Project Finance Tim Thompson Corporate Restructuring

How is most corporate investment organized? In corporations Debt is usually recourse to entire organization’s assets Leverage is usually modest (obvious exceptions)

What is project finance? Refers to a wide range of financing structures. These financing structures usually have one thing in common --- the financing is not primarily dependent on the credit support (credit quality) of the sponsors or the value of the assets involved. Instead, debtholders (banks, public lenders) place a substantial degree of reliance on the performance (I.e., cash flows) of the project itself… Non-recourse (or at least limited resource) financing Project finance is both a financial structure and a corporate governance structure aimed at resolving capital market imperfections and efficiently allocating risk.

What types of projects? Somewhat arbitrary, but Single purpose capital investment Stand alone entity Finite and long life Large in size

Project finance versus conventional financing Modigliani Miller still holds if its assumptions are true if there were no taxes or transactions costs no costs of financial distress no agency conflicts no information costs THEN PROJECT FINANCE WOULD ADD NO VALUE RELATIVE TO CONV. FIN.

Project finance is very costly Transactions costs very large Contracts: very complex organizational structure, not much flexibility Long negotiations, long time to close Fees (0.6% of deal size, similar to M&A) DISADVANTAGE RELATIVE TO CONVENTIONAL FINANCE

Costs of distress/bankruptcy Risk of default and allocation of this risk very different than conventional debt Less risk contamination with other parts of firm Less co-insurance benefit Rearranges “states” in which default occurs Trade-off, clearly

Agency costs High leverage, dedicated cash flows, very specific contractual terms for repayment and contingencies May limit opportunities for risk shifting May limit cross subsidization incentives May replace managerial incentives of a public-sector project with a for-profit venture, contracts used to enhance incentives

May improve economics MM theorem assumes the investment is fixed It may be that the investment itself is improved by the structure Walt Disney got huge tax and governmental relief by setting up EuroDisney as a project structure rather than owning outright Tax, gov’t. reg.’s may be reduced

Outside guarantees Project finance is usually high leverage and non recourse to project sponsors even with its possible benefits, this usually leads to high risk debt, which is often illiquid, costly and sometimes simply not available Often a guarantee or credit support is offered by Governments/international agency (IFC/World Bank)/Sponsors/etc.

Different contractual relationships Contracts needed: Management/shareholder agency relationship Intercorporate agency relationship Government/corporate agency relationship Bondholder stockholder relationship Definition of the organization (corporation) is a nexus of these contracts