before I move on to discuss further on this subject, risk is verily associated with every projects. This is the reason why the risk needs to be assessed by the project parties. The risk assessment is the starting point of the project discussion by the project parties. There are different types of risks involved in project finance. I will proceed to discuss four risks out of the range of risk that abound:
- Country risk:
Where a project is of an international nature, the project parties (sponsor, lenders, etc.) must consider the issues of expropriation and nationalization laws of the host country and assess whether or not the government can take over such projects without recourse to law. The parties also must discuss whether the government can interfere in the internal affairs of the SPV project by using the coercive force of the state. Where this risk is high, project lenders and sponsors will be risk averse and may not want to invest in the project or consider suspension of the project if no remedy exist for the risk. Note that every investor wants to protect his or her interest no matter what.
- Currency Risk
Another risk of interest during project finance and deliberations is currency risk. Investors assess the potential currency fluctuations and exchange rate during the period of the project development and forecast through to execution.
Where the currency is deemed to be potentially not stable and performs badly economically against major currencies, the investors may be averse to invest in the project. This is so because the project prices are fixed to the currency and the fluctuations can cause exchange losses thereby increasing the project cost.
Further to this, where prices are fixed to foreign currencies as against the local currency in trade, should currency fluctuations occur, it will affect the company’s Balance of Payment deficits (BOP) where the project company imports raw materials for production. It will further potentially increase the cost of operation of the project. This risk should be assessed well enough in the board room to avoid exposure of the project to high risk which may cause delay of completion.
c. Completion Risk
Here, the parties to a project assess factors which can contribute to either early or delay the completion time of the project.
This risk assess the cost overrun within the contractor’s control or acts of the contractor which delays project completion. It further involves assessing cost overruns which are not within the contractor’s control. The later include change in laws, site condition or any other external factors by government. Other risk factors include the economy or labour unrest at site as well as internal factors attributable to the project contractor or other parties on the project who may potentially contribute to the delay of the project completion. To avert this risk, for example, project developers must fix price contract with the contractor to avoid cost overrun. Lenders must also have stand-by finance facility for any contingency that may arise during the pendency of the project. Also, the completion date must be fixed in the construction contract with penalty clauses so that where there is a default a party can seek remedy. The penalty clauses will serve as punitive clauses and this will cause the contractor or parties to work to term so to avoid such liquidated claim under the penalty clause. This can to a large extent addresses completion risk.
d). Market Risk
This is a major risk factor for most project sponsors or lenders. The existence of a market for the project products is very essential. Feasibility studies must be conducted on the general project. The results will inform key stakeholder on the path to go. It will also indicate the potential market size and segmentation for the project, the adoptive process of the project and general marketing strategy for the project. This must be embarked on to avert the project from becoming a white elephant after completion or serve little benefit to its target population or perform under capacity.
Also, the services or products from the project must match up to the anticipated cash-inflow projections. The solution to this is due diligence conducted by both the lender and sponsor(s) in order to determine the profitability of the project and how the market force will determine the performance of the products from the project. To avert high market risk, the parties, need to take this point serious.
4.0. DUE DILIGENCE
This is the appraisal or investigation of a business or project by reasonable business persons to establish the assets and liabilities of a company or project and further evaluate the commercial viability of the project. During due diligence all of the appraisal documents and proposal of the project are reviewed. The appraisal contains write ups on management and shareholding structure, financial performance, business proposal of the project being funded, profitability projections, risks analysis, company background and legal due diligence. The due diligence is carried out by the lawyers, finance experts and other professionals on the project.
4.1. Due Diligence deliberations in project finance.
There remain several deliberative issues that arise in project finance. The under-listed points are not exhaustive of typical due diligence deliberations in project finance but these remain amongst the inevitable issues that needs to be deliberated upon in project finance.
a). The Project Sponsor:
The project sponsor is the developer of the project or the group of persons who are project executives and ensure the execution of the project deliverables. It is important to note that, the project sponsor could be an interest-holder in the project. This means that the project sponsor could be a shareholder in the project.
The lender (financial institutions) needs to access the track record of the project sponsor(s) before committing to fund the project. It is presumed that the project sponsor(s) should have a certain degree of equity in the project. The lenders are secondary investors to a project. The lender and project sponsors therefore become equal stakeholders in the project but limited to the level of equity and financing.
The lender will have to fund the project to its satisfaction based on the finance structure. The lender must further request and assess the past experience of the sponsor in managing projects, assess the capital structure of the sponsor, assess whether there are construction and other forms of agreements required and any other relevant document to the project. The equity and debt ratio must be addressed by the sponsors to the lender. The lenders must assess whether the project sponsor have met the minimum equity required to issue debt at a reasonable cost. The averages should range between 10% – 30% of the total capital required for the project. The parties must also ensure that the sponsor does not go beyond the legal and accounting rules for maximum equity position of a sponsor, above which the project company will become a subsidiary of the sponsor. The lenders must ensure that the project company assets and the project cash-in flow can repay the loans from the lenders. The lender does these assessments through its advisors, lawyers and financial experts. A failed appraisal could mean potential liabilities for the lender.
b). Site of Project
A lot of thinking must inform the site selection for the project. The feasibility report must contain conclusive facts for decision making on the choice of a particular site. If the project is for the construction of a hospital, then the location of the project must be geologically good and accessible to the locals it anticipates to benefit. The condition of the site must to suitable for the construction of the project. The site must not be inaccessible to the very target people it seeks to benefit. The general nature of the site must be studied by experts to ascertain that the risk level is low for the commencement of the project.
c). Political, Economic and Legal Risk
There must be a comprehensive due diligence in respect of the above sub-topic. During deliberations, on the execution of the project, political factor is amongst one of the first issues that pops-up in the board room. Interestingly, political factor has both direct and indirect connection to the economy and the legal regime (laws) of the host country as well for the project implementation.
Political stability causes the micro and macro functions in the economy to be stable and for the economy to thrive and be resilient. But where the political situation is chaotic and the constitution is overthrown the economy degenerates and increases the standard of living in the country. In the same political situation justice delivery will be affected where the constitution is over-thrown thus, the independence of the judiciary will be compromised and this will affect investor confidence in the host country. This high risk variable will increase the risk of doing business in the host country and may dissuade investors to the host country. Issues of tax policies on tax rebates or holidays, laws and regulations, currency fluctuations, the market economy, expropriations and nationalization laws, foreign exchange laws and regulations must be discussed.
d). Financial Parameters
This is one of the most important stages in the deliberation process in project finance. A failed due diligence, the financial statements and structure of the project could potentially frustrate the project cycle or implementation and cause it to collapse in the course of time when practical difficulties emerge. Considerations include analysis of the debt to equity ratio. Debt to equity ratio is where the project company’s total liability is divided by the equity of the shareholders. A high debt to equity ratio means that the company will not be able to generate enough cash or income to service its loan from the lenders. But a low debt to equity is viable. The sponsors need to have initial capital to make the project attractive and financially for lenders to come on board. A ratio of 0.4 to 40% is good for project finance. The lenders must assess the total budget of the project, financial projections, and whether the projected cash flows and assets can repay the loan from the lenders. The lenders must also put in place contingency financial facility. The sponsors in their project report must demonstrate strong finance strategies. This is based on the cash flow requirements of the project as well as multiple sources or funds. The discussion by parties should include short and long term funding options, what the lenders and investors want, the maturity time for securities and the capital structure of the project.
e). Parties Obligations
This is one of the most important strategies of the due diligence process. This includes, the obligations of the various parties in the project finance structure, Construction cost, funding sources as well as commitment agreements of project sponsors (equity investor) and the lenders should be discussed and documented. The roles, terms and conditions of parties should be incorporated into the project agreement.
Construction overruns, and additional credit facility must always be made available by parties as constructions overruns can potentially change the funding obligation of the parties when it is not provided for. This means that, the parties must deliberate over critical costings issues and have drawn, fixed estimated prices such that even when prices are subjected to inflation project, costing will not be affected or cause delay in completion of the project. Critical attention must also be paid to the contractor’s performance.
Liquidated amounts should be incorporated into the agreement to tackle issues of delays and non-performance by parties. This ensures remedy to breaches as well as acting as punitive clauses.
- Draw down conditions
This must be discussed and agreed upon between the parties. The term indicates how funds will be transferred from the investors’ account to the project account. Further to this it should be that the cash flow requirements has already been finalized by the parties. Thus, the equity the project sponsors are expected to invest into the project needs to be agreed on. This draw down is based on the cash-inflow requirement. The debt to equity ratio must be agreed upon by the parties and labelled either as condition or warranty clause or hybrid term. That is, where there is a breach of condition by a party the contract is repudiated whereas breach of warranty may give rise to a claim for damages. A breach of a condition is serious and goes to the root of the project. The contract is repudiated no matter the remedy available to the other party. On the contrary, again, where there is the breach of warranty it is important to note that, no matter the losses caused, it will never give right to the other party to treat the project contract as repudiated.
At all times where there is a breach whether to a condition or warranty term, the innocent party must elect and inform the breaching part of the breach before termination where the breach is a condition and claim for damages. The party must elect and point out the breach and later claim for specific performance and or damages where it is a warranty.
- Interest Rates and Dividends
In project financing, because there are debt investors (lenders) in the scope of the financing and the project financing involves long-term financing, the whole finance structure is based on existing rates plus an amount of risk. The parties are to discuss and agree on the type of interest rate, for the repayment of the loan (i.e. variable or fixed interest rates). Note that there are main types of interest rates, i.e. fix and variable interest rates. The fixed interest rate is where the rate does not fluctuate over the set period whereas variable interest rate fluctuates.
The parties should conclude on the type of interest rate and the agreed rate so that repayment of the loan is clear and fair. Dividends are the profits from the project. This is realized based on the cash flow projections. Dividends should be shared to shareholders per their shares.
h. Off-take Agreement.
This is a type of commercial agreement where the project company enter into an agreement with a buyer and the buyer agrees to buy specific quantity of goods or services produced by the project company in the future. The project company should agree on realistic prices even though the transaction is a future market. The price should be sufficient to off-set the debts of the company. In a nutshell, thorough discussions should be reached with the off-take purchaser so that revenue from the transaction will be sufficient to cover the debt servicing and operating cost of the company. I must add that, off- take agreements should be discussed earlier on and agreed upon by the parties before the project is executed. This is to guarantee the market for the project company.
J. Environmental Considerations and General Review.
There should be discussions on environmental standard of the project. Permits and safety zones should be discussed and the necessary approvals procured. The parties and their advisors should thoroughly review the project and all agreements complementing the finance structure.
5.0. In conclusion
The nature of the project is very important as it dictates the complexion of the type of financial structure to be arranged. Thus, where the project is of international nature negotiation begins with the government or its department concerning permits and approvals etc. Further to this, the project sponsors must raise substitutional equity so that the debt to equity ratio will be realistic and satisfy required legal and accounting ratios. This makes servicing the debt easier as the debt will be based on cash flows and securities. The project documentation is major part of the transaction which will bring real perspectives of the project to the lender and other interested parties.
Due diligence is wholly everything in transactions like this, and affords the parties to weigh on the risk matrix of the project finance structure for successful execution. The above summarizes essential deliberations in due diligence by parties during project finance transactions but are not exhaustive.