PS - Project Finance Concepts and Applications

Padmalatha Suresh holds a post-graduate diploma in Management from the Indian
Institute of Management, Ahmedabad, as well as a degree in Law. She is a Certified

Associate of the Indian Institute of Bankers. She has more than two decades of
work experience at senior levels in the Banking and IT industries. At present, she is
a consultant in the areas of Banking and Finance. A visiting faculty of Finance at
the Indian Institutes of Management at Kozhikode and Indore, she also teaches at
Great Lakes Institute of Management, Goa Institute of Management and the Icfai
Business School. Apart from post-graduate programs, she has also taught at
Executive Education programs and Management Development Programs of reputed
Business Schools, including corporate in-house training programs. She has
presented papers in the areas of Banking and Infrastructure financing and her
works have been published in reputed business dailies and magazines.
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Project Finance
Concepts and Applications
Edited by
Padmalatha Suresh
ICFAI B OOKS
The ICFAI University Press
Project Finance Concept and Applications

Editor: Padmalatha Suresh
2005 The ICFAI University Press. All rights reserved.
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Designers: Ch Yugandhar Rao and M Vijay Kumar
Contents
Overview
Section I
The Project Finance Market An Overview

1.
Project Finance: The Need to Treat Large

Projects Differently
Padmalatha Suresh
2.
Project Finance in Developing Countries

The Importance of Using Project Finance
14
Padmalatha Suresh
3.
Public-Private Partnerships: The Next

Generation of Infrastructure Finance
25
www.fitchratings.com
Section II
How Project Structures Create Value

4.
Budget: Overcoming Roadblocks to Growth
51
Padmalatha Suresh
5.
Structure Matters in Project Finance
57
Padmalatha Suresh
6.
Assessing the Economic Impact of

Infrastructure Projects The ERR
70
Padmalatha Suresh
7.
Complexities in Valuing Large Projects

Prof. R Subramanian
81
Section III
Managing Project Risks

8.
The Nature of Credit Risk in Project Finance
93
Marco Sorge
9.
Refinancing Risk Permutations of

Project Finance Structures
107
10.
Exchange Rate Risk
124
Philip Gray and Timothy Irwin
11.
Contingent Liabilities for Infrastructure

Projects: Implementing a Risk Management
Framework for Governments
131
Christopher M Lewis and Ashoka Mody
Section IV
Financing Projects
12.
The Syndicated Loan Market: Structure,

Development and Implications
141
Blaise Gadanecz
13.
Equator Principles Why Indian Banks

Too Should be Guided by Them
158
Pratap Ravindran
14.
Synthetic Leasing
164
15.
Project Finance: Debt Rating Criteria
172
Peter Rigby and James Penrose, Esq.,
16.
Pension Funds In Infrastructure Project

Finance: Regulations and Instrument Design
Antonio Vives
197
Section V
Applications and Cases

17.
Private Power Financing From Project

Finance to Corporate Finance
225
Karl G Jechoutek and Ranjit Lamech
18.
Pooling Water Projects to Move

Beyond Project Finance
232
David Haarmeyer and Ashoka Mody
19.
Financing Water and Sanitation

Projects The Unique Risks
239
20.
Successful Project Financing HUB Power Project
246
World Bank Project Finance Group
21.
Insurance Funds to Flow into Road

Projects-lic Finalising Loan Pact with Nhdp
254
P Manoj
Index
257
Overview
Project Finance is like a chameleon: It always finds a way to take
advantage of changes in the Business1
The last two decades have witnessed the emergence of a new,
important method of financing large-scale, high-risk projects, both
domestic and international. The distinguishing features of this method
are that the creditors share much of the business risk in the projects,
and the funding is obtained, based on the strength of the viability of
the project itself, rather than on the creditworthiness of the project
sponsors. The method, called project finance is typically defined as
limited or non-recourse financing of a new project through separate
incorporation of a vehicle or project company.
Project finance is not a new financing technique. The earliest known
project finance transaction took place in 1299, when the English Crown
negotiated a loan from a leading Italian merchant bank of that period
to develop the Devon silver mines. Under the loan contract, the lender
1
Esty Benjamin C, Overview of the Project Finance Market, Harvard Business School, 2000.
II
would be able to control the operations of the mines for one year. He
was entitled to all the unrefined ore extracted during the contract period,
but had to pay all the operating costs associated with the extraction.
There was no provision for interest, nor did the Crown guarantee the
quantity or quality of silver that could be extracted. In current parlance,
this transaction would be known as a production payment loan.
Since the 1970s, when Project finance was used on a large scale to
develop the North Sea Oil fields, this financing technique has been
extensively associated with several financial and operating success
stories in developing natural resources, electric power, transport and
telecommunication projects. Equally spectacular have been some
recent financial failuresthe Dabhol Power project (India), the
Eurotunnel, EuroDisney (Paris), and Iridium (the USA). In spite of
these failures, which have attracted considerable public attention, the
market for project finance has been growing worldwide.
Project financing has been increasingly emerging as the preferred
alternative to conventional methods of financing infrastructure
worldwide. New financing structures, access to private equity and
innovative credit enhancements make project finance the preferred
alternative in large-scale infrastructure projects.
According to World Bank estimates, the demand for infrastructure
investment is staggering. Asian countries alone, which historically
have accounted for about only 15% of the Project Finance market,
need to invest USD 2 trillion in infrastructure in this decade to
maintain their current rate of development. Most studies on economic
development find that large-scale infrastructure investment is
associated with one-for-one growth in the countrys GDP. Similar
country studies of economic development find that inadequate or
absent infrastructure severely impede economic growth.
The intricacies of large scale project financing are formidable and
call for skills that are different from other financial applications.
Consequently, these intricacies can be misunderstood, and even
misused. Although project financing structures share certain common
III
features, every project is unique and requires tailoring of the financial

package to the particular circumstances and features of the project.
Here lie both the benefits and the challenges.
India, too, will be witnessing a boom in the infrastructure sector
in the years to come.
Infrastructure has been recognized as a national priority in India.
It is preferable that long-term Infrastructure finance in emerging
markets like India, is based on project financing arrangements, thus
attempting to mitigate the extreme risks of operating very large
projects. Large infrastructure projectscustomarily implemented by
the government now being implemented with private participation
and management, reflect the new trend. All these projects use some
form of Project Finance, a term currently being used synonymously
with Contractual Finance.
Due to its increasing importance and use as a funding vehicle for
large projects, Project Finance has been attracting a great deal of academic
interest. The innovative deals being crafted in project finance revolve
around financial packages that offer rich opportunities for testing core
financial theories. The large number of financial contracts that
characterize project finance must be able not only to allocate risks to
various parties who can best bear them, but also should be able to solve
basic agency problems between sponsors and creditors. Recent researches
have achieved theoretical breakthroughs in the analysis of separate
incorporation (a distinctive feature of project finance), secured debt
financing, the maturity structure of debt contracts, the choice between
private debt (bank loans) and public debt (bonds and notes), the role
of covenants and collateral in debt contracts, the optimal design of
securities, and the monitoring role of financial intermediaries, and have
yielded important insights into project finance structures.
Drawing on existing finance theory, detailed case studies, and
extensive field research, Benjamin Esty 2 mentions three primary
motivations for using project finance: (1) reduced agency costs and
2
Esty Benjamin C, The Economic Motivations for using Project Finance, 2003, Harvard Business
School.
IV
conflicts, (2) reduced debt overhang problem and (3) enhanced risk
management. The motivations explain why financing assets separately
with debt creates value, and why it can create more value than
financing assets jointly with corporate debt, the traditional and most
popular financing alternative.
The research on project finance, though limited, collectively helps
reinforce the practice of project financing techniques. Practitioners 3
assert that Project finance will most commonly be used for capitalintensive projects, with relatively transparent cash flows, in riskier
than average countries, using relatively long-term financing, and
employing far more detailed loan covenants and allocating risks far
better to those parties best able to manage them, than to those who
will manage conventionally-financed projects.
In the above context, an understanding of the basic concepts
underlying project finance is necessary. This book, presented in five
distinct sections, presents insights into the concepts and applications of
project finance through articles by experts. The first section defines
Project finance, and provides an overview of the Project finance market,
the second section elaborates the unique value that project financing
structures generate, the third section is devoted to risk management
and the fourth to innovative financing instruments. The last section
outlines some applications of project finance, by sectors and projects.
Section I provides an overview of the Project finance Market.
The opening article Project Finance: The Need to Treat Large
Projects Differently, by Padmalatha Suresh describes the origin and
growth of project finance. It explains the features of project financing,
how it differs from corporate finance, and the advantages and
disadvantages of using project finance for large infrastructure projects.
The second paper, Project Finance in Developing Countries
The Importance of Using Project Finance sourced from the
3
Kensinger and Martin (1988), Smith and Walter (1990), and Brealey, Cooper and Habib (1996) from
Kleimeier, Stefanie, and Megginson, William L, An Empirical Analysis of Limited Recourse Project
Finance, July 2001.
International Finance Corporation (IFC), features the growing

importance of Project Finance as a tool for economic investment
and describes non recourse and limited recourse project finance
concepts. Some examples of IFC supported projects and their
developmental impact on the economy, along with data on the project
finance market have been provided. Differentiating project finance
from traditional balance sheet financing, the paper outlines the
advantages that project finance has for private sponsors, and concludes
that in spite of all the advantages, the rigorous requirements ensure
that there are no free lunches in project finance.
Analysts from the pre-eminent rating company, Fitch Ratings, have
contributed the third article, a special report titled Public Private
Partnerships: The Next Generation of Infrastructure Finance.
The report looks at the larger roles PPP models would play in emerging
and other economies, for funding the infrastructure requirements far
in excess of the currently available financing resources. The private
sector can play an active role as project sponsor or a passive role as an
institutional bond investor. The report identifies the pre-requisites
for a receptive PPP debt market as a relatively stable macro economic
environment, a sound legal framework for concessions, contract
enforcement and bankruptcy remedies, a stable regulatory framework
and a developing domestic debt market. With more and more
innovations coming into PPPs, the article expresses confidence that
the PPP market is all set for growth. Some of the next-generation
developments relate to (a) pooling of credit risks (b) the US SRF
model, and (c) enhancing Pooled credit risk. The report in conclusion,
quotes the successful experiment with such credit enhancements in
the case of USAID support of the Water and Sanitation Pooled Fund
(WSPF) in Tamil Nadu, India.
Section two of the book is titled How project structures create
value. The section elaborates the uniqueness of project structures
that enable them to take on the inherent risks of long-term projects.
The first article in this section is published by Padmalatha Suresh in
the Business Line, titled Budget: Overcoming Road Blocks to Growth.
VI
Taking the cue from the remarks on FDI flows made by Indias Finance
Minister in his 2005 Budget Speech, the article outlines the role of
the banking system and the government in building world class
infrastructure in India, with particular reference to transport. Drawing
extensive references to the remarkable transformation of the Chinese
economy, the article underscores the need for innovative project
financing and active involvement of the banking system, capital
markets and legal system in this process.
The next article Structure Matters in Project Finance by
Padmalatha Suresh, summarizes the rationale for various types of
contracts and models that form the backbone of project financing
transactions. In doing so, the article tries to seek answers to the
following questionsWhat are the structural attributes of project
companies that enable them to find the financial and other resources
for very large projects? Having found the resources, how do the project
companies structure the project organization to take care of its longterm needs? How do project companies take care of the risks involved
in constructing, financing and operating very large projects? What
are the structural features of project companies that enable lenders
and equity holders to invest substantial funds?
In the next article in this section, Assessing the Economic Impact
of Infrastructure Projects The ERR, Padmalatha Suresh avers that
an infrastructure project has to generate social returns as well, apart
from private returns. While the Financial Rate of Return measures the
private returns, the Economic Rate of Return [ERR] measures the social
returns from the project. Since the ERR is the basic criterion for
governments, multilateral agencies and development banks to lend for
an infrastructure project, the article discusses the issues involved in
calculating the ERR. Traditional capital budgeting techniques may not
be able to measure the value of long term, risky projects effectively.
In the last article of this section, titled Complexities in Valuing
Large Projects, R Subramanian outlines the shortcomings of
traditional methods while valuing large projects, and describes some
prevalent methodologies for valuing such projects. Most of the
VII
methodologies being used now, do not take into account the embedded
options in investments in large projects. Real options methodologies
are now being preferred for valuing long-term infrastructure projects.
Section three has been devoted to the vital issue of Managing
project risks.
Project financing structures are designed to allocate risks through
contracts to the parties who can best bear the risks. In the first article
in this section, Marco Sorge from the Bank of International Settlements
(BIS) describes The Nature of Credit Risks in Project Finance.
This paper aims to establish that in project finance, credit risk tends
to be relatively high at project inception and to diminish over the life
of the project. Hence, longer-maturity loans would be cheaper than
shorter-term credits. In order to cope with the asset specificity of
credit risk in project finance, lenders are making increasing use of
innovative risk-sharing structures, alternative sources of credit
protection and new capital market instruments to broaden the
investors' base. Hybrid structures between project and corporate
finance are being developed, where lenders do not have recourse to
the sponsors. Two main findings have emerged, based on the analysis
of some key trends and characteristics of this market. First, unlike
other forms of debt, project finance loans appear to exhibit a humpshaped term structure of credit spreads. Second, political risk and
political risk guarantees have a significant impact on credit spreads
for project finance loans in emerging economies This is particularly
relevant, given the predominant role of internationally active banks
in project finance and the fundamental contribution of project finance
to economic growth, especially in emerging economies.
The second article is a report from analysts from Fitch Ratings,
elaborating on Refinancing Risk Permutations in Project Finance
Structures. Fitch observes that, refinancing risk is increasingly creeping
into the financing of single revenue-generating assets. Refinancing risk,
in some instances, has arisen from financings that aim to avoid some
of the restrictions commonly imposed by the terms of project
financings, such as stringent limits on additional debt or from the
VIII
implementation of a debt structure that finances a project that is changing

in design or scope (expansion of a toll road or pipeline network). More
frequently, refinancing risk has resulted from the limited term or tenor
available in a particular debt market. Assets and projects with strong
economics that are financed subject to covenants or structural elements
have been observed to mitigate refinancing risk adequately. In Fitchs
viewpoint, acceptable flexibility in the repayment structure can have a
beneficial effect on project credit quality.
In the third article of this section, a World Bank Group note, Philip
Gray and Timothy Irwin discuss an important risk in large projects
Exchange Rate Risk. Private foreign investment in the infrastructure
of developing countries seems to hold great promise. But foreign investors
must cope with volatile developing country currencies. This note proposes
that investors take on all financing-related exchange rate risk, even though
this may mean higher tariffs for consumers as a premium for bearing
that risk. Reducing reliance on foreign debt may mean that the volumes
of private finance and privatizations in developing countries will not be
forthcoming; and that the initial costs of finance will be higher. But the
benefits may be long-lived and quite robust.
The fourth article in this section Contingent Liabilities for
Infrastructure Projects: Implementing A Risk Management
Framework for Governments is also drawn from a World Bank
publication. This article is relevant to India, where the government is
getting involved in PPP projects in a big way. The authors, Christopher
M Lewis and Ashoka Mody propose that to manage their exposure
arising from guarantees to infrastructure projects, governments need
to adopt modern risk management techniques. Because guarantees
come due only if particular events occur, and involve no immediate
cost to the government, they rarely appear in the government accounts
or have funds budgeted to cover them. The note introduces an
integrated risk management system that draws on recent advances in
the private sector. The approach to risk management suggested in
this note also provides a mechanism for governments to critically
assess the distribution of risks within a loan guarantee or insurance
IX
program and come up with better-designed contracts and fewer and

smaller calls on guarantees. And as risks change over time, the
framework provides a basis for easy re-estimation and quick
adjustments to the budgetary and reserve system.
Project financing has been characterized by innovative deal
structures and financing instruments. Section four takes a look at
some New sources of Project financing.
Syndicated loans are credits granted by a group of banks to a
borrower. They are hybrid instruments combining features of
relationship lending and publicly traded debt. They allow the sharing
of credit risk between various financial institutions without the
disclosure and marketing burden that bond issuers face. Blaise
Gadanecz, in the BIS Quarterly Review, describes The Syndicated
Loan Market: Structure, Development and Implications.
Syndicated credits are a significant source of international financing,
with signings of international syndicated loan facilities accounting
for no less than a third of all international financing, including bond,
commercial paper and equity issues. The paper presents a historical
review of the development of this increasingly global market and
describes its functioning, focusing on participants, pricing
mechanisms, primary origination and secondary trading.
In the second article titled Equator Principles Why Indian
Banks Too Should Be Guided By Them?, Pratap Ravindran,
writing in The Hindu, describes the equator principles adopted by
leading banks for financing infrastructure projects around the world,
at the behest of IFC. The article impresses that Indian banks too
should be guided by these principles, since most large projects need
environmental clearance.
The synthetic lease has emerged as a popular financing structure
since it provides off balance sheet treatment for book purposes, while
allowing a company to retain the tax benefits associated with asset
ownership. Energy firms, to finance the acquisition of new assets or
to refinance existing assets, frequently use this structure. In the third
article in this section, analysts from Fitch Ratings have described

"Synthetic Leasing" as a viable alternative structure that can be readily
applied to various types of energy-based assets, including electric
turbines and other generating assets or natural gas and liquids pipelines.
The synthetic lease moves the asset off the balance sheet while
maintaining ownership for tax purposes. The vast majority of the
financing for the asset purchase is achieved through a combination of
senior and subordinated notes issued by the special purpose entity
(SPE) created for this purpose.
The next article, excerpted from the Standard & Poor's Yearbook,
describes in detail the Debt Rating Criteria for project financing
transactions. This article summarizes an analytic framework that can
be used to systematically assess cash flows based on project-level risks
and then to analyze risks external to the project. Standard & Poor's
project ratings address default probability. Project ratings do not
distinguish between the debt issue rating and the issuer credit rating, as
is the case with corporate credit ratings. Five levels of analysis forming
Standard & Poor's framework of project analysis are: (a) project level
risks (b) sovereign risk (c) business and legal institutional development
(d) force majeure risk and (e) credit enhancements. Standard & Poor's
expects that as infrastructure investment needs increase, project debt
will remain a key source of long-term financings, and nonrecourse debt
will most likely continue to help fund these changes.
The last paper in this section is Pension Funds in Infrastructure
Project Finance: Regulations and Instrument Design by Antonio
Vives for Inter American Development Bank. The article discusses in
detail the experiences of the Latin American economies, which are
building a pool of individual savings to be invested in attractive
investment opportunities, and the applicability of these experiences to
other emerging economies. On the other hand, infrastructure projects
are providing needed services that promote economic growth and social
well-being and require long-term local financing. The time is now right
to enact the necessary measures that will bring the pension funds and
infrastructure investment together. This paper describes what it takes
XI
to achieve such a union. Fortunately, there has been an almost

simultaneous trend toward pension fund reform, including the creation
of privately managed pension fund accounts. The paper suggests ways
to structure projects to make them more attractive to pension funds,
and describes needed regulatory changes to permit pension funds to
invest in them.
Section five describes Applications of project finance concepts
in various infrastructure projects the world over.
Karl Jechoutek and Ranjit Lamech, in their World Bank publication
Private Power Sector Financing From Project Finance to Corporate
Finance, argue that to achieve substantive progress in Independent Power
Producer (IPP) financing, limited recourse project financing will have to
evolve toward structures with greater balance sheet support. The IPP
experience in the United States offers useful insights, and indicates new
evidence that variants of corporate financing are being used for financing
electric utilities. Developers are pooling projects into entities that are
then able to raise capital on the strength of a combined balance sheet
comprising the "pooled" assets of different projects. Providers of equity
and debt then finance the business of building and operating private
generation facilities rather than an individual power plant. Pooling spreads
project risk. Industry consolidation has become a steady trend in the IPP
business. Greater corporate finance support will make it possible to raise
private capital for independent power financing from wider, deeper, and
cheaper sources. But innovative strategies will be required from
governments, lenders, investors, and power sector enterprises alike.
The second article in this section is a study of water projects,
Pooling Water Projects to Move beyond Project Finance. This
paper reviews the new trends in financing water projects. Many
commercial banks have had little interest in water and sanitation
projects not only because of noncommercial, political and regulatory
risks, but also the small size, weak local government credit, and high
transactions costs. The move from project to corporate (balance sheet)
financing, is occurring in stages. Designed in part to shield a companys
XII
balance sheet and improve a project's credit strength, innovative

structures and financial instruments are emerging. Ultimately, the
goal is for water utilities to raise debt and equity from capital markets
on the basis of their own balance sheets, strengthened by a diversified
and stable rate-paying customer base.
Carrying this vital subject further, the next article titled Financing
Water and Sanitation Projects The Unique Risks by David
Haarmeyer and Ashoka Mody (World Bank publications), reviews some
recent innovative projects, and shows that private participation on a
limited recourse or no recourse basis has required support from
multilaterals and federal government agencies to absorb
noncommercial risks. In industrial countries the credit strength of
off-taking municipal governments and the sector's traditional
monopoly structure expose lenders to potentially significant credit,
regulatory, and political risks. These risks, combined with the sunk,
highly specific, and non-redeployable nature of water investments,
mean that lenders and investors are vulnerable to government
opportunism and expropriation.
The challenge for the future is in mitigating the noncommercial
risks that characterize the sector. Pakistans HUB Power Project, is
one of the success stories of recent times. This World Bank publication
describes how the Project marks the first use of a World Bank guarantee
for a private sector project and is a major step forward in the Banks
effort to increase private sector investment in infrastructure.
The last article in this section explores another potential avenue
for financing long-term projectsInsurance funds. Titled Insurance
Funds to Flow into Road Projects, and authored by P Manoj (in
the Business Line), this note describes the use of LIC funds in financing
road projects in India.
Project finance is fast emerging as the most preferred alternative for
financing infrastructure projects all over the world. In India, project
finance models have been used recently in the NOIDA toll bridge and
XIII
the Bangalore Airport projects. In this book, an attempt has been made
to elaborate upon the key financial concepts underlying project finance
and illustrate a few applications. This book, therefore, would serve as
an introduction to the exciting and growing field of project finance.
There are several changes in the project finance market that are
either under way or likely to emerge in the near future. Co-financing
structures conventional corporate finance with project finance, or
Islamic financing structures in combination with project finance, have
already been implemented successfully in infrastructure projects in
other parts of the world. In the coming years, in India, the banking
system and the capital markets will have to gear themselves up to
handle the demand for funds. Similarly, more private players will
enter infrastructure development either with the government in
public-private-partnerships (PPPs) or with government guarantees,
or even without government guarantees. The biggest changes would
occur in the capital markets, and more specifically, bond markets.
From the issuer's perspective, project bonds are attractive because
they have longer maturities, fewer covenants, and represent a deeper
market. As the supply of bonds increases, there will be more
participation from institutional investors such as Insurance funds and
Pension funds. Project bonds would appeal to these investors since
their tenure would match the long-term liabilities of the investors.
As the project debt market develops, securitization of project loans
will occur with greater frequency. The derivative market and secondary
project debt markets would also have to develop alongside. There
will have to be simultaneous innovations in the equity markets as
well. Already sponsors and financial advisors in developed countries
are forming dedicated pools of capital, to invest in infrastructure and
other long-term projects.
To take advantage of the growth and deepening of the project
finance market for development of its infrastructure, India will have
to institute several reformsfinancial, regulatory, legal and social.
In conclusion, the Project Finance market will continue to grow
well into the future, in tandem with increasing globalization,
XIV
deregulation and economic development. As markets integrate and

firms globalize, the scale of projects is likely to increase. These new
markets will contain opportunities to appraise and finance not only
larger projects, but also different kinds of projects. Many countries
that have not used Project Finance techniques historically, for financing
their large-scale investments, are likely to do so in the coming years.
Project Finance: The Need to Treat Large Projects Differently
Section I
The Project Finance Market:

An Overview
PROJECT FINANCE CONCEPTS AND APPLICATIONS
1
Project Finance: The Need
to Treat Large Projects Differently
Padmalatha Suresh
Large infrastructure projects are unique. Typically, they take five
to seven years to structure, require huge upfront capital, comprise
of mostly large, tangible assets, and have a very long life. The
risks of such projects are different from those of capital investments
for shorter time frames. Traditionally, the government was
financing infrastructure projects. However, government finances
are increasingly under pressure, necessitating greater private
participation in financing such projects. What are the capital
providers incentives to participate in infrastructure development?
Would they be willing to bear the construction and completion risks
of the project and the operating, financial and political risks once
the project is completed? Would they be able to bring in the
phenomenal amounts of equity and debt needed? Would they be
prepared for the financial risk, which could, in bad times, lead to
financial distress? Project finance provides satisfactory answers
to these questions, and is increasingly being used to finance very
large projects. The article outlines the evolution of modern project
finance and the global project finance market, contrasts it with
conventional corporate financing, and concludes that project
finance is relevant for Indias infrastructure development.
The ICFAI University Press. All rights reserved.
Rationale for Project Finance

What is a large project? Benjamin Esty1 defines large projects as those costing
USD 500 million or more, accounting for 25% of the worlds projects by number
and 75% by value. Typically, these large investments take five to seven years to
structure, require huge doses of capital upfront, comprise of mostly large, tangible
assets, and have a life of 15 to 25 years or more. Such projects are mostly in the
nature of necessary social infrastructure in a country, or a large investment that
fills a need of economic development.
Most studies on economic development find that infrastructure investment is
associated with one to one percentage increases in the countrys Gross Domestic
Product (GDP). Similar country specific studies find that absent or inadequate
infrastructure severely impedes economic growth. A study by the International
Finance Corporation2 has shown that insufficient or irregular power supply reduces
GDP by one to two percent in India, Pakistan and Columbia.
Traditionally, the public sector or the government financed large infrastructure
projects in a country. However, finances of governments are increasingly under
pressure, leading to greater use of the private sector in financing such projects. In
some cases, use of private financing for infrastructure has enabled the governments
to invest in more developmental projects. In other cases, private sector financing
of large projects has aided the governments in reducing their public borrowings,
thus rejuvenating the flagging financials of the governments.
However, given the nature of such projects as described above, it is evident
that the risks of such long term projects will be quite different from the risks of
capital investments for shorter time frames. While the returns of a viable project
will have to be commensurate with the risks in the long run, the private investors
and the government should be able to sustain the upfront investment of enormous
capital and the gestation period till positive cash flows are generated. In some
infrastructure projects such as toll roads, the mindset and number of users of the
facility will largely determine how profitable the project would be.
1
Esty Benjamin C, Why Study Large Projects? An Introduction to Research on Project Finance, European
Financial Management, vol 10, no 2, 2004, 213-224.
1996, Lessons of Experience #4: Financing Private Infrastructure, World Bank, Washington DC, pp 43-44.
What then are the incentives for capital providers to participate in infrastructure
development? Would the private investors or lenders be willing to bear the
construction and completion risks of the project and the operating, financial and
political risks once the project is completed? Would they have the financial muscle
to wait patiently for cash flows that may happen only over a very long period of
time, with no certainty that these cash flows would sustain over the life of the
project? Would they be able to bring in the phenomenal amounts of equity and
debt needed to finance these projects? And having decided to borrow, would the
project sponsors be able to service the debt from the project cash flows, or would
they have to intermingle the cash flows from their other operations in order to
service the debt? Would they be prepared for the financial risk to be undertaken,
which could, in bad times, lead to a financial distress situation?
Project finance provides satisfactory answers to most of the questions raised above.
Project finance is increasingly being used to finance very large projects during the
last decade, due to the advantages it offers over the conventional corporate finance.
Defining Project Finance

Simply put, Project finance involves the creation of a legally independent project
company, with equity from one or more sponsoring firms, and non- or limited
recourse debt, for the purpose of investing in a single purpose, industrial asset.3
Other working definitions of project finance include the following:
1. The raising of funds to finance an economically separable capital investment,
in which the providers of funds look primarily to the cash flows from the
project as source of funds to service their loans and provide the return of,
and a return on their equity invested in the project. 4
A project is further defined as a set of legally and economically independent
assets with a single industrial use.
2. Limited or non-recourse finance of a newly to-be-developed project through
the establishment of a vehicle company. 5
3
Esty Benjamin C, Why Study Large Projects? An Introduction to Research on Project Finance, European
Financial Management, vol 10, no 2, 2004, 213-224.
Finnerty John D, Project Finance: Asset Based Financial Engineering, 1996, John Wiley and Sons, p 2.
Kleimeier Stefanie and Megginson William I, An Empirical Analysis of Limited Recourse Project Finance,
working draft, 2001.
3. Financing of a particular economic unit in which the lender is satisfied to look

at the cash flows of earnings of that economic unit as a source of funds, from
which the loan will be repaid and at the assets as collateral for the loan.6
Evolution Of Project Finance

Contrary to the general impression that it is a recent phenomenon, Project finance
has a history that dates back to about 700 years. The earliest recorded Project financing
transaction was in 1299, when the English Crown asked a Florentine Merchant
Bank to develop the Devon silver mines. The agreement was in the form of a years
lease of the total output of the mines to the Bank, in exchange for bearing the
operating costs. This implied that the bank was entitled to all the output, whether
more or less than the expected level; and in case the value or volume of output fell
below the banks expectations, the bank would have no recourse to the Crown. In
current parlance, this is known as a Production payment loan.
A similar concept was used in some of the earliest applications (1930s) of
Project finance in the US, in natural resources and real estate. For instance, wildcat
explorers in places like Texas and Oklahoma used production payment loans to
finance oilfield explorations. In the case of commercial development of real estate,
developers used loans whose repayment depended on project cash flows only.
Figure 1: How Project Finance Works
Sponsor
Lender
Minimum
Recourse
Sufficient
Credit Support
Project
Credit/
Contract Support
Third Party Participants
Hewitt, 1983
Figure 2: Non-Recourse Project Finance Structure

Equity
Equity
Vehicle Company
Contracts
Revenues
Guarantees
3rd Parties
Construction,
Ownership,
Operation
Project Assets
Loan
Repayment
Loan
Lenders
Collateral
However, Project finance in its modern form, started evolving only in the 1970s.
Several natural resource discoveries and spiraling demand for energy were the triggers
that set off this development. Some of the applications during this period were:
British Petroleum raised USD 945 million from the market on a project
basis, to finance the development of the oil reserves in the North Sea.
The Erstberg copper mines in Indonesia were project financed by Freeport
Minerals.
Conzinc Riotionto of Australia project financed the Bougainville copper
mines in Papua New Guinea.
The 1980s saw a spurt in project financing of power projects in the US and other
developed countries. In the US, the Power Utilities Regulatory Policy Act (PURPA)
aided the growth of project finance by necessitating financing of new power plants
with long-term purchase agreements. In this period, project finance was seen as being
synonymous with power finance in developed markets like the US.
Since the 1990s, project finance applications have widened, both geographically
and sectorally. A wide array of asset types has been project financed around the
world in developing and under-developed economies.
The use of Municipal bonds by the government and municipalities in many

countries, has also contributed to the growth in modern project finance.
As government finances got scarce, municipalities and the public sector started
floating bonds secured only by the revenues to be generated by the public utility
projects. To create confidence in investors, private sector participation in public
projects was solicited. The entry of the private sector into typical public sector
projects, brought with it the necessary funds, managerial expertise and risk sharing.
Public Private Partnerships (PPPs) have now been given a formal structure in
many countries. In the UK and some other countries, this acronym takes the
form of PFIPrivate Finance Initiative.
Features of Project Finance

A specially incorporated project company is formed to build and operate
the project. The project company enters into a concession agreement with
the host government.
The project company enters into extensive contracting
with several partiesthere could be up to 1000 contracts in very large
projects.
contracts govern inputs, offtake, construction and operations.
ancillary contracts include financial hedges, insurance contracts etc.
Project companies are distinguished by their highly concentrated equity
and debt ownership, with frequently more than one equity sponsors, a
syndicate of banks and other financial institutions providing credit, and
the governing board comprising primarily of affiliated directors drawn from
sponsoring firms and lending institutions.
Project companies are characterized by their highly leveraged structures
with mean debts as high as 70%, and the remaining equity contributed by
the group of sponsoring firms in the form of either equity or quasi-equity
(subordinated debt), debt being non-recourse to the sponsors. The debt is
also termed project recourse since debt service depends exclusively on
project cash flows. Typically, debts to project companies have higher spreads
than corporate debt, though this scenario has been changing as lenders
develop more experience in lending to large projects.
Structuring a project finance deal entails substantial transaction costs in

the nature of fees to lawyers, consultants, and financial advisors, apart from
obtaining necessary permits, environmental clearances, etc. A deal could
typically take five to seven years to structure, since it also involves identifying
and entering into suitable contracts with construction companies, suppliers
of equipment and inputs, purchasers of output, operating companies and
tying up the financing with various capital providers.
Comparison of Project Finance With Other Financing Vehicles

1. Secured debt is collateralized by a specific asset or assets. To that extent it is
similar to project finance. However, secured debt almost always has recourse to
other assets of the firm as well. Herein lies the dissimilarity with project finance.
2. Asset-backed securities can often be mistaken for project finance, since they
appear to have all the features of the lattercollateralized by asset cash
flows, and non-recourse to the originator. However, the major difference
lies in the fact that asset-backed securities hold single-purpose financial
assets, not single-purpose industrial assets, the latter being mostly illiquid.
One of the latest developments in project finance is the securitization of
project finance loans.
3. Leveraged buy outs/management buy outs may seem similar to project
finance due to their high debt levels. However, LBOs/MBOs are dissimilar
in that, they do not have separate corporate/government sponsors and may
not consist of single purpose industrial assets.
4. Privatizations: Those that involve single purpose, industrial assets could be
categorized as project finance, provided the debt is non-recourse to the
private sponsors. Privatization of airports or large telecom facilities could
fall under this category. However, privatization of banks or administrative
bodies would not be termed project finance, since they do not satisfy the
single-purpose industrial asset criterion.
5. Venture-backed Companies display concentrated equity ownership like
project companies. However, debt levels are much lower than project
companies, and in most cases, the managers themselves are equity holders.
10
Comparison of Project Finance With Conventional Corporate

Finance
Project finance and conventional corporate finance can be compared on several
parameters to bring out the relative advantages and disadvantages of the two forms
of financing.
1. Organization: Project companies can be structured as independent entities;
hence project cash flows and assets can be segregated from the sponsors
other assets and cash flows. If conventional corporate financing is used,
there will be no such distinction between the new projects and the sponsors
cash flows and assets. Hence, project companies can insulate sponsors from
failure of risky projects.
2. Control and Monitoring: In project finance, closer control is possible since
the assets and cash flows are segregated, and project specific contracts and
covenants lead to closer monitoring and accountability to investors. Such
close monitoring would not be possible in the conventional financing model.
3. Risk Allocation: This is one of the most important advantages of Project financing.
Project structures add value since they effectively allocate risks to parties, who
can best bear them through contractual arrangements. Under conventional
financing, however, the project risks are spread over the entire asset portfolio of
the sponsor firm, and creditors have full recourse to project sponsor.
4. Financing Arrangements: Financial closure can be achieved under project
financing after substantial structuring, which could be time consuming
and costly. Structuring and obtaining finance under the conventional
financing mode are relatively easier, quicker and less costly.
5. Free Cash Flow and Agency Costs: This is another important advantage of
Project finance. Free cash flows arising out of conventional financing
structures can be allocated according to corporate policy, implying that
managers of these firms have discretion over allocation of cash flows. Such
discretion sometimes leads to the underinvestment problem, whereby
managers of highly leveraged firms pass up positive Net Present Value (NPV)
projects, because the additional cash flows would go towards debt service.
These are agency costs attributed to conventional corporate financing. On
the other hand, in project financing structures, managers have limited
11
discretion in allocating free cash flows due to the cash waterfall mechanism
inherent in most projects. Further, by contract, residual cash flows have to
be distributed to equity holders. Closer monitoring by investors is possible
due to segregation of assets and cash flows. Hence, the agency costs arising
out of underinvestment are greatly reduced.
6. Debt Contracts and Debt Capacity: In conventional corporate financing,
the lender looks to the entire asset portfolio of the sponsor for debt service.
In some cases, the credit granted by the lender could also be unsecured.
Further, the amount of debt depends largely on the sponsors capacity for
additional debt on the balance sheet. However, in project finance, the lender
looks solely at the projects cash flows for debt service, and to the assets for
collateral. A unique advantage of project finance is its ability to expand the
debt capacity of the sponsors by being off-balance-sheeteven sponsors
with weak balance sheets can look at project finance as a viable alternative
for their projects. In fact, in spite of the risks of funding long-term projects,
high leverages are achieved in project finance, which provides valuable tax
shields to the project company. Supplemental credit supports are also
available in project financed structures.
7. Financial Distress: A significant advantage of project financing structures is
the lower cost of financial distress or bankruptcy. The fact that the project
and the sponsor are two different entities, isolates the project from the
sponsors possible bankruptcy and vice versa. The creditors cannot claim
their dues from unrelated projects. This scenario can be contrasted with
the conventional corporate financing alternative, where the lenders have
access to the sponsors entire asset portfolio in case of project failure. Under
this scenario, difficulties in one key line of business could drain off cash
from good projects, with the converse holding good too. Such complications
make financial distress costly and time consuming in the traditional corporate
lending option.
The Flip Side of Project Finance

Project finance takes longer to structure than an equivalent size of corporate
finance.
12
Transaction costs are higher in project finance due to the complexity of

transactions involved.
Project debt could be more expensive (50 to 400 basis points over the
comparable rate under corporate finance) due to its non-recourse nature.
However, research shows that the average cost of project finance is not much
more than corporate finance, because of the superior risk management
techniques employed in project finance.
Extensive contracting could impose constraints on managerial
decision-making in the case of project finance.
Project finance requires more transparent disclosure of proprietary and strategic
information. This is both an advantage and disadvantageadvantage since
asymmetric information and the associated costs would be lower, and
disadvantage since revealing more and more information leads to higher costs.
The Global Project Finance Market 7

Recent statistics show that, globally,
Project finance investment has grown steeply between 1994 and 2001,
with a major portion of the investment in the form of bank loans.
Compared to bank loans, the growth in project finance equity has been
lower; even lower than the equity growth, has been the growth in project
finance bonds.
However, the proportion of project bonds in project debt is increasing.
Leverage of projects is increasing substantially. Most project companies
have debt to value ratios of more than 70%, with less than 10% of project
companies having leverage ratios of less than 50%in any case, these leverage
ratios are well above those of the typical firm.
Investment in electric utilities, telecommunications and transport have
grown substantially during the period 1999-2002, as compared to the two
decade period up to 1999.
The syndicated loan market for project finance has shown sizeable growth
in the four years up to 2001.
7
Esty Benjamin C, An Overview of the Project Finance Market, Harvard Business School, 2002.
13
Conclusion
It is evident that the dynamic nature of globalization and economic development
would necessitate innovative financing structures and instruments. Project financing
structures, with their innate flexibility and risk management capabilities, will
continue to adapt to future requirements of large investments.
Project financing concepts and structures are of great interest and relevance in
the Indian context. There is no gainsaying the fact, that the primary impediment
to Indias fast track growth is the lack of quality infrastructure. It is also obvious
that the government cannot fund the enormous requirements, which according
to one estimate, is a staggering Rs.2000 billion in the next three years. If the
private sector has to take the initiative in partnering the government in infrastructure
development, sweeping changes will be required in the mindsets and framework
of regulators, investors, markets and financing agencies.
(Padmalatha Suresh is a post graduate in Management from IIM-A, holding LLB
and CAIIB. She has two decades of banking and IT sector experience. She is currently
running a financial consultancy, she is visiting faculty at IIMs and other reputed
B-Schools. Adjunct faculty-Consulting Editor at IBS Chennai. She can be reached at
padmalathasuresh@yahoo.com).
References
1.
Finnerty John D, Project Finance: Asset-Based Financial Engineering John Wiley and
Sons, 1996.
2.
Kleimeier Stefanie and Megginson William L, An Empirical Analysis of Limited Recourse

Project Finance, working draft, 2001.
3.
Esty Benjamin C, Why Study Large Projects? An Introduction to Research on Project

Finance, European Financial Management, vol 10, no 2, 2004, 213-224.
4.
Esty Benjamin C, An Overview of the Project Finance Market, Harvard Business School,
2002.
14
2
Project Finance in Developing Countries
The Importance of Using Project Finance
Padmalatha Suresh
Project Finance is growing in importance as a tool for economic
investment, by structuring the financing around the projects own
operating cash flow and assets, without additional sponsor
guarantees, thus alleviating risks and raising finance at a relatively
low cost. Non-recourse and limited recourse project finance
concepts are discussed citing examples of IFC supported projects,
and their developmental impact on the economy. Government
willingness in emerging markets, to fund large-scale infrastructure
investments through private participation, has given the impetus
for the growth of project finance. The report differentiates project
finance from traditional balance sheet financing, and outlines the
advantages that project finance has for private sponsors. The report
concludes that in spite of all the advantages described, there are
rigorous requirements and hence no free lunches in project
finance.
The ICFAI University Press. All rights reserved. This article is a summary of Chapter I from Project Finance in
Developing Countries The Importance of Project Finance by International Finance Corporation, April 1999.
Project Finance in Developing...
15
he settings are different; the industries are different; the needs of the countries
are different. Yet a common thread runs through the following examples:
Argentina, 1993: Project finance structuring helped raise USD329 million

to finance the rehabilitation and expansion of Buenos Aires water and
sewerage services. The concession of 30 years had been awarded to Aguas
Argentina.
Hungary, 1994: Project finance structuring helped finance a 15-year
concession to develop, install and operate a nation-wide digital cellular
network at a cost of USD185 million.
China, 1997: Limited recourse project financing helped launch a $57
million greenfield project to install modern medium-density fiberboard
plants in interior China, using timber plantations developed over the
previous decade.
Mozambique, 1998: Project finance structuring helped establish a $1.3 billion
greenfield aluminum smelter.
All the projects cited above used project finance to fund the huge investments
required to develop the facilities in these developing countries. All these investments
were financed with International Finance Corporations (IFC) support. All these
investments were made with private sector participation for creating public
infrastructure. Above all, these investments helped improve the quality of life of
people in these countries, generated employment, increased export earnings and
fostered more infrastructure development and thus, tangible economic growth.
What is project finance, and what has caused this new wave of interest in
project finance as a tool for economic development? The Report elaborates, Project
finance helps finance new investment by structuring the financing around the
projects own operating cash flow and assets, without additional sponsor guarantees.
Thus, the technique is able to alleviate investment risk and raise finance at a relatively
low cost, to the benefit of sponsor and investor alike. (p.1)
Project finance is not a new concept. It has been used for hundreds of years,
primarily in mining and natural resource projects. Its other possible applications
in developing markets, especially for financing large greenfield projects
16
(new projects without any prior track record or operating history) have been
receiving serious attention of late. The shift in focus to the private sector to supply
the investment required for large scale investments have necessitated regulatory
reforms, which in turn have created new markets in spheres of activity previously
considered to be the exclusive domain of governments. For example, in the United
States, the Public Utility Regulatory Policy Act (PURPA), passed by the government
in 1978, not only encouraged a private market for electric power, but was also seen
as a precursor to the growth of project financing models in many other industrial
countries. More recently, in the late 1990s, large-scale privatizations in developing
countries were embarked upon to bolster economic growth and stimulate private
sector investment. These developments and the governments willingness to provide
incentives for attracting private investors into new sectors have given further fillip
to the growth of project finance.
The surge in the use of project finance was temporarily halted in the wake of
the East Asian financial crisis in mid 1997, since many large projects that were
being implemented at that time, suddenly turned economically and financially
unviable. Contractual arrangements, the backbone of project finance structures,
were all of a sudden unenforceable; though, in hindsight, many projects had
failed to adequately mitigate potential risks, including currency risks. Analysts
started questioning the prudence of continued use of project finance.
In IFCs experience, however, project finance remains a valuable tool. Although
many projects are under serious strain in the aftermath of the East Asia crisis,
project finance offers a means for investors, creditors, and other unrelated parties
to come together to share the costs, risks, and benefits of new investment in an
economically efficient and fair manner. As the emphasis on corporate governance
increases, the contractually based approach of project finance can also help ensure
greater transparency. (p.3)
Despite the setbacks of the past, project finance techniques are likely to grow
in importance, as developmental investment in emerging markets needs enormous
capital, which cannot be met through government finances alone. Moreover, the
ability of project finance structures to allocate and mitigate risks will be valuable
for getting several projects with private investment off the ground. The crisis has
also demonstrated that individual projects have to be adequately supported by
17
far reaching regulatory reform designed to enhance competitiveness and efficiency,

and to develop domestic financial markets to support local investment.
IFC is certain that in the appropriate framework, project finance can provide
a strong and transparent structure for projects and through careful attention to
potential risks, it can help increase new investments and improve economic growth.
The Report then goes on to outline the basic concepts and features of project finance:
Every project finance deal is tailored to meet the needs of a specific project.
Repayment to capital providers depends solely on the cash flows and the
project assets.
Along with the sponsors, the risks and returns are borne by various
investorsequity holders, debt providers, or quasi-equity investors.
The important criterion to decide if an investment can be project financed
is the projects ability to stand alone as a distinct legal and economic entity.
Project assets, project related contracts and project cash flows are segregated
from those of the sponsor.
Project finance can be non-recourse or limited recourse.
Non-recourse project finance is an arrangement under which investors and
creditors financing the project, do not have any direct recourse to the
sponsors, as is the conventional practice. Although creditors security will
include the assets being financed, lenders rely solely on the operating cash
flow generated from those assets for repayment. The project must therefore
be carefully structured to satisfy its financiers about its economic, technical,
and environmental feasibility, its debt servicing capacity and its ability to
generate financial returns commensurate with its risk profile.
Limited-recourse project finance permits creditors and investors some recourse
to the sponsors. This frequently takes the form of a pre-completion
guarantee during a projects construction period, or other assurances of
some form of support for the project. Creditors and investors, however,
still look to the success of the project as their primary source of repayment.
In most developing market projects and in other projects with significant
construction risk, project finance is generally of the limited-recourse type.
18
Project Finance vs. Corporate Lending

Project finance differs in many respects from conventional corporate lending.
The most striking point of difference is that in traditional corporate financing,
the primary source of repayment for investors and creditors is the sponsoring
company itself, its reputation, and the strength of its balance sheet, apart from
the project economics. The sponsors financial standing is a hedge against project
failure for the lenders. On the other hand, in project finance, the primary source
of repayment is the project cash flows alone.
In corporate finance, if the project fails, lenders do not necessarily suffer, as
long as the sponsoring company remains financially viable and solvent. However,
in project finance, since the lenders look primarily to the project cash flows for
their repayment and have little or no recourse to the sponsors balance sheets,
project failure may entail significant losses to lenders and other investors.
Therefore, all types of assets may not benefit from being project financed.
IFC believes that project finance benefits primarily those sectors or industries in
which projects can be structured as separate entities, distinct from the other
activities of the project sponsors. A stand-alone production facility, which could
be isolated from the project sponsors other assets and separately assessed in
accounting and financial terms, would therefore benefit from project finance.
Typically, these projects tend to be relatively large, take a long time and, are costly
to structure and absorb huge doses of debt.
Since market risk greatly affects the potential outcome of most projects, project
finance tends to be more applicable in industries where the revenue streams can
be defined and fairly easily secured. In recent years, private sector infrastructure
projects under long-term government concession agreements, have been able to
attract major project finance flows. Though, in developing countries, project
finance techniques were traditionally used in the natural resource sectorsmining,
oil and gas and such others, regulatory reform and a growing body of project
finance experience continue to expand the situations in which project finance
structuring makes sense. For example, project finance is used for building merchant
power plants that have no Power Purchase Agreements (PPA), but sell into a
national power grid at prevailing market prices.
19
In IFCs experience, project finance is applicable over a fairly broad range of

nonfinancial sectors, including manufacturing and service projects such as privately
financed hospitals (wherever projects can stand on their own and where the risks
can be clearly identified upfront). Although the risk-sharing attributes of a project
finance arrangement make it particularly suitable for large projects requiring
hundreds of millions of dollars in financing, IFCs experienceincluding textile,
shrimp farming, and hotel projectsalso shows that the approach can be employed
successfully in smaller projects in a variety of industries. (p.4) Thus, IFCs vast
experience suggests that project finance could help attract private funding to a
wider range of activities in many developing markets.
IFCs experience also shows that of late, increasing proportions of project
finance flows go into developing markets. Since project finance allocates costs,
risks and rewards of a project effectively among a number of unrelated parties, an
economically viable privatization or infrastructure improvement program in
developing markets now has wider opportunities and sources to raise funds.
As a result, it is now standard practice for large and complex projects in
developing markets to employ project finance techniques. The total volume of
project finance transactions concluded in 1996 and 1997 before the financial
crisis (an estimated 954 projects costing $215 billion), would have been hard to
imagine a decade ago. The number of active participants in these markets also
increased as many international institutions (investment banks, commercial banks,
institutional investors, and others) started to quickly build up their project finance
expertise. Most of this dramatic growth had taken place in East Asia. However,
the financial and economic crisis that began in mid-1997, and spread to other
countries since then, had temporarily slowed market evolution. The estimated
number of projects in developing markets fell in 1998. IFC opines, When the
growth of new productive investment picks up again, however, project financing
is likely to increase, particularly in countries where perceptions of risk remain
high, and investors could be expected to turn to structuring techniques to help
alleviate these risks.1
1
Note: The article was published in 1999, hence developments after this period have been surmised by IFC. Recent
statistics show that project finance transactions are on the rise again, especially in developing countries.
20
Advantages of Project Finance

In situations where project finance is the most suitable, it scores over traditional
corporate finance on two major counts(a) it increases the availability of finance,
and (b) it reduces the overall risk for major project participants to an acceptable
level. As already stated in an earlier paragraph, corporate sponsors of risky projects
prefer project finance since the risks of the new project would be isolated from
the sponsors existing business, and project failure would not contaminate the
sponsors balance sheet or its core businesses. Since the project debt is also isolated,
a properly structured project finance transaction would protect the sponsors
capital base and debt capacity, and would also allow the new project to be financed
without the high doses of equity investment that traditional corporate finance
would demand for a similar project. Thus, the technique enables sponsors to
increase leverage to high levels and simultaneously expand their business, without
being tainted by the projects risks. Since project finance structures typically
involve multiple sponsors, it would be possible for interested sponsors to take on
larger projects with greater risks. By allocating risks effectively among a group of
interested parties, project finance enables effective risk management.
This was the case in 1995, when IFC helped structure financing for a $1.4 billion
power project in the Philippines during a time of considerable economic uncertainty
there. Sharing the risks among many investors was an important factor in getting
the project launched.
The Report remarks in this context, To raise adequate funding, project sponsors
must settle on a financial package that both meets the needs of the projectin
the context of its particular risks and the available security at various phases of
developmentand is attractive to potential creditors and investors. By tapping
various sources (for example, equity investors, banks, and the capital markets),
each of which demands a different risk/return profile for its investments, a large
project can raise these funds at a relatively low cost. Also working to its advantage
is the globalization of financial markets, which has helped create a broader spectrum
of financial instruments and new classes of investors. By contrast, project sponsors
traditionally would have relied on their own resources for equity, and on commercial
banks for debt financing. (p. 5)
21
Private equity investors, who are willing to take more risk, are becoming
increasingly important players in the project finance market. They are willing to
extend long-term subordinated debt in anticipation of higher returns, which
could be in the form of equity or income sharing. Such investors, who tend to
take a long-term view of their investments, are being increasingly attracted into
projects to supplement or even substitute for bank lending.
Box 1: Project Financing Instruments, Sources, and Risk-Return Profiles
Commercial Loans: Funds lent primarily by commercial banks and other financial institutions,
generally securitized by the projects underlying assets. Lenders seek: (1) projected cash flows
that can finance debt repayment with a safety margin; (2) enough of an equity stake from sponsors
to demonstrate commitment; (3) limited recourse to sponsors in the event of specified problems,
such as cost overruns; and (4) covenants to ensure approved usage of funds and management of the
projects.
Equity: Long-term capital provided in exchange for shares, representing part ownership of the
company or project. Provided primarily by sponsors and minority investors. Equity holders receive
dividends and capital gains (or losses), which are based on net earnings. Equity holders take risks
(dividends are not paid if the company makes losses), but in return, share in profits.
Subordinated Loans: Loans financed with repayment priority over equity capital, but not over
commercial bank loans or other senior debt in the event of default or bankruptcy. Usually provided
by sponsors. Subordinated debt contains a schedule for payment of interest and principal but may
also allow participation in the upside potential similar to equity.
Supplier Credit: Long-term loans provided by project equipment suppliers to cover purchase of
their equipment by the project company. Particularly important in projects with significant capital
equipment.
Bonds: Long-term debt securities generally purchased by institutional investors through public
markets, although the private placement of bonds is becoming more common. Institutional
investors are usually risk-averse, preferring projects with an independent credit rating. Purchasers
require a high level of confidence in the project (for example, strong sponsors, contractual
arrangements, and country environment); this is still a relatively new market in developing
countries.
Internally Generated Cash: Funds available to a company from cash flow from operations (that is,
profit after tax plus noncash charges, minus noncash receipts) that are retained and available for
reinvestment in a project. In a financial plan, reinvested profits are treated as equity, although they
will be generated only if operations are successful.
Contd...
22
Contd...
Export Credit Agency (ECA) Facility: Loan, guarantee, or insurance facility provided by an ECA.
Traditionally, ECAs asked host governments to counterguarantee some project risks, such as
expropriation. In the past five years, however, many have begun to provide project debt on a
limited-recourse basis.
Multilateral or Bilateral Agency Credit Facility: Loan, guarantee, or insurance (political or
commercial) facility provided through a multilateral development bank (MDB) or bilateral agency,
usually long term. Loans may include a syndicated loan facility from other institutions, paralleling
the MDBs own direct lending.
Source: IFC: Project Finance in Developing Countries: The Importance of Using Project Finance.
No Free Lunch
For all its advantages, project finance cannot be said to offer a free lunch. On
the contrary, it has rigorous requirements. To render a project suitable for project
finance, the following aspects need to be taken care of :
The project has to be carefully structured to ensure that all the parties
obligations are negotiated and are contractually binding.
Considerable time and effort on the part of financial and legal advisers and
other experts may have to be expended to do a detailed appraisal of the
projects technical, financial, environmental and economic viability, and
structure the project in the most optimal manner.
Identification and analysis of the projects risks, and allocation and mitigation
of these risks, are extremely important steps. Though it may be costly and
time-consuming, detailed risk appraisal is absolutely necessary to assure
other parties, including passive lenders and investors, that the project makes
sound economic and commercial sense.
These preliminary steps imply that transaction costs could be much larger
than for conventionally financed projects. Framing the detailed contracts will
add to the cost of setting up the project and may delay its implementation.
Moreover, the sharing of risks and benefits brings unrelated parties into a close
and long relationship. A sponsor must consider the implications of its actions on
the other parties associated with the project (and must treat them fairly) if the
long-term relationship is to remain harmonious.
23
Lenders and investors must be kept abreast of the projects operational

performance as it progresses. The largest share of project finance normally consists
of debt, which is usually provided by creditors who have no direct control over
managing the project. They try to protect their investment through collateral
and contracts, broadly known as a security package, to help ensure that their
loans will be repaid. The quality of the security package is closely linked to the
effectiveness of the projects risk management. It is therefore, essential to identify
the security available in a project and to structure the security package to mitigate
the risks identified (see Box 2).
Box 2: A Typical Security Package
The security package will include all the contracts and documentation provided by various parties
involved in the project, to assure lenders that their funds will be used to support the project in the
way intended. The package also provides that if things go wrong, lenders will still have some
likelihood of being repaid.
A typical security package will include a mortgage on available land and fixed assets; sponsor
commitments of project support, including a share retention agreement and a project funds
agreement; assignment of major project agreements, including construction and supply contracts
and offtake agreements; financial covenants ensuring prudent and professional project
management; and assignment of insurance proceeds in the event of project calamity. The quality of
the package is particularly important to passive investors, since they normally provide the bulk of
the financing, yet have no say in the operations of a project and, therefore do not want to bear
significant operating risks.
The strength of the package, as judged by the type and quality of security available, governs the
creditworthiness of the project, effectively increasing the share of project costs that can be funded
through borrowings. Significant additional expense may accrue in identifying and providing the
security arrangements, which will also require detailed legal documentation to ensure their
effectiveness.
Source: IFC: Project Finance in Developing Countries: The Importance of Using Project Finance
The IFC report further clarifies, Some projects may need additional support
in the form of sponsor assurances or government guaranteesto bring credit risk
to a level that can attract private financing. The overall financial costs of a project
finance transaction may not be as high as under corporate finance if the project is
carefully structured, risks are identified and mitigated to the extent possible, and
appropriate financing is sourced from different categories of investors. The senior
debt component may be more expensive, however, because debt repayment relies
24
on the cash flow of the project rather than on the strength of the sponsors entire
balance sheet. The project sponsors will need to carefully weigh the advantages of
raising large-scale financing against the relative financial and administrative costs
(both upfront and ongoing) of different sources of finance. (p 7)
Conclusion
The report has drawn on IFCs experience in more than 230 greenfield projects
costing upward of USD30 billion. All these projects had relied on project finance
on a limited recourse basis. IFC and other multilateral, bilateral and export credit
institutions have been playing major roles in making project finance more
attractive in developing markets.
IFC, in particular, was a pioneer of project finance in developing countries
and has a unique depth of experience in this field, which spans more than 40
years in the practical implementation of some 2,000 projects, many of them on
a limited-recourse basis. IFCs ability to mobilize finance (both loan and equity
for its own account and syndicated loans under its B-loan program), the strength
of its project appraisal capabilities, and its experience in structuring complex
transactions in difficult environments have been reassuring to other participants
and important to the successful financing of many projects.
Public-Private Partnerships: the Next Generation...
25
3
Public-Private Partnerships: The Next
Generation of Infrastructure Finance
The private sector can play an active or passive role in
infrastructure investment as project sponsor or an institutional
bond investor. PPP models have larger roles to play in emerging
and other economies for funding infrastructure requirements far
in excess of currently available financing. The pre-requisites for
a receptive PPP debt market are a relatively stable macroeconomic
environment, a sound legal framework for concessions, contract
enforcement, and bankruptcy remedies, a stable regulatory
framework and a developing domestic debt market. The blurring
of the thin line between structured financing and PPPs has given
rise to some myths regarding PPPs, which are listed out and
explored. With more and more innovation, the PPP market is all
set for growth. Some of the next-generation developments relate
to (a) pooling of credit risks (b) the US SRF model, and
(c) enhancing Pooled credit risk The successful experiment with
such credit enhancements in the case of USAID support of the
Water and Sanitation Pooled Fund (WSPF) in Tamil Nadu, India,
has also been highlighted.
Source: http://www.fitchratings.com.au/projresearchlist.asp 2004 Fitch Ratings, Ltd. Reprinted by permission of
Fitch, Inc.
26
Summary
The scope of global demographic, public health and safety needs, as well as
economic development goals, translates into infrastructure requirements, far in
excess of currently available financing resources. While the degree of this funding
backlog differs from country to country, it extends from the poorest to the richest
of nations. This is true even in the United States, which enjoys the full benefits of
decentralized governmental responsibility and an extensive domestic debt market.
Recognition of this funding gap has resulted in a nearly universal acceptance
that the private sector can and should play a larger role in the financing of
infrastructure in partnership with the public sector, whether actively as a project
sponsor or passively as an institutional bond investor. The latter role carries greater
promise for enhancing the supply of capital for infrastructure, provided that
structural elements meaningfully enhance the credit quality of proposed debt
instruments so as to engage a countrys domestic debt market. Sustainable
infrastructure financing can be achieved from the traditional lending roles of
national and international development banks, although not in meaningful
amounts. Dependence on existing project sponsor companies is even less reliable,
given the ongoing contraction within that industry.
In developed countries, these funding partnerships arise regularly through
varying combinations of bond and commercial (or government-owned) bank loan
transactions issued directly by local governments, government-owned enterprises
and private companies contracted by government authorities to provide a public
service. In the 1990s, private sector participation in the financing of infrastructure
needs outside of the Organization for Economic Cooperation and Development
(OECD) countries was defined actively by privatizations and concessions. Passively,
it occurred through private debt placements with a select group of foreign
institutional investors or loan syndications sponsored by a few multilateral banks.
These efforts yielded some positive results but failed to resolve the global
infrastructure funding gap outside the OECD countries. In emerging markets,
the public and private sectors jousted over sovereign control versus investor rights
and remedies, as well as expectations over public access to infrastructure versus a
reasonable rate of return on capital. Market expectations were further battered by
27
macroeconomic volatility, the political expense of privatization without public

involvement at the local level, and the incompatibility of financing documents
with the host countrys legal practices and customs. Finally, private sector project
equity relied largely on a collapsing field of financially extended construction
companies and showed little capacity for sustained investment. After considerable
expectations and a thorough education concerning the various iterations of
designing, building, operating and transferring, the global infrastructure funding
gap grew.
For a number of countries, a new and more interesting generation of publicprivate partnerships (PPPs) is now emerging, which Fitch Ratings believes will
center on a more efficient and sustainable allocation of capital. Local governments,
in partnership with development banks, and international aid agencies are slowly
discovering that, by pooling project credit risk through infrastructure banks and
adding layers of credit enhancement (initial payment of project debt by local user
fees or taxes, followed by the ability to intercept intergovernmental aid, reserve
funds and partial credit risk guarantees from external sources), they can engage
domestic private capital. By providing an enhancement role with its capital, this
public sector coalition will be able to leverage its funds much further, while domestic
investors will benefit from the gradual diversification of their investment portfolios.
The remaining construction conglomerates are still on the scene, but their role is less
for equity and more for their expertise in designing, constructing and operating
projects. Privately financed infrastructure banks that pool project risk are not far
behind. In this new generation of PPPs, the private sector role shifts to the financial
engineers who work in conjunction with government authorities, as well as development
and multilateral banking partners, to create enhanced investment vehicles that
are attractive to domestic capital.
Stabilized revenue streams and a strong ultimate recovery value of infrastructure
assets open the door for progressively longer debt tenures, correcting an age-old
mismatch between the term of debt and the useful life of an infrastructure asset.
While a state-owned highway or municipal water system may default on its debt,
these are assets with long useful lives that will not be wound up, as in a bankruptcy
of a corporate entity. The ultimate test for these developing domestic debt markets
is whether this more efficient allocation of risk between the public and private
sectors will also translate into more realistic (i.e., achievable) rates of return on
28
private investment. If it does, then for these countries the allocation of capital will
not only be efficient, but it will also be sustainable.
For this new generation of PPPs to flourish, the host countries must nurture
some important prerequisites. These include promoting a relatively stable
macroeconomic environment, developing a legal and regulatory framework for
infrastructure projects and nurturing the development of a domestic debt market.
Unfortunately, these prerequisites do not exist in most parts of the world, which
means that some of the traditional roles of the multilateral and development
banks will remain necessary over the long term. In countries where these
prerequisites are taking shape, however, there are real opportunities to expand the
availability of capital by using pooled financings and credit enhancements to
harness a developing domestic debt market.
Stimulating the efficient use of capital is not the only challenge facing the next
generation of PPPs. These partnerships must also expel a set of myths that have
developed along with PPPs. This includes a careful evaluation of partnership
structures that utilize private sector expertise and efficiency without also embracing
corporate bankruptcy and consolidation risk. (Consolidation risk, in particular, is
not widely understood or anticipated in many non-common law countries, partly
due to codified provisions on the nature of trusts and other legal entities that
presumably guarantee their assets are separated and, therefore, protected from
third-party claims).
Due to their nature, PPPs will be affected legally by both administrative law
and commercial or corporate laws. Consequently, a court might dictate against
the rights of the private partners on the reasoning that the public interest must be
elevated above the interests of the private entity. This decision may be based on
the essentiality of services derived from the infrastructure project and their function
with respect to maintaining social order and safety, as well as public health.
Evidently, public partners can and will change their minds, so that structured
debt transactions will never achieve the level of securitization (security) expected
of credit card or residential mortgage receivable transactions. Trustee relationships,
while greatly enhancing the credit quality of PPP debt transactions, will never
mitigate credit risk fully.
29
Finally, a more sophisticated approach to understanding the true enhancement

value of government project support, which is too often overinterpreted as a direct
government guarantee, is required. Does this support promote the full and timely
payment of debt service or enhance a transactions ultimate recovery value? Is it a
general obligation of the government or a contingent obligation subject to
budgetary appropriation? The shades of gray concerning government guarantees
form a broader spectrum than most market participants acknowledge, even in
developed countries. The perpetuation of these myths impedes the participation
and pace of development of domestic capital for infrastructure. Nevertheless, the
next generation of PPPs, armed with pooled project risk and supplemented by
multiple layers of credit enhancement, is perhaps the best chance for a sustainable
supply of capital to meet global infrastructure needs.
Prerequisites for a Receptive PPP Debt Market

A relatively stable macroeconomic environment.
A developing legal framework for concessions, contract enforcement,
bankruptcy and lender remedies.
A relatively stable regulatory framework that recognizes the lifecycle needs
of the project.
A developing domestic debt market.
The traditional alternatives to infrastructure finance in most countries are central
government deficits and debt and multilateral bank lending, as well as the foregone
economic opportunities of simply not investing in infrastructure. A greater capacity
of infrastructure investment is present in the developed countries due to the
participation of the private sector, both passively as institutional and retail investors
in infrastructure bonds and actively through companies that sponsor projects as
contractors, operators or equity investors.
However, private sector participation requires some structural prerequisites
(i.e., a stable playing field) that lessen a countrys susceptibility to economic and
financial contagions and create an orderly legal and regulatory environment in
which to invest and operate. Unfortunately, a quick perusal of these investor
prerequisites reveals how few countries fit all of these categories. Nevertheless,
30
private investors (both domestic and international) have shown interest in countries
that are at least moving toward these structural prerequisites. This allows Fitch to
distinguish certain countries, such as Mexico, Korea, Chile and Poland, as more
ripe for private sector investment than others.
Relatively Stable Macroeconomic Environment

Only a few countries have truly stable macroeconomic environments, and most
are susceptible to the contagion effect of a financial and economic crisis.
Nevertheless, countries that have taken steps to control inflation and external
debt, increase official international reserves and utilize trading partnerships often
provide fertile ground for domestic and foreign private investment. For an
infrastructure project, a national and economic crisis creates not only risk for the
financial performance of the infrastructure transaction (i.e., its ability to generate
sufficient revenues to cover operating and debt service costs) but also added
uncertainty as to the range of political responses that might affect its operations
during a crisis.
Developing Legal Framework

The private sector requires clear and stable rules of engagement as provided through
a countrys legal framework. If a countrys public policy wants to encourage private
sector participation in the financing of infrastructure, its laws should support
that policy. This includes laws governing concessions and/or privatizations, a clear
process for dispute resolution and the ability to enforce contracts, as well as lender
remedies under bankruptcy and insolvency.
A number of countries, including Chile, Panama and Korea, have developed
comprehensive and transparent concession laws, where public sector goals and
objectives in private participation are clear. Equally clear is the process by which
the private sector is to bid on an infrastructure project or system, operate after
winning a concession contract and recover a return on its investment. Nevertheless,
dispute resolution systems in many countries look good on paper but do not
work well in practice. The rules of negotiation continue to prevail over rules for
contract enforcement, in most legal documentation. Finally, legal precedents (such
as in the state of Parana, Brazil) where a court upheld a contested concession
provision (in this case, a scheduled rate increase) are rare.
31
Bankruptcy laws also have been amended in many countries, as borrowing

migrates from commercial bank loans to the capital markets. Still, as lender rights
become codified, their application in the real world is often untested due to the
continuing propensity to negotiate financial arrangements outside the courts. For
these reasons, the ongoing practice of diluting, rather than eliminating, the equity
participation of construction and project sponsor firms that are in or near
bankruptcy, as in Korea, may unnecessarily expose an otherwise economically
viable project to bankruptcy and consolidation risk. Of equal concern is the belief,
as in Mexico, that a future flow securitization can sidestep the ongoing bankruptcy
proceedings of a private project partner. With new and untested legal regimes, it
is dangerous to rely solely on the integrity of financial structuring techniques,
especially during a financial and economic crisis.
For the private partners, the range of compensation mechanisms for political risk
is still developing. Public sector partners can and will change their minds, thereby
affecting the projects operating environment. Compensation is usually expressed as
extraordinary rate relief or as an extension of the term of the concession. In the case
of termination of a concession, provisions that provide compensation based on some
measure of the net present value of revenues over the remaining life of the concession
but for no less than the amount of debt outstanding, are increasingly present.
Relatively Stable Regulatory Framework

A countrys regulatory framework is simply the reflective implementation of its
legal and public policy framework. The base set of regulations should be developed
in tandem with the legal framework for concessions and privatizations. This process
takes time, but it allows the host government to gain its own comfort level with
the classic trade offs between access to private capital and the dilution of its own
sovereignty. Regulations should focus on the lifecycle of the project (i.e., from
design, to construction, to operation and to its eventual return to the public
sector). In Korea, the project selection process involves representatives of all the
governmental ministries that will be involved with that project over its lifespan.
This mitigates much of the regulatory risk upfront, since the concession agreement
can reflect the concerns and agendas of the various government ministries that
will be involved with the project. The private sector operator can choose to adapt
its concession expectations to an onerous regulatory environment. However, project
economics often lack the flexibility to adapt to a shifting regulatory environment.
32
Developing a Domestic Debt Market

Development of a domestic capital market is key to creating a sustainable supply
of capital for infrastructure. For infrastructure finance, the domestic debt market
should be the cake, while the foreign capital markets should be the icing, since
in most cases the source of repayment will be generated in the host countrys
currency. Local investors also are in a better position to assess the concessions
service area and political risk. Infrastructure transactions with either a US dollar
revenue stream or with construction or acquisition costs that exceed the financing
capability of the local debt market make better candidates for foreign capital but
not without structural enhancements, such as offshore reserves and multilateral
risk guarantees.
A growing number of emerging-market countries are developing domestic debt
markets. The development process requires financial sector reforms, including the
ability to invest funds in more than direct government debt. It also necessitates a
savings plan. Typically, these markets are shallow in that investments are usually
limited to the bonds of the central government and a handful of other governmental
or privatized entities. Investments also are limited to short- and medium-term
maturities. The ability to issue the long-term debt maturities needed by
infrastructure projects simply does not exist throughout most of the world. Even
in countries that have robust domestic debt markets, like Korea and Mexico, the
average life of a corporate bond is still approximately 37 years; a notable exception
is Chile, where to date nine projects have been financed in the national bond
market at terms of 20 years. Generally, the remarketing of these medium-term
debt maturities is a big risk for infrastructure projects, where revenue growth and
financial margins may not be able to accommodate interest rate volatility. Finally,
infrastructure bonds often represent a new form of asset class for domestic investors.
Until these userbased revenue streams prove themselves, many domestic investors
will continue to require other forms of government support.
Critique of Traditional PPPs

The drive toward privatization and concession-based project financing in the mid1990s was seen by many governments as a way to jump start infrastructure
investments. The belief was project finance could infuse new capital and better
management practices into poorly maintained and overutilized infrastructure
33
systems. The initial efforts of the 1990s were promising, but they soured
throughout the emerging-market countries with the contagion effect of the Asian
financial crisis of 1997. While this explains the sudden interruption of new capital,
it does not fully explain why infrastructure finance never really recovered. Evidence
from the past decade points to difficulties caused by the government sectors rush
to privatize basic public services, in most cases without a proper transition period.
This resulted in an inevitable clash between public policy goals, public expectations
and the private sectors desire for a reasonable rate of return on capital.
While the project finance community enjoyed creating a new vocabulary for the
many iterations of these partnerships (e.g., build-operate-transfer, build-transferoperate, build-own-operate, buy-build-operate and design-build-operate, among
others), most of these transactions did not have the transitional underpinnings to
operate as independent enterprises, or the credit enhancements necessary to withstand
macroeconomic volatility. The developed world pushed its construction and financing
contractual frameworks onto the developing world, external financing was seen as
synonymous with external expertise and both sides misinterpreted the consequences.
Public-Sector Risk in Traditional PPPs

It is important for the private and public sectors to understand the risks of
transacting with each other. The key risks that the private sector faces in dealing
with the public sector are described below, followed by the key risks of dealing
with the private sector. In all cases, this is not intended to discourage interaction
but to point out areas where proper structuring can enhance the survivability of
an infrastructure transaction.
Determining Service Ownership

In many countries, ownership disputes over certain public services continue
between state and municipal governments. While some governments, like Mexico
and Brazil, slant resources and regulation at state-owned water utilities, actual
title to the water services remains unresolved. It will be difficult to engage private
capital until the ownership issue is legally addressed. In many cases, state-owned
utilities have contracts with neighboring municipalities, but these are often
short-term contracts, and the utilities desire longer term debt. Ownership disputes
lend uncertainty to the continuity of utility revenue streams.
34
Creating Dependable Project Revenue Streams

Capital markets count on dependable revenue streams to make full and timely
payment of debt service. State and local revenues (including infrastructure user
fees), outside of central government transfers, rarely make a dependable revenue
stream for infrastructure debt in emerging markets. This is partly because local
governments in many parts of the world depend on central government transfers
as their main source of revenues. The relative newness of decentralized governmental
services is another factor. Local enterprises, such as water authorities, are often
plagued with poor revenue collections, reflecting relative inexperience and feeble
administrative capacity to operate their enterprises as a business. These challenges
are coupled with a still weak public acceptance for user fees and, equally, hikes in
user fees after an improvement in service.
The opportunity for a public enterprise to operate as a publicly owned business,
including productivity gains and rate increases for capital improvements, can
facilitate its transition to the private sector. Corporatization, whereby the publicly
owned enterprise is organized and run as an independently financed and operated
business, can prepare users for the consequences of improved and reliable services.
Along this line, the state of So Paulo, Brazil, operated the Anchieta-Imigrantes
toll road as a public enterprise, first implementing tolls along this important
route and then increasing rates commensurate with capital improvements or with
inflationary cycles. When the private consortium Ecovias won concession over the
toll road, its customers had already adjusted their behavior to paying for service
enhancements. Similarly, the National Water Commission in Mexico has targeted
certain service-level and administrative efficiencies as prerequisites, before
state-owned water utilities can borrow for additional water or sewer capacity.
Protecting Against Political Risk

Many governments, until recently, were caught up in the rush to privatize now
and worry about the consequences later, causing a general public backlash against
privatization. This is especially the case in Latin America, where project contractual
covenants, government budgetary capabilities and public expectations are at odds
with one another. The absence of corporatization, as mentioned, and the lack of
public participation at the local level resulted in an escalation of political risk for
both privatizations and concessions. For countries where the prerequisites attract
35
private sector investment and the legal system supports compensation, effective
ways to mitigate political risk are as follows:
Select projects that best fit the national, state or local priorities for economic
development.
Choose projects with sound economic value.
Seek project partners with strong levels of commitment and expertise with
infrastructure assets.
Provide an adequate period of corporatization prior to privatization to ensure
interim improvements in the efficient delivery of public services.
Endow projects with sufficient financial protections to mitigate risk, such as
liquidity to offset completion risk, operating ramp-up risk and economic cycles.
Clarify the relationship between the subnational entity and its public-service
companies; the flows of capital and the administrative control between
parent government and enterprise should be well understood.
Private Sector Risk in Traditional PPPs

Host governments want the expertise, efficiency and capital that the private sector
can bring to infrastructure and local government services. They should avoid
exposure to the corporate sectors bankruptcy and consolidation risk. PPP structures
are improving upon their ability to isolate voluntary bankruptcy risk (via starting
with an economically viable project). However, the relative newness of revisions to
bankruptcy codes contributes to a lesser understanding of the risk of involuntary
bankruptcy in countries where this legal concept applies. Evaluating bankruptcy
risk requires a full understanding of who the projects partners are and their roles
with respect to ultimate ownership of the projects land, facilities, equipment
and cash.
Mitigating Voluntary Bankruptcy

For mitigating voluntary bankruptcy, the foremost rating consideration is the
economic value of the infrastructure project or system. If it has strong economic
value, there is less reason to worry about testing the host countrys legal
environment, which in most cases is either underdeveloped or untested. After
36
that, credit quality can be enhanced by the structure of the projects financial
transaction. Governing by covenants provides investors with minimum legal
parameters for an infrastructure transactions financial margin and limits the events
of default that could lead a project into bankruptcy. Typical infrastructure project
covenants include the following:
A revenue covenant with minimum required debt-service coverage levels.
Lowest required funding levels for various debtservice and operating reserves.
Minimum financial tests for the issuance of additional debt.
An order of priority for the payment of operations, debt service and the
replenishment of reserves, as well as certain tests prior to making equity
distributions.
Requirements to re-engage financial consultants if the performance of a
project does not meet the minimum covenant levels.
Conditions that cause an infrastructure transaction to default should be
sufficiently limited to promote its survival. Typical defaults are for nonpayment of
debt service and a continuing breach of other covenant requirements beyond a
prescribed cure period. The latter provides some latitude for reaching compliance
without placing the project into immediate default.
Mitigating Involuntary Bankruptcy

More difficult to detect is the involuntary bankruptcy risk of a private sector
partner. This partly reflects shortcomings in corporate sector accounting, as well
as the market volatility of certain corporate activities. Involuntary bankruptcy
exposure of infrastructure projects to which these corporate entities are counterparty
assumes the project is functioning fine, but its ability to meet financial obligations
is interrupted externally by investor claims on the corporate parent or subsidiary
to the company associated with the project. There are a number of ways to mitigate
this involuntary bankruptcy risk.
Structuring the Issuer (Creating a Bankruptcy-Remote Entity)

The type of vehicle employed to issue project debt will depend on the possibilities
afforded by national laws. Thus, in Mexico trust is the one entity that enjoys legal
37
person status under Mexican law. In the United States and other countries, trusts
and special-purpose vehicles are also available, with respect to which bankruptcy
risk mitigation is the most vital characteristic. Chile created a special corporation
under its concession laws. Generally, a nationally incorporated subsidiary or
consortium can be created as a special-purpose, bankruptcy-remote entity. The
further this independent entity is removed from the operations of the infrastructure
project or system, the more bankruptcy-remote it becomes. A special-purpose entity
can be a shell, with it being solely responsible for receiving and transferring a given
asset to a trustee. A special-purpose entity also can own an asset, have no ability to
voluntarily file for bankruptcy and contract out for operations. A bankruptcy-remote
structure can be an independent commercial entity and protects against consolidation
of the issuers assets in a bankruptcy case involving either its parent corporation or
another subsidiary of the parent. Many so-called, special-purpose companies are
not so limited. They may be incorporated under the host countrys law, but their
articles of incorporation and shareholder documents may not create enough distance
from the parent company or subsidiaries. In addition, many articles permit
engagement into ancillary businesses, creating an additional window for bankruptcy
risk.
Structuring the Transaction (Creating a Trust Estate)

Another approach structures the infrastructure debt transaction. The debt issuer
sells its rights to the cash flow, securing the debtholders obligation to a specially
created trust estate. Alternative structures can include a limited liability corporation
(LLC) or a limited partnership. Under this deed of trust, all of the issuers interests,
rights and obligations are sold to a trustee on behalf of the bondholders. While
the issuer has assigned away its rights, it can still earn returns from the project,
although no money is released until the trustee has satisfied all other financing
agreement requirements. The trust estate concept is gaining acceptance in such
domestic debt markets as Mexico through the creation of a master trust agreement.
Nevertheless, there are cases in which a trusts value may be overestimated,
particularly where a project trust is created during the ongoing bankruptcy of a
parent project sponsor company.
Limiting the Operators Interest in the Project

In addition to sponsor companies in a project consortium, project operators are
38
the other private partners in an infrastructure transaction. Their role is important

since it is often the operator that holds the cash. Legal structures that limit the
operators interest in the project to that of an agent contractually obligated to
provide a specified service for the project (i.e., the operator has no legal rights to
the cash) can eliminate its bankruptcy risk. It is also important to have provisions
in an operating agreement for the potential replacement of an operator under
certain conditions of nonperformance.
Common Myths Concerning Public Infrastructure Finance

Much of the discussion has centered on how structural elements enhance the
credit profile of PPP transactions. The lines between PPPs and structured finance
have blurred considerably, which carries both positive and negative consequences.
The most positive consequence is that domestic debt markets for infrastructure
bonds are now developing in countries like Korea, Mexico and Chile, where until
recently such projects were financed only by commercial or government
development banks. Strong concession laws, revised bankruptcy regimes, the
creation of special-purpose entities and new trustee relationships have set the
stage for an exciting evolution in infrastructure finance for both local governments
that have large infrastructure financing needs and domestic investors that need to
diversify their investment portfolios.
Nevertheless, while PPP transactions have much of the appearance of
securitizations, they will never be true securitizations. There are two explanations
for this. The primary reason is the role of administrative law, not only corporate
law, in the legal frameworks in which most public infrastructure is developed.
Namely, the essentiality of the public service can persuade a court under certain
circumstances to dictate against the interests of the private sector and cut off
investors from the revenues and assets derived from the project. In addition, a
public-sector partner in the PPP can and will change its mind about public policy
objectives, its regulatory framework and interest in cooperating with private sector
requirements for return on capital, especially during difficult economic times.
This leads to the secondary reason, which concerns the ratio dynamics that
drive much of the structured finance world. Collateral and other tests that are
developed for the securitization of traditional asset classes, such as residential
mortgages, are based on the collective behavior of thousands of loans observed
over a long period. Traditional PPPs are often single-asset facilities instead of a
39
portfolio of thousands of credit card or mortgage accounts. There are not enough
existing PPPs from which to derive statistically meaningful default behavioral
patterns or to develop fixed-coverage tests for a given rating category. Add to this
individuality the constant possibility that a PPPs operating environment can
change with the policies of a new administration. This diminishes the value of
traditional structured finance ratio-driven analysis.
From this experience, some important misconceptions about PPPs have
emerged. Fitch has categorized four as myths, not because their claims are never
true or cannot be made true but because they are frequently misconstrued as true.
Myth 1: Bulletproof Financial Transaction

Experience with PPPs suggests it is not possible to structure the kind of bulletproof
transactions common among more conventional securitization asset classes.
Governments from China to Argentina to the United States can and do change
the rules governing PPP transactions.
Every project has multiple agreements, but they generally fall into two broad
sets. One set governs the projectconcession, construction and operating agreements
fall into this category. The other governs financingtrustee, assignment and
intercreditor agreements. While the financial community likes to focus its attention
on the protections afforded by the financing documents, it is important to
remember that the concession agreement actually sets the tone for everything to
do with the project.
The concession agreement is the governments grant to a public- or private
sector partner to build, operate and benefit from a projects revenue stream for a
period, and under a certain set of conditions, until the project reverts back to the
government. This includes the governments grant to the project partner to charge
and collect user fees, that will recover operating and capital costs of the project
and pay debt service and potential dividends to private sector partners. The
concession agreement can also determine the circumstances and timing of fee
increases (e.g., annual increases tied to inflation, with a maximum allowable rate
of return on capital). All the protections afforded by the financing documents should
be calibrated to these overriding rights and obligations under the concession
agreement if they are to remain enforceable. Strengths of various Mexican toll
40
road master trust agreements, are the broad cross-referencing to the underlying
concession agreement and the enabling legislation for the toll road. Sometimes,
the financing documents are not harmonized with the concession document, and
that is where bulletproof turns into bullet-ridden.
Governments can change their regulations for a project, and they can even
terminate a concession agreement through expropriation. When they do, this can
seriously impair or cease access to revenues under a financing agreement, rendering
it ineffective. That is why many concession agreements contain provisions for
extraordinary rate relief, extension of the term of the concession or compensation
in case the concession is terminated. For these reasons, PPP financial transactions,
with their assignment of rights, covenants and reserves as well as all of the other
bells and whistles, which provide so much credit enhancement, cannot be viewed
as true securitizations.
Myth 2: Financial Transaction Through a Special-Purpose Entity

Every project has internal and external bankruptcy risk unless it has statutory
protection that prevents a default from leading into bankruptcy. For financial
transactions involving PPPs, sheer economic strength, combined with structural
elements, can act as the best mitigant to voluntary bankruptcy risk.
For involuntary bankruptcy and consolidation risk, the best protection comes
from a special-purpose entity, as previously discussed. A determination of whether
or not the transaction benefits from a special-purpose entity status requires an
opinion from a qualified local counsel or other source (such as a third-party
guarantee), providing a clear description of the powers and obligations of the
entity and certainty with respect to the obligation pledged. Only a handful of
countries require this opinion to be rendered, or even requested, as part of the
documentation to market such bonds. In most countries, while it is customary
for Fitch to request this opinion as part of its due diligence for a rating, it is
simply not demanded by the market.
Myth 3: Trustee Controls Revenue Flow

Trustee relationships are a critical feature of project and structured finance. They
provide passive bond investors with the comfort that project revenues and accounts
are assigned to the trustee on their behalf and payments from these accounts will
41
be made in a prescribed manner and timetable, as determined by the trust

indenture. Nevertheless, investors should be aware of when the trustee takes control
of the revenue flow and the full range of circumstances under which the trustee
retains control.
The tightest trustee control over revenues requires frequent (often daily) deposits
of project revenues into an account maintained by the trustee. From here, the
trustee can follow the dictates of the financing document with respect to when
deposits are required into predetermined accounts for operations, debt service
and reserves, among other costs.
The now familiar theme of bankruptcy remoteness plays a role here. Legal
circumstances can limit the value and effectiveness of trustee control. To begin with,
the trustee is not the first participant to handle the revenue. The project operator
collects user fees from the projects patrons and channels them to the trustee. As
mentioned, it is important to structure around operator bankruptcy risk.
The second consideration is the full range of circumstances under which the
trustee retains control over the revenues; thus it is necessary to return momentarily
to the risks posed under the second myth (the importance of determining whether
the concessionaire is really a special-purpose entity). If the bankruptcy remoteness
of the project entity is not established, the trustee can only have full contractual
control over the revenue flow under normal circumstances.
Under an involuntary bankruptcy proceeding, there are a variety of ways the
trustee can lose control over the revenue flow. The shortest period that loss of
control can occur is when the court determines whether to allow project assets
under the proceeding. If it decides not to allow the projects assets, trustee control
can resume under normal operating conditions.
If the court decides to allow project assets as collateral under the proceeding,
their fate can take several courses. One is where the court allows the project to
continue operating but diverts revenues into the ultimate creditor settlement.
The other is when the court decides to wind up the projects assets as part of the
ultimate creditor settlement. It is important to remember that the court may
consider not just project revenue as an allowable asset but also amounts held by
42
the trustee under the reserve. The legal process and interpretations of bankruptcy
proceedings vary from country to country, emphasizing the importance of an
independent bankruptcy opinion.
Myth 4: Financial Transaction Debt Is Government Guaranteed

Debt guarantees from host governments are often required by investors, if an
infrastructure asset class is new or unfamiliar to the market or investors do not
believe the user revenue stream from the project can provide a reliable payment
source for the debt. This can either be because the project has a public
developmental purpose in a region that needs the infrastructure but cannot pay
debt service solely through user fees, or because the organizational and
administrative mechanisms to operate infrastructure on a self-sufficient basis are
either untested or not trusted. While part of the rationale for bringing private
partners into an infrastructure project is to provide the skills and efficiency to run
the project on a business basis, the high probability of political risk with respect
to rate flexibility, among other things, often causes investors to still demand a
government guarantee.
There is a long-held financial proverb that the government guarantee is as good
as the sovereigns own credit risk (i.e., equal to its unsecured obligation risk). A
sovereign obligation is an unconditional, irrevocable risk, which although it may
not be guaranteed or collateralized is still a high bar for the vast majority of guarantees
provided to PPP transactions. In fact, investors should question the logic of why a
government would grant the same pledge to a project with a private sector partner
as it does to its own bonds. For an investor to assign a value to the debt guarantee,
experience suggests a number of considerations, such as the following:
It is important to determine whether the guarantee is automatic or subject
to appropriation as part of the governments budgetary process. A financial
obligation that is subject to budgetary appropriation is of lesser credit quality
than the sovereigns unsecured debts.
Investors should know the guarantees priority of payment with respect to
other government obligations. Pari passu status with respect to general
obligation debt is the strongest. Anything less than pari passu is a subordinate
obligation and of lesser credit quality than a general obligation.
43
It is important to be familiar with the mechanism that triggers the guarantee.

Essentially, there are two types of triggers. A proactive trigger requires a trustee
and/or concessionaire to formally notify the government in advance if the
debt-service account is deficient for an upcoming debt-service payment. Giving
the government prior notice and time to respond by making a deposit of the
deficiency into the debt-service account on or prior to the payment date
preserves the full and timely nature of the payment and is the strongest type
of trigger. A reactive trigger waits for a payment default to occur, then asks
the government to retroactively use its guarantee mechanism to make up the
payment deficiency; this is a weaker guarantee but also the most common.
The concession agreement should outline the process and timing by which
the government will evaluate and settle upon the guarantee commitment.
The most effective guarantee specifies which government representatives
are responsible for evaluating the guarantee request and how many days
they have to respond. A time-certain review and payment under the
guarantee clause is the strongest form of guarantee. An open-ended review
process is the weakest. Of equal concern is whether the responsible
government agency can reach a different conclusion than the trustee or
concessionaire as to the deficiency amount. The concession agreement should
restrict the governments ability to interpret a guarantee request.
Nevertheless, governments may exercise their own calculations as to guarantee
amounts regardless of the mathematical debt-service deficiency. Nothing is
ever simple where PPPs are concerned.
Investors should be concerned about the financial sustainability of guarantee
commitments, given other financial and service demands on the government.
One should not compare the small debt-service commitment of a project
to the largeness of the governments budget. Instead, the focus should be
on the rigidity of the expenditure budget (how much of it is already
accounted for under legally mandated programs). Additionally, contingent
liabilities of a growing portfolio of project guarantees as more PPPs are
executed could cause financial pressures on the government.
Finally, investors should consider the political risk inherent to every project
finance transaction. It is reckless to believe that documentation creates
equality among projects in the governments opinion. Some projects will
44
be successful and politically popular, while others will be economically or

politically unpopular. Governments will not treat each project equally,
especially at election time or during a crisis. For Fitch, this is a rating
consideration. Project documents can mitigate political risk, but they do
not create an impervious barrier.
PPPs: The Next Generation of Infrastructure Finance

After considering the litany of risk considerations described, it easy to understand
why there has not been a greater proliferation of PPP financial transactions (i.e., a
stronger response to the infrastructure funding gap), despite much anticipation and
effort. However, Fitch believes this situation is about to change, as explained herein.
Pooling Credit Risk

The greatest concern for lenders to local government enterprises and PPPs in nonOECD countries, is a lack of confidence in the ability of local revenue streams to
repay debt service when due. Economic and political factors often lead to
unacceptable rates of default on project debt. Over time, public and lender interest
would be best served if these enterprises became self-sufficient, but in most
countries, this is a long-term goal at best. In the more desperate environments,
self-sufficiency may never be attainable.
For this reason, the pooling of new or refinanced infrastructure loans into a
bank is an important way to mitigate against individual loan loss. This concept
may be less applicable to the pooling of existing loans that have different debt
structures. Where the ultimate recovery value of the loan portfolio looks promising,
the country with multilateral bank grants, if necessary, can capitalize the fund
with reserves against the expected cash flow deficiencies within the loan portfolio.
Interest income from the collateral can be used to reduce the borrowing costs of
the entities within the infrastructure pool. A single debt emission by the bank on
behalf of the pool participants will also create liquidity within the domestic debt
market on the theory that the market has more appetite for the larger debt issuance
of the bank than for the smaller individual project loans of the banks participants.
Liquidity in the capital markets also lowers borrowing costs for the participants.
This cheaper access to pooled capital greatly increases the resources available to
meet local infrastructure needs.
45
US SRF Model
The state revolving funds (SRFs) model was used to create the wastewater and
water projects in the United States. Matching capitalization grants from the
Environmental Protection Agency (EPA) and their respective states evidence a
prioritized list of eligible municipal projects. The model includes qualitative
adjustments for a lack of geographic diversity within the pool (in the United
States, SRFs are single-state funds), as well as expected loan default rates.
Capitalization grants can be set aside in a debt-service reserve fund and invested
in collateralized guaranteed investment contracts (GICs) with highly rated financial
institutions. They can also be used to make direct loans, the repayment of which
can be pledged against future leveraging. Many SRFs issue bonds, lending debt
proceeds to participating municipal utilities. Loan repayments from the
municipalities are used to repay SRF debt and provide capital for additional lending.
Investment income can subsidize loan interest rates and, of course, invested
reserves can act as collateral against the loan portfolio, as can overcollateralized
loans. Key factors supporting a high ratings profile for SRFs include the extent of
overcollateralization and low default rates on this type of loans. Other rating
factors are the funds criteria and managerial expertise as they relate to structured
and municipal finance transactions, the loan pool structure (including expected
default rates), loan underwriting and due diligence guidelines, and investment
practices. Substantial reserves and excess cash flows allow bond payment, even
during stress scenarios with unprecedented loan defaults.
Enhancing Pooled Credit Risk

Where the default risk of the loan portfolio is expected to be high and its ultimate
recovery prospects are weaker, the initial reserves will not be enough to protect
the bank. In these situations, extra layers of credit enhancement are needed to
improve the cash flow of the loan portfolio. These layers include the initial payment
of project debt service by local user fees or taxes, followed by the ability to tap the
funds reserves for cash flow purposes and then to intercept intergovernmental aid
to replenish the funds reserves. These layers could be further supplemented by
available lines of credit or other partial credit risk guarantees from external sources,
such as multilateral banks, international aid agencies or monoline insurers.
46
Repayment of multilateral lines of credit should be a subordinate obligation

to the banks debt, but it should not be a grant. In this case, the bank may have to
divert interest income from its reserves as a form of repayment for the external
lines of credit. The multilateral agencies can determine on a country-by-country
basis (by a combination of needs assessment and public policy), which pooled
recovery rates they expect for these subordinated lines of credit (e.g., full and
timely basis in one instance, 75% recovery after 10 years in another, 40% recovery
over 10 years in another, and so on).
While unrecovered amounts can be written off as uncollectible by the
multilaterals (having the same economic effect as a grant), this system allows the
multilaterals to benefit from the possibility of improved recovery rates over time.
Since the assets being financed will have a long useful life, entry into the bank
should be accompanied by acceptance of measures to increase the administrative
and service level efficiency of the local government or PPP enterprise. This increases
the prospects for better financial performance over time. For the borrowing entities,
the incentive to improve loan performance is that it progressively frees up the
banks interest income to provide interest rate subsidies instead of repayment to
the multilaterals for use of their lines of credit.
The pooling of infrastructure loans plus credit enhancements provides
much-needed stability to project revenue streams, creating an opportunity to
engage the domestic capital market as an investor in the infrastructure banks
debt. This has the additional benefit of diversifying domestic investment portfolios.
Stabilized project revenue streams also allow for progressively longer debt tenures,
correcting a long-standing mismatch between the term of debt and the useful life
of an infrastructure asset. The ultimate test for these developing domestic debt
markets is whether this more efficient allocation of risk between the public and
private sectors will also translate into more realistic (achievable) rates of return on
private investment. If it does, then for these countries, the allocation of capital
will not only be efficient, it will also be sustainable and regenerative.
Outlook
In this new generation of PPPs, the private sector role shifts to the financial
engineers who work in conjunction with government authorities, as well as
47
development and multilateral banking partners, to create enhanced investment

vehicles that are attractive to domestic capital. Old allies, the remaining construction
conglomerates, will still be involved, but their role is less for equity and more for
their expertise in designing, constructing and operating projects.
Is this visionary portrait of the future of PPPs in non-OECD countries realistic?
Fitch believes that it is close to becoming a reality. The first steps have been taken,
with some multilateral banks starting to provide credit enhancement (partial credit
risk guarantees) to project debt in the local markets and in the local currency.
This enhancement role allows these banks to allocate their capital further than
through direct lending. If they were enhancing pooled project loans, their capital
could be extended even further.
Enhanced pooled capital is the concept behind the US Agency for International
Developments (USAID) support of the Water and Sanitation Pooled Fund (WSPF)
in the state of Tamil Nadu, India. WSPF is a special-purpose vehicle to be
incorporated under the Indian Trust Act, with an initial debt-service reserve
contribution from the Tamil Nadu government. Tamil Nadu Urban Infrastructure
Financial Services, Ltd. (TNUIFSL) will manage the fund. Loan repayments for
certain municipal users will be made directly by user fees or local taxes, with the
ability to intercept state aid if there is a deficiency. For other types of municipal
users, the WSPF has the authority to directly intercept state aid for loan repayment.
The debt-service reserve fund carries an amount equal to one full year of debt
service. If these layers are insufficient, USAID contractually plans to guarantee an
amount equal to 50% of WSPFs principal. The funds debt will be offered to
domestic investors.
Private banks are also exploring the creation of infrastructure banks in select
emerging-market countries. These banks would most likely work in conjunction
with a host countrys development bank to achieve the risk allocation and cost-offund advantages of the SRFs. Finally, for certain emerging-market countries with
an investment-grade sovereign rating on the international scale, the monoline
insurers are exploring opportunities to provide credit enhancement at the AAA
national scale rating level. All these signs are important for the development of
domestic capital markets and the creation of a sustainable and regenerative supply
48
of capital for infrastructure projects. The financial engineers from both the public
and private sectors will create the next generation of PPPs. A more efficient allocation
of capital engages a broader set of participants and creates new incentives to enhance
the capacity for infrastructure finance while also promoting a more efficient delivery
of municipal services. The process has already begun.
(Fitch Ratings is a leading global rating agency committed to providing the worlds
credit markets with accurate, timely and prospective credit opinions.)
49
Section II
How Project Structures Create Value
50
51
4
Budget: Overcoming
Roadblocks to Growth
Padmalatha Suresh
Taking a cue from the comparison of FDI flows into China with
that into India in the Indian Finance Ministers 2005 budget speech,
this newspaper article identifies the role of the banking system
and the government, in building world-class infrastructure in India,
with particular reference to transport. Building world-class
infrastructure has been the key to the transformation of the Chinese
economy from planned to market-oriented. According to studies,
infrastructure investment is associated with one-for-one growth
in GDP, while inadequate infrastructure impedes economic
growth. With GDP growth expected to be around seven percent
this year, the Plan target is achievable only if GDP growth for the
next two years is ten percent. The article underlines the need for
innovative project financing and proposes active involvement of
the banking system, capital markets and legal system in this
process.
erhaps one of the most striking pronouncements by the Finance Minister,

Mr. P Chidambaram, during his Budget speech was, to quote
Mr. Chidambaram, At a recent meeting of G-7 finance ministers in London
Source: http://www.thehindubusinessline.com/2005/03/22/stories/2005032200810800.htm, March 2005 Business

Line. Reprinted with permission.
52
(that India and China attended), Chinas finance minister looked in my direction
and said China had received $60 billion of foreign direct investment in 2004.
Indias Foreign Direct Investment (FDI) last year was less than ten percent of
Chinas. Ignoring for the time being the ongoing academic discussion on FDI
composition anomalies, the comparison with China in the Budget speech is
acknowledgement of the increasing international visibility of Chinas aggressive
growth policies.
Building world-class infrastructure has been the key to the transformation of
the Chinese economy from planned to market-oriented.
According to studies, infrastructure investment is associated with one-for-one
growth in GDP, while inadequate infrastructure impedes economic growth.
The Tenth Plan targeted an average GDP growth rate of 8.1 percent. The
actual performance was 4.6 percent for 2002-03 and 8.3 percent for 2003-04.
The shortfall is disturbing since the momentum for acceleration, essential to
achieve the 8.1 percent target, is absent.
With GDP growth expected to be around seven percent this year, the Plan
target is achievable only if GDP growth for the next two years is ten percent.
A McKinsey study estimates that addressing impediments to economic growth
such as inadequate infrastructure, bureaucracy, corruption, labour market rigidities,
regulatory and foreign investment controls, reservation of key products, and
high fiscal deficits, would enable Indias economy to grow as fast as Chinas, at
ten percent a year, and create some 75 million new jobs.
It was, therefore, expected that infrastructure would occupy the pride of place
in the recently announced Budget. But it appears that the dream-budget merchant
has not woven innovative dreams for infrastructure development and financing in
the ensuing year.
Consider Indias road infrastructurethe primary mode of transport
increasingly seen as a major factor influencing economic growth and social
development.
53
India has a very large network of poor quality roads. The 58,000 km stretch of
national highways that carries 45 percent of total traffic, is mostly two-lanes with
heavy traffic, low service and slow speeds. Despite the 3.5 million km stretch of
roads (the worlds second largest), 40 percent of Indias villages have no all-weather
access.
Government expenditure on roads accounts for 12 percent of capital expenditure
and three percent of total expenditure, but road maintenance is grossly under-funded,
with only one-third of needs being met. This has led to road deterioration, high
transport costs and accessibility loss.
While highway length has grown 1.26 times over the last five years (2000-04),
traffic on these highways has increased 14 times.
Even if the Golden Quadrilateral (GQ) project is completed by mid-2005,
and the north south-east west (NS-EW) highway project is completed on schedule
by 2008, India will have reasonably well-surfaced, four-lane national highways
that accounts for just 22 percent of the countrys national highways.
India has 3,000 km stretch of four-lane highways, and no inter-state expressways.
In contrast, China has highway network of over 25,000 km stretch of four or
six-lane access-controlled expressways linking major cities, all built during the
last decade.
The Centre plans to spend over Rs.2,25,000 crore on highway improvements
in the next six years, apart from the substantial investment to connect villages.
In addition, annual expenditure of Rs.7,000 crore is essential to maintain the
1,70,000 km stretch of national and state highways, and further funding is required
to maintain urban networks, district and rural roads.
All these expenditures have to be financed within the current fiscal environment
of deficits amounting to 9.5 percent of GDP. In comparison, by 2020, China
plans a 35,000 km stretch, $150 billion trunk highway system.
While continuing massive reforms, Chinas budget deficit for 2005 is expected
to be hardly two percent of GDP. India, therefore, has to grapple with the serious
54
issues of financing the development of highways and other infrastructure, and its
structuring. There are two approaches to highway financingtraditional and
commercial.
The traditional approach treats roads as public goods, and finances construction
from general revenue with little connection between road-provision costs and
road-user charges.
The commercial approach treats roads as capital assets, and charges road users
directly or indirectly.
In India, the traditional approach largely persists, although national and state
fuel cesses, tolls and private financing are increasingly being introduced. Not
adopting the commercial approach has contributed to under-funding of road
maintenance, and substantial economic losses.
The need of the hour, therefore, is innovative infrastructure financing.
China has been financing infrastructure growth through private domestic
investment, multilateral funding and FDI.
The achievement is laudable, when viewed against the backdrop of a relatively
weak banking system.
China also proposes to invite cross-border investments from strong global
players.
The Budget has proposed some measures for infrastructure financing. Are these
sustainable?
Using a portion of Indias foreign exchange reserves for financing infrastructure
carries the potential danger of fuelling money supply and inflation.
The Inter-Institutional Group (IIG) of Banks can finance infrastructure,
provided they source long-term funds on a sustainable basis. Besides, the
security aspects need to be worked out.
The allocation of Rs.10,000 crore for the year to the new financial special
purpose vehicle seems meagre, given the required infrastructure investment.
55
It is becoming imperative that India look increasingly at private participation,

domestic and international, to fund infrastructure growth.
The most attractive option for these private investors would be to use project
financelimited or non-recourse financing of a project through the
establishment of a vehicle company. The project financing structure permits
multiple equity investors, lenders and long-term contracts with third parties. The
risk-return trade-off of long-term infrastructure projects would be rendered
attractive through the project and capital structures and the risk management
techniques employed. Indias strength is its relatively robust financial system.
However, use of project financing structures call for a sound legal system, since
project financing is governed by contracts. Financial regulations and laws have
been upgraded but poor enforcement weakens market discipline and integrity.
Involvement of the Banking System

World over, bank lending plays a key role in project finance due to its disciplining
effect on borrowers cash flows. However, project lenders should re-orient their
skills to assess and hedge the risks of non-recourse lending.
Development of syndicated loan and long-term bond markets to cater to
the enormous funding requirements.
Presence of strong insurance mechanisms for risk-mitigation.
Development of innovative financial and hedging instruments tailored for
deal structureshybrid-financing structures, such as mix of corporate and
project finance, leveraged leasing structures, etc. Investment bankers would
have to upgrade deal-structuring skills, and project capital providers, their
negotiating skills.
Superior project management capabilities. Indias ongoing portfolio
performance in the World Bank funded projects is less than satisfactory.
Chinas portfolio performance is the best in the World Bank.
Fast track government clearances/permits/licences/concession agreements
and minimal government interference in project implementation. Soon,
China will adopt innovative private participation models, as is evident by
the infrastructure construction plan for Beijing to be implemented from
56
October 1. Infrastructure development has been vital for Chinain the

1990s, breaking infrastructure bottlenecks was critical to the sustaininghigh-growth-without-inflation strategy; in recent years, infrastructure
development has been considered the most effective way of promoting
market integration, poverty reduction, and inland China development.
Past experiences indicate that India has innovated best in the face of external
triggers. A decade ago, it was the IMF loan that triggered financial reforms. Will
Chinas policies trigger innovation in infrastructure development and financing?
57
5
Padmalatha Suresh
What are the structural attributes of project companies, that enable
them to find the financial and other resources for very large
projects? Having found the resources, how do the project
companies structure the project organization to take care of its
long term needs? How do project companies take care of the risks
involved in constructing, financing and operating very large
projects? What are the structural features of project companies
that enable lenders and equity holders to invest substantial funds?
This article summarizes the rationale for, and various types of
contracts and models that form the backbone of project financing
transactions.
Introduction
Project financing structures have been the subject of substantial research during
the last decade or so. How do standalone project entities with separate legal
incorporation, high leverage and concentrated equity ownership manage the risks
associated with long-term infrastructure development and still deliver financial,
social and developmental value?
58
Project financing involves innovative techniques to be used in many

high-profile large-scale and infrastructure projects. Employing a carefully engineered
financing mix, it has been used over the last decade to fund large-scale natural
resource projects, from pipelines and refineries to hydroelectric, telecommunication
and transportation projects and even projects, in the entertainment and social
sectors.
Although project-financing structures share certain common features, every
project is unique and requires tailoring the financial package to the particular
circumstances and features of the project. Here in lie both the benefits and the
challenges.
India is on the verge of an infrastructure boom. The pressures created by the
need for central and state governments to balance their fragile budgets, have led
to a greater use of the private sector in infrastructure development and financing.
Large infrastructure projectscustomarily implemented by the government
now being implemented with private participation and management, reflect the
new trend. It is preferable that long-term Infrastructure Finance in emerging
markets like India is based on project financing arrangements, thus attempting to
mitigate the extreme risks of operating very large projects. All these projects use
some form of project finance, a term which is currently being used synonymously
with Contract or Structured Finance.
Project finance involves the creation of a legally independent project company
financed with non-recourse debt for the purpose of investing in a capital asset,
usually with a single purpose and a limited life. One of the most important aspects
of this definition is the distinction between the asset (the project) and the financing
structure. In other words, project companies have evolved as institutional structures,
that reduce the cost of performing important financial functions such as pooling
resources, managing risk, and transferring resources through time and space
(Merton and Bodie, 1995).
We are talking here of projects which typically take five to seven years to complete,
have a finite life of 20 to 30 years or more, with very large upfront investments
followed by very large expected cash flows. These features are characteristic of
most large, infrastructure projects. What are the structural attributes of project
59
companies that enable them to find the financial and other resources for such
projects? Having found the resources, how do the project companies structure the
project organization to take care of its long-term needs? How do project companies
take care of the risks involved in constructing, financing and operating very large
projects?
Structural Attributes of Project Finance

The following facts on the structural attributes of project companies have
emerged from research.1
Organizational Structure: Project companies involve separate legal
incorporation. Special-Purpose Vehicles (SPVs), or Special-Purpose Entities,
(SPEs), are created to facilitate construction, financing and operation of
very large projects.
Capital Structure: Project companies employ very high leverage compared
to public companies. Research shows that the average (median) project
company has a book value debt-to-total capitalization ratio of 70% compared
to 33.1% for similar-sized public firms. While only a few project companies
have leverage ratios below 50%, almost 30% of public companies have
leverage ratios less than 5%!
Ownership Structure: Project companies have highly concentrated debt
and equity ownership structures. Most of the debt comes in the form of
syndicated bank loans, and not bonds, and is non-recourse to the sponsoring
firms (Esty, 2001b). As a result, creditors must look to the project company
itself for debt repayment. In terms of equity ownership, the typical project
company has around one to three sponsors, and the equity is almost always
privately held. International research shows that the average (median) project
has 2.7 sponsors. In the average project company, the largest single sponsor
holds 65% of the equity.
Board Structure: Project boards are comprised primarily of affiliated
(or gray) directors from the sponsoring firms. Again, international research
shows that 83% of the directors are affiliated with the project company compared
1
Esty Benjamin C, The Economic Motivations for Using Project Finance, Harvard Business School, Working draft,
2003.
60
to 37% in reverse LBOs (Gertner and Kaplan, 1996), 25% in IPO firms
(Baker and Gompers, 2001), and 10% in large public companies (Yermack, 1996).
Contractual Structure: Project finance is sometimes referred to as contract
finance because a typical transaction can involve a vertical chain of about
15 parties from input suppliers to output buyers bound through 40 or
more contractual agreements. In a typical project, four major contracts are
prevalentcontracts governing supply of inputs, purchase of outputs
(off-take or purchase agreements), construction, and operations. Larger deals
can even have several thousand contracts. According to the Australian
Contractors Association, the Melbourne City Link Project, an A$2 billion
road infrastructure project, had over 4,000 contracts and suppliers (see the
2002 award finalists at www.constructors.com.au) (Esty, 2002).
How do the above structural attributes contribute to the success and popularity
of project financing? There is no magic formula. Success is accomplished by prudent
financial engineering that combines the various contracts, undertakings and
guarantees between parties interested in the project in such a manner, that no one
party has to assume the full risk of the project. Yet, when all these undertakings
and contracts are viewed as a whole, the result has to be a satisfactory credit risk
for the lenders and minimal equity risk for the sponsors.
The key to successful project financing therefore lies in structuring the
financing of the project with limited recourse to the sponsors, at the same time
providing sufficient credit support through guarantees or undertakings of a sponsor
or a third party, so that lenders will be satisfied with the credit risk.
In other words, capital providers to the project (both equity and debt holders)
should be confident of a reasonable return on the capital employed, which is
commensurate with the risks taken by them.
Since project financing is characterized by the plethora of contracts associated
with the project company, a closer look at the common contractual structures of
projects is warranted.
Generally, contracts take the form of guarantees and undertakings, so that the
combined guarantees and undertakings of all parties amounts to a credit-worthy
61
transaction for the lenders. Guarantees also enable project and market risks to be
allocated to the parties who can best bear them.
There are generally two types of guarantors who will come forward to bind
themselves to the project outcomes. The first of these are the owner-guarantors
the obvious choice in any project. Direct guarantees by owners or project sponsors
would appear on their balance sheets under international accounting standards.
The Role Contracts Play

However, the attractiveness of project financing lies in its being non-recoursein
other words, off balance sheet for the project sponsors. Apart from keeping the new
projects risks from tainting the balance sheets of the project sponsors, such
non-recourse financing also preserves the capital and debt capacity of the sponsors
for other uses. Therefore, project sponsors would prefer to enter into contracts with
the project company, whereby they provide indirect guarantees to the project, and
thus enhance the projects bankability. Apart from the project sponsors, there will
be other third parties willing to guarantee some aspect of the projects functioning.
These third party guarantors would be those, who are eligible to receive direct or
indirect benefits from the projects successful implementation and functioning.
Typically, these third party guarantors could be any one of the following:
Suppliers of raw material and other inputs to the project.
Sellers of plant and equipment for the project.
Users or buyers of the project output.
Contractors who construct the project infrastructure.
Contractors who operate the infrastructure facility after construction.
Government agencies interested in getting the project implemented
successfully.
Multilateral agencies such as the World Bank and its arms, particularly in
developing countries.
Banks, Insurance, Pension funds and other Institutional Investors.
In project financing, where the typical capital structure is highly leveraged,
lenders require security arrangements and contracts that ensure minimal default
62
risk. This implies that lenders would require assurances that (a) the project will
be completed on time and at the projected cost (b) even if there are cost or time
overruns, the lenders debt would be serviced in full, (c) when completed, the
project cash flows would be sufficient to service interest and principal repayment
obligations, and, (d) if for any reason, force majeure or otherwise, the project is
terminated or suspended, the lenders dues would be repaid in full.
In the typical non- or limited recourse structure for project financing, the
prime security for lenders is the viability of the project itself. However, even a
good credit risk has to be supplemented by other security arrangements. In project
finance, supplemental arrangements take the form of contracts, the benefits of
which are assigned to the project lenders.
Lenders have the first right over the project cash flows. One of the
fundamental contracts in every project is the cash flow waterfall, which
prioritizes claims on project cash flows. Through the waterfall, parties agree
in advance to meet all operating expenses, capital expenditures, maintenance
expenditures, debt service, and shareholder distributions in that order, from
the project cash flows. Sometimes, appropriations to an escrow or reserve
fund (described later) are also included in the cash waterfall. Typically,
such cash flow waterfall mechanisms are under the control of a Trust set up
specifically for this purpose, and therefore reduce managerial discretion
over free cash flows from the project.
Lenders would take direct security interest in the project assets/facilities by
holding a first mortgage/lien. The lien gives lenders the right to seize project
assets in the event of debt service default, and realize their dues.
Completion risk is the risk that the project is not completed in time or not
completed at all. Completion risk in a project would endanger the lenders
chances of debt recovery. Hence the security arrangement to cover completion
risk, typically requires that the sponsors or other creditworthy parties provide
an unconditional undertaking to bring in additional funds to complete the
project, or repay the debt in full.
After the project construction is completed, operations commence.
Operational risks include input risks (availability of raw material and other
63
inputs), and output risks (production capability, demand for output, price
of output, and other market risks). Here, contracts are framed to ensure
that the project will receive cash flows sufficient to meet recurring operating
expenses and meet the debt service obligations.
Project debt is also normally secured by direct assignment of the project
companys right to receive payments under various contracts, such as
completion agreements, purchase and sale contracts or financial support
agreements.
In addition, the sanction of credit to the project company by lenders will
also contain various covenants. These covenants take the form of representations
and warranties, positive covenants and negative covenants. Many of these
covenants, while disciplining the project companys operations and its use
of cash flows, may also impose limitations on the functioning of the project
company.
Some of the typical indirect guarantees provided for project-financed
transactions are:
1. Take-if-offered Contract: Under this contract, the buyer of the projects
output is obligated to accept delivery and pay for the output that the project
is able to deliver. The buyer need not pay if the project is not able to deliver
the product. This implies that lenders will be protected only when the
projects operations are adequate for debt service. Under this contract,
therefore, lenders may require supplemental credit arrangements to
compensate for the credit risk that may arise if the project is unable to
operate.
2. Take or Pay Contract: Under this contract, the buyer has to pay for the
output whether or not he takes delivery. Like the take-if-offered contract,
the buyer need not pay if the project is unable to produce the required
output. In this case also, lenders will require supplemental credit
arrangements to offset the likelihood of a credit risk. For example, in the
Dabhol power project, according to the Agreement signed with Oman
LNG, MSEB was required to pay for a minimum of 90% of the contracted
quantity of 1.6 MMTPA. Similarly, an agreement with ADGAS required it
64
to pay a minimum of 75% of the contracted amount of 0.5 MMTPA. This

means that MSEB was obligated to pay for 1.8 MMTPA of LNG, at a CIF
price of US$ 3.35/MMBTU on a take or pay basis, which was the fuel
requirement for 73% Plant Load Factor (PLF). LNG supply contracts are
usually contracted on a take or pay basis. However, in this case, being the
sole customer, the entire demand side risk had to be borne by MSEB. On
the supply side too, MSEB was obligated to purchase all the power that
the project generated, whether or not it took delivery.
3. Hell-or-High Water Contract: Under this contract, there are no outs for
the buyer. He is obligated to pay whether or not any output is delivered.
Lenders are more protected against force majeure events in this type of
contract.
4. Throughput Agreement: Such agreements are found typically in oil or
petroleum pipeline financing. Under this contract, the shippers (oil companies
or gas producers) are obligated to ship, through the pipeline, enough output
to provide the cash flow required to pay all operating expenses and meet all
debt service obligations. Typically, such throughput agreements are
supplemented by a cash deficiency agreement, which obligates the shipping
companies to advance funds to the pipeline in the event of a cash shortfall.
5. Cost-of-Service Agreement: The contract requires each buyer to pay project
costs as actually incurred, in return for a proportionate share in the projects
output. Typically, such contracts require payments to be made whether or
not the output is delivered.
6. Tolling Agreement: The project company levies tolling charges for processing
raw material usually owned and delivered by project sponsors.
7. Step-up Provisions: These provisions are included in purchase and sale
contracts when multiple buyers are involved. In case one of the buyers
defaults, the provisions obligate the remaining buyers to increase their
participation.
8. Raw material Supply Contracts: These are long-term contracts between
the suppliers and the project company, for fulfilling the projects raw material
requirements. For instance, under a supply or pay contract, the supplier has
65
to make payments, sufficient to cover the debt service requirements of the

project company, in the event of failure to supply the contracted amount of
raw material to the project.
Some Common Models In Project Finance

The various well-known models of concession agreements, such as Build-OperateTransfer (BOT), or Build-Own-Operate-Transfer (BOOT) models are derived
from contracts such as the Take-or-Pay contract. The features of a few frequently
used models of project structure are presented below:
Build-Operate-Transfer (BOT): This is one of the most popular models,
where the project company enters into a long term concession agreement
with the host government for building and operating an infrastructure
facility. After the concession period, which may typically range up to 20
years or more, the ownership is reverted to the host government, to continue
operating the facility. In some models, ownership reversion happens only
after the vehicle company is able to generate a satisfactory return on the
invested capital. Sometimes, the host government may also be asked to
lend limited credit support or guarantee. Common variations of this model
are the Build-Own-Operate-Transfer (BOOT) model, recently used in the
Noida Toll Bridge project, or the Build-Own-Operate (BOO) model,
recently seen in the Bangalore International Airport project. Several highway
construction projects all over the world and in India have been using the
BOT models successfully
Build-Transfer-Operate (BTO): The ownership of the infrastructure to be
developed is vested with the project company till construction is completed.
Thereafter, the legal title is transferred to the host. The facility is
subsequently leased back to the vehicle company for a fixed term, during
which the company can collect the revenues generated by the completed
facility. At the end of the term of lease, the host will operate the facility by
itself or can hire another operating company.
Buy-Build-Operate (BBO): In this model, the vehicle company buys the
(typically underdeveloped) infrastructure from the host, builds on it by
modernizing or expanding, and thereafter operates it.
66
Lease-Develop-Operate: The option is attractive when the vehicle company

is unable to raise sufficient resources for the purchase in a BBO. The leased
facility is then operated for a fixed term, along with the host on a revenue
sharing basis. This model signifying public-private risk sharing has been
seen to be beneficial in cases when the project is losing money.
Wraparound Addition: In this model, the vehicle company undertakes to
expand an existing host facility. The vehicle company acquires legal title
only to the addition of the facility. Though ownership is shared, the vehicle
company is excluded from the liability for the debt already incurred by the
core facility.
Temporary Privatization: This model is workable when the host is unable
to transfer legal title. The vehicle company repairs, operates levies and collects
appropriate charges, and bears the financial risk.
Speculative Development: This model is popular in developed economies
like the US. The private sponsors identify an unmet public need and fulfill
it through a financially feasible and economically viable project. The vehicle
company set up for this purpose undertakes structuring the project and
allocates risk to various parties. The host (government) may join the process
by financing or issuing guarantees.
A project company can therefore, choose a structure or model that is befitting
the objective, financing pattern and risks associated with the project. The list of
workable models given above is only illustrative and is by no means exhaustive.
Supplemental Credit Arrangements

In spite of the presence of contracts, several events can happen to disrupt the
functioning of the project. To guard against these contingencies, Supplemental
credit arrangements are woven into the contractual structure of projects. These
mechanisms are also termed ultimate backstops, and can take the following forms:
Financial Support Arrangement: Typically, the arrangement is in the form
of guarantees or letters of credit from the project sponsors or the bank. In
the event that payments are to be made under the guarantee or letter of
credit, they will be treated as subordinated loans to the project company.
67
Cash Deficiency Arrangement: As the name suggests, the arrangement is

designed to make good the shortfalls in cash flows, that would ultimately
impair the debt service capacity of the project company. Cash deficiency
arrangements usually accompany throughput agreements and payments
are made in advance for the output to be delivered in future.
Capital Subscription Agreement: This is typically structured as purchase
for cash of junior securities (equity or subordinated debt), issued by the
project company.
Clawback Agreement: In some cases, project sponsors agree to plough back
the equity cash flows arising from the initial period of operation, or cash
dividends received from the Project Company, or tax benefits that may
flow in as a result of their investment in the project, back to the project
company. In such cases, the investments may be treated as additional equity
or subordinated loans to the project company.
Escrow Fund: In many cases, lenders insist upon creation of an Escrow
fund (sometimes called a Debt Service Reserve Fund) out of project cash
flows, to cover from 6 to 18 months of debt service requirements. A trustee
administers this fund, and in case of a shortfall in project cash flows, draws
from the fund to ensure debt service.
Insurance: This is emerging as one of the strong risk mitigating tools in
project financing. Needless to state, appropriate insurance mechanisms are
a prerequisite for successful project financing. The presence of costly
insurance, for example, political insurance, may push up project costs, but
the benefits, in many cases, are seen to outweigh the costs.
Motivations For Using Project Finance Structures

Research2 shows that there are three motivations for using project finance structures
to finance large infrastructure projects.
The first is agency cost motivation. Project structures can reduce costly agency
conflicts between owners and related parties due to the transaction-specific nature
of project assets and high leverage.
2
Esty Benjamin C, The Economic Motivations for Using Project Finance, Harvard Business School, Working draft,
2003.
68
The second motivation to use project finance is to counter leverage-induced

underinvestment. Though there may be several reasons for underinvestment in
positive net present value projects by firms, John and John (1991) have identified
leverage induced underinvestment as one of the major reasons. Managers of highly
leveraged firms are more likely to pass up positive NPV investment opportunities,
since the incremental cash flows from the new project would go towards servicing
debt. Project finance structures allow project cash flows to be allocated to new
capital providers, without impacting the sponsors debt capacity.
The third motivation is risk management. By isolating the assets of the risky
project in a separate standalone vehicle company, project finance reduces the
possibility of risk contaminationthe phenomenon where an otherwise healthy
firm faces financial distress through the projects failure.
Through the project structure, sponsors are able to share project risks with
other sponsors, with related participants (e.g. contractors, customers, suppliers,
etc.), and with debt holders. In summary, this combination of structural features
(extensive contracting, concentrated debt and equity ownership, separate legal
incorporation, and high leverage) effectively manages risks, reduces asymmetric
information and controls managerial discretion at the project level.
Conclusion
Recently, the BOOT (Build-Own-Operate-Transfer) model was employed in the
NOIDA toll Bridge project in India. This USD 100 million project, implemented
with a 30 year concession and an assured post tax rate of return of 20%, is Indias
first major PPP initiative. The entire funding of the project has been on a non-recourse
basis. Though beset by traffic risksthe risks that typically afflict any retail
transportation project worldwidethe project is a precursor for more such workable
initiatives.
Structuring projects non-recourse to sponsors would therefore, be an incentive
for the private sector to participate in large scale, risky infrastructure projects, so
vital to economic development.
(Padmalatha Suresh is a post-graduate in Management from IIM-A, holding LLB
69
References:
1.
Esty Benjamin C, The Economic Motivations for Using Project Finance, Harvard Business
School, Working draft, 2003.
2.
Finnerty John D, Project Finance: Asset Based Financial Engineering John Wiley and
sons, 1996.
3.
Nevitt Peter and Fabozzi Frank, Project Financing, 7th edition, Euro money books, 2000.
70
PROJECT FINANCE - CONCEPTS AND APPLICATIONS
6
Assessing the Economic Impact of
Infrastructure Projects The ERR
Padmalatha Suresh
Governments would be interested in supporting an infrastructure
project, only if the social benefits exceed its social costs. This
article explains why social returns are different from private
returns, and outlines the difficulties in assessing the economic
impact of very large projects. Some traditional approaches to
determining social cost benefit are described. The focus of the
article is on the Economic Rate of Return (ERR) used by
Multilateral Institutions such as the IFC, to evaluate the
developmental impact of large projects. The stakeholder analysis
for calculating ERR has been elaborated, and the related issues
dwelt upon. The article concludes that the ERR can be evolved to
be a useful tool, for assessing the development impact of large
infrastructure projects in the country.
Introduction
The decision to go ahead with a social infrastructure project is critical for any host
government. This is because the private sponsors and the government view the
value of a large project differently. While the private sponsors would be willing to
Assessing the Economic Impact of Infrastructure Projects The ERR
71
implement the project if its return is commensurate with the risks, governments
would be interested in supporting a project, financially or otherwise, only if the
social benefits outweigh the social costs.
In financial terms, the private sponsor of a large project would be looking for
an attractive Internal Rate of Return (IRR) or Financial Rate of Return (FRR)
from the project. However, the government supporting the project would look at
a rate of return that would factor in, apart from the risks, the social costs and
benefits as wellsuch a rate of return is called the Economic Rate of Return
(ERR).
Why should the profitability of an investment from the government or societys
perspective differ from the private investors perspective?
Factors Influencing Social Returns

In a market where people are free to decide on the transactions they would like to
enter into, there are a few primary factors that can explain why and where social
returns would differ from private returns.
1. Taxes, Tariffs, Subsidies and other Government Interventions: For example,
the amount a firm receives from sale of its product, may be less than the
amount the customer pays to acquire it. The reason is taxes. Similarly,
tariffs, subsidies and other public sector interventions result in differences
between private and government or social returns.
2. Transaction Costs: A private investor may have to construct a road or bridge
to make his new plant accessible to the firms employees and other
stakeholders. However, the public living in the vicinity, which is unconnected
with the firm, also starts using the facility. It may not be feasible for the
private firm to restrict access of the facility to outsiders, nor collect tolls
for usage since the transaction costs of toll collection may exceed the amount
collected. Hence, the improved facility becomes an unpriced benefit to
society. High transaction costs and other restrictions may keep the private
firm away from charging a fee for the services provided to society.
72
3. Externalities: Not easily quantifiable, non-market related effects fall under

this category. A leather or chemical factory may give rise to environmental
impacts like pollution. A plants location may lead to congestion in the
vicinity. Such effects are not captured in private returns. There are two
other types of externalities that may ariseNetwork and Demonstration
effects. A firm may train a subcontractor or a supplier in improving the
quality of his product. While the consequent improvement in quality would
benefit the firm in the short run, the supplier would stand to benefit from
the training received, since he can supply products of improved quality to
outside firms as well. A demonstration effect would occur when a firm
demonstrates the utility or viability of a new business model or technology,
which can be replicated by other firms.
4. Imperfect Markets: Laborers or workers with similar skill sets may be paid
more in a modern plant or a multinational firm than in traditional activities.
This could be the case especially in developing countries, where markets
are still evolving. In other words, the price paid for a good or service could
be significantly different from the opportunity cost of that good or service.
Approaches to Assess Social Returns

Some of the difficulties in assessing social returns are:
Assessing the social impact of educating and training the workforce, not
only on the workforce itself, but also on the local and domestic economy;
Assessing the developmental impact of construction of schools, hospitals,
housing and other facilities that the project could bring with it;
Assessing the spin-off effects of investment in a particular industry, or locality
on the larger goal of economic development; and
Assessing the multiplier effect of one large project on the community and
the country.
A look at the traditional approaches to social cost benefit analysis is appropriate
before understanding the Economic Rate of Return (ERR) approach being practiced
by multilateral institutions like the International Finance Corporation (IFC).
73
A. UNIDO Approach1
The UNIDO approach has been structured in the following stages:
1. It calculates financial profitability at market prices.
2. It then shadow prices the resources, to obtain the net benefit at economic
prices. Shadow prices reflect the uncontrolled market prices of goods and
services in the economy. Some of the items typically shadow priced are the
primary outputs of a project, the importable material inputs, the major
non-imported material inputs and unskilled labor.
3. The next step is to adjust for the projects impact on savings and investment.
Such adjustments are carried out by determining the amount of income gained
or lost by different income groups due to the project, evaluating the net impact
of these gains or losses on savings, based on the marginal propensity to consume
of each of these groups, and finally estimate the additional savings the project
would induce through the income generation potential of the project.
4. The fourth step involves adjusting for the projects impact on income
distribution. The income flows for each group are derived from stage three,
and suitable weights are assigned to reflect the relative changes in incomes
for each group.
5. A final adjustment is made for the projects production or use of goods,
whose social values could be less or greater than their economic value. Goods
whose social values exceed their economic value are called merit goods,
and if less, demerit goods. For example, a country may include tobacco or
alcohol in the list of demerit goods. An upward adjustment is made to the
social benefit in the case of merit goods, and a downward adjustment is
made in the case of demerit goods.
B. Little Mirrlees Approach (LM)
The seminal work of Little and Mirrlees has developed a theoretical basis for the
analysis and its underlying assumptions, and lays down step-wise procedure for
undertaking benefit-cost studies of public projects. The mathematical formulation
is identical to the UNIDO method, except for differences in assigning value to
1.
UNIDO - United Nations Industrial Development Organisation
74
discount rates and accounting for imperfections and other market failures and
social considerations. The five main elements of the LM approach to shadow
pricing are in the nature of valuation of traded goods, valuation of non-traded
goods, the choice of numeraire (the unit of account in which values of inputs and
outputs are to be expressed), the shadow price of labor and the rate of discount.
Little and Mirrlees have also suggested an elaborate methodology for calculating
shadow prices of non-tradables. This methodology entails use of detailed
input-output tables with a view to tracing down the chain of all non-traded and
traded inputs that go into their production. However, in the case of non-availability
of detailed input/output tables, a conversion factor based on the ratio of domestic
costs of representative items to world prices of these items could be used for
approximation of shadow prices of non-traded resources.
The similarities of this approach to that developed by UNIDO are:
Both approaches calculate the shadow prices for foreign exchange savings
and unskilled labor.
They take into account, equity as a factor.
Both use discounted cash flow analysis.
However, the dissimilarities between the two approaches are in the following areas:
The LM approach measures costs and benefits in terms of international
prices, while the UNIDO approach measures these in domestic currency.
The LM approach measures costs and benefits in terms of net social income
while the UNIDO approach concentrates on consumption.
The LM approach considers efficiency, savings and redistribution
simultaneously, while UNIDO takes a staged approach in measuring all three.
C. Approach Adopted by Indian Financial Institutions

The Indian financial institutions base their assessment of developmental impact on
a modified version of the LM approach. The stages in their assessment are as follows:
1. All non-labor inputs and outputs are valued at international prices. The inherent
assumption here is that international prices reflect true economic value.
75
2. In the case of tradable items, for which international prices are readily
available, inputs are valued at CIF prices and outputs are valued at FOB
prices. Goods are called fully tradable if the impact of increased
consumption will result in more imports or fewer exports, and increase in
production results in fewer imports and more exports, other things being
equal. It is also to be noted that, goods that are fully tradable, need not
necessarily be freely traded.
3. In the case of tradable items whose international prices are not available, social
conversion factors are used. The rupee values of these tradable goods are multiplied
by appropriate social conversion factors to arrive at the social value.
4. The financial institutions also gauge the degree of protection available to
an industry through a simple ratiothe Effective Rate of Protection (ERP).
This ratio is arrived at by reducing the value added at world prices for an
industry from the value added at domestic prices, and dividing the result
by value added at world prices. The degree of protection enjoyed by an
industry shows its vulnerability to overseas competition if the government
withdraws the protection. The ERP being zero implies that the industry
does not enjoy any protection from global competition. If the indicator is
greater than zero, the industry is protected, and if less than zero, the
domestic industry is more competitive.
5. A measure related to the ERP is the Domestic Resource Cost (DRC). This
is expressed in terms of the relevant exchange rate multiplied by ERP plus
1, and indicates the spending of domestic currency required to generate
savings of one unit of the relevant foreign currency. The higher the DRC,
the more the domestic currency required to generate foreign currency savings.
Hence as the DRC increases, the priority accorded to the project should
typically decrease.
D. Approach Adopted By The Indian Planning Commission

The Project appraisal division of Indias Planning Commission appraises public
sector projects on the following parameters:
Border prices are used to value tradable inputs.
Non-tradable items such as power or transport are valued at marginal cost.
76
The amount of foreign currency involved in inputs or outputs is valued at

a predetermined premium.
Transfer costs such as taxes and duties are ignored.
Semi-skilled and unskilled labor is valued at shadow wage rate.
The Economic Rate of Return (ERR)-Framework Used by Multilateral

Institutions
Multilateral institutions such as the World Bank and its arms support private and
public projects in developing countries, with the objectives of reducing poverty
and stimulating economic growth. To participate in large projects of these countries,
they need to understand and assess the private and social returns of the projects.
In the traditional approaches to social cost benefit analysis described above,
the private returns are calculated using actual market prices, and the social returns
using shadow prices. The Multilateral institutions calculate the social return in
two stages, also using shadow prices.
In the first step, the Financial Rate of Return (FRR} or private returns, is calculated
using market prices.
In the second stage, a stakeholder analysis is carried out. Stakeholders are those
who may be affected by the project. The development impact of the project is
estimated by aggregating the net impact on each of the stakeholder groups affected
by the project. The additional return to each of the identified stakeholder groups is
assessed as the difference between the actual market price and opportunity costs.
The framework for identifying stakeholders is presented in Figure 1.
Project Financiers, including the owners, are the core organizers of the
project, and the Internal Rate of Return to them is the stream of private
cash flows (net of costs). This is the FRR and has already been calculated in
the first step.
Another important stakeholder group will be the labor employed by the
project. The labor employed would benefit to the extent that the wages
they earn as a consequence of being employed on the project, exceed what
they would have otherwise received, had this project not been built. It is
77
Figure 1: Framework for Assessing Development Impact
Rest of
Society
Neighbors
Customers
Financiers
(FRR)
Employees
Producers of
Complementary
Products
Competitors
New
Entrants
Suppliers
noteworthy that wages include annual bonuses and benefits such as

healthcare, pensions, food and food allowances, housing and so on. A wage
above the opportunity cost would hence be added to private benefits, as a
component of the ERR. In addition, upgrading of skills due to training,
and the consequent higher wages they can command in the market would
also form part of the assessment.
Customers can benefit in several ways. They can now get products that
were not available before, or get products with better quality at the same
price or get products of the same quality, cheaper. While the first two impacts
are difficult to quantify, the impact of a fall in price is measurable as an
increase in the consumers surplus.
Producers of complementary products will benefit due to the increased
demand for their products, if the project succeeds. A complementary product
is one whose value increases, as a consequence of increased supply of another
product. An example is the benefits accruing to tour operators, artifact
sellers, taxi drivers, airlines operators and so on, as a result of a new hotel
resort opened at a popular tourist destination.
78
Suppliers will directly witness increased demand, and hence increased sales
and profits. Then, there may be increases in wages to the additional labor force,
employed to meet the increased demand. If considered important, the chain
can continue to the suppliers suppliers and so on. Beyond these quantifiable
benefits, the training given to the suppliers for providing better quality, which
in turn upgrades the suppliers transactions with the outside world, and so on,
forms an important network effect, that may or may not be quantifiable. The
development of such backward linkages (forward linkages in the case of
customers, who themselves may be producers), has been emphasized as being
among the more important development impacts a project can have.
Competitors may lose clientele due to the new project, which may result in
lower demand or lower prices for their products. However, this is not a loss
for the society. The lower prices are offset by the benefits derived by the
consumers. The competitors may also benefit if the new project demonstrates
a new technology or an innovative business model, or if the network effects
lead to supply of better quality raw material for the competitors operations.
New entrants will also benefit from the demonstration and network effects
described above.
Neighbors to the project encompass the entire surrounding community. Impacts
on neighbors may be from environmental externalities, better physical
infrastructure and the communitys social infrastructure. Environmental effects
may be positive or negative, depending on what would have happened if there
had been no investment. For instance, felling trees to make way for a new plant
may have a negative impact, while replacing an old polluting plant with a
modern non-polluting one may have a net positive impact. Physical infrastructure
may cause or ease congestion. Finally, the communitys social infrastructure
may receive a fillip if the project company creates the necessary social
infrastructure such as healthcare and education for the community. Wherever
feasible, these effects are quantified for calculating the ERR.
Rest of society would include the impact of taxes, subsidies, tariffs and
other government interventions. Profit taxes go to the government, and
therefore can be added to the ERR calculations. However, the free cash
flows to private investors will be computed after taxes, and hence might
79
affect their FRR. The government may recycle the tax revenues into more
socially beneficial projects, in which case there may be second order or
third order effects on the economy. If important and quantifiable, such
effects can be included in computing the ERR. Other tax revenues such as
those from Value Added Taxes, Sales taxes and Excise duties would be
expected to increase, as sales of the new project increase and have to be
treated similarly. However, if the product is an import substitution product,
the total sales may remain unchanged in the economy. The cost of providing
subsidies, which would benefit the private sponsors and be reflected in the
FRR, would have to be deducted from the ERR calculations. Similarly, for
the goods produced by the project, the social revenue streams should be
reduced by that portion of the price accounted for by the tariff.
Thus, the steps to calculate ERR for a project must begin with the FRR.
1. Calculate free cash flow for every year in the project period.
2. Add net (positive/negative) returns to important stakeholder groups as the
difference between the actual market price and the opportunity costs.
3. Add net profit or losses from taxes, tariffs and subsidies where applicable.
4. Calculate social cash flows for every year.
5. Calculate terminal values where appropriate.
6. Adjust cash flows for inflation.
7. Arrive at real social cash flows.
8. Calculate ERR.
Issues to be Considered While Applying the ERR Framework

The framework to some extent measures the efficiency of resource allocation, but
treats all groups equally. For example, the framework does not measure the impact
of a project on poverty alleviation in the economy. Similarly, environmental impacts
are difficult to value in totality.
Further, not all costs and benefits are quantifiable, and many times it is more
worthwhile to make a qualitative assessment on the direction of the ERR, rather
than attempt to quantify the demonstration and network effects.
80
Another issue is the fact that the concept of a social discount rate is yet to
attain clarity. At present, IFC uses an arbitrary 10% real discount rate for its
social cost benefit analysis, which is also IFCs hurdle rate for accepting projects
for financing.
The framework is static and does not take into account the value of embedded
optionality in project analysis. If embedded real options such as sponsors
abandoning the project, or deferring the project are quantified, it is possible that
the calculated ERR may lead to a different decision.
Nevertheless, in spite of these limitations, the ERR is a useful framework for
assessing the social impact of infrastructure projects.
Conclusion
In summary, the ERR gives results similar to traditional social cost benefit analysis,
but is more scientific in its approach. Being adopted and in the process of
improvement by IFC, the ERR would be a powerful valuation tool for governments
and public bodies to make decisions on the economic viability of infrastructure
projects.
(The author is a post graduate in Management from IIM-A, holding LLB and
CAIIB. With two decades of banking and IT sector experience. Currently running a
financial consultancy, she is visiting faculty at IIMs and other reputed B-Schools, Adjunct
faculty-Consulting Editor at IBS Chennai. She can be reached at
References
1.
Results on the Ground: Assessing Development Impact, International Finance Corporation,

Washington DC, 2002.
2.
Esty Benjamin C, An Economic Framework for Assessing Development Impact , Harvard

Business School, 2002.
3.
Social Cost Benefit Analysis ICFAI Books, Project Management, volume 3.
81
7
Prof. R Subramanian
Traditional capital budgeting techniques exhibit various
shortcomings when employed to value long-term projects. This
article outlines the various methodologies that could be employed
while valuing large projects.
Introduction
The economic development and prosperity of a nation depends on the quantum
of funding by, and the quality of commitment of the government and private
companies. In India there are many structural changes required, in the development
of power, transportation and telecommunication sectors, and in the national and
international logistics and distribution network systems. Infrastructure
development, therefore, is the need of the hour.
The structure, nature, size and complexity of financing infrastructure projects
call for huge investments, and hence, enormous sources of capital to fund these
projects. Such large projects require meticulous planning, a well-organized
administrative setup, and a careful understanding of risks associated with it. Large
engineering projects are complex in nature, and the degree of multiple risks associated
with such projects will finally lead to failure of such projects. There are many factors,
like technology, innovative engineering methods, financial re-engineering, international
82
political changes and similar unpredictable factors, which could totally alter the
very basis of infrastructure projects as they progress. The risks associated with
such large mega projects therefore, need to be carefully scrutinized with a view to
managing their risks effectively.
For example, financial risk can arise at the commissioning, implementation and
distribution phase in a power project, and in the case of highway projects, the
general risk associated is usage rate. How do we value these projects, which are
essentially long-term in nature and whose risks could be severe and dynamic? Are
the typical capital budgeting methods adequately equipped to handle the
complexities of infrastructure projects?
It is therefore essential to study, at this juncture, the various techniques of Capital
Budgeting which can be used to analyze long-term projects. In this exercise it is
worthwhile to highlight the four basic points of view essential for valuing long
term projects, viz.,
The project sponsors point of view.
The project lenders point of view.
The institutional investors point of view.
The host governments point of view.
How are their perspectives different? While project sponsors would look to the
equity cash flows for their residual returns, lenders would look to the project cash
flows to service the debt, and institutional investors would require a competitive
rate of return on their investment. The government, however, would look more to
the social costs and benefits of the project. Are the traditional valuation techniques
geared to meet these requirements?
Techniques Generally Applied in Assessing Long-Term Projects

The common approach that a valuation analyst, must consider are threefold:
Base year Company Cash Flow.
The Future Cash Flow (projection).
Cost of Capital.
83
In the first step, the sponsor identifies the cash flow for the base year and bifurcates
the firms reported cash flow into three possible sources:
1. Cash flow from operations.
2. Cash flow from passive investments.
3. Ancillary cash flows.
The second step is to make adjustments wherever appropriate, to report the operating
cash flow for the base year according to the Generally Accepted Valuation Standards.
The areas where adjustments are to be made for valuation purposes are enumerated
below:
Sponsors Compensation.
The Discretionary Expenses of the long-tem Projects.
Other Discretionary Projects.
Issues in Valuation
Cost of Capital
The development of a unique Cost of Capital for each long-term project is
inevitable, since characteristics of projects differ from country to country. The key
to valuing a corporate investment opportunity as a viable option, is the ability to
carry out an analysis of the project characteristics.
The following are the chief characteristics that have to be taken cognizance of,
while applying the capital budgeting techniques:
1. Project Feasibility details need to be worked out.
2. Length of the project.
3. Equity Cash Flow Analysis.
4. Financial leverage.
5. Operating Cash flow.
84
Deficiencies of IRR in Valuing Long Term Projects

The basic IRR assumption about investment in mega infrastructure projects is
that if two unrelated projects, like construction of ports or a golden quadrilateral,
with identical cash flows, risk levels, and duration are identified, then the relevant
reinvestment rate for interim cash flows has to be considered. If, for example, an
investor invests in Project B, then the interim cash flows could be redeployed at a
typical 8% cost of capital, while if he invests in Project A, the cash flows could be
invested in an attractive investment, then both the projects are expected to generate
a 30 to 40% annual return.
Some analysts feel that mega projects should use a Modified Internal Rate of Return
(MIRR), wherein the weaknesses of IRR can be circumvented and greater clarity can
be arrived at, to assess such projects. When the calculated IRR is higher than the true
investment rate for interim cash flows, the measure will overestimate the annual
equivalent return from the project. Some analysts strongly recommend that managers
must either avoid using IRR entirely or at least make adjustments and rely on MIRR.
Empirical evidence shows that three-fourths of CFOs, generally involved in
large projects, use IRR for assessing such projects, be it on irrigation, power or
other infrastructure projects.
Valuation Threats
The resource-allocation process presents not one, but three basic types of valuation
problems. Managers need to be able to value operations, opportunities and
ownership claims. The three fundamental factors for evaluating the three types of
valuation problems, which can be highlighted are timing, cash and risk.
At this stage, to overcome these threats, the three complementary tools, which
can be brought out are WACC-based DCF, APV and option pricing. Most of the
companies now use Option Pricing as their workhorse valuation methodology.
Weighted Average Cost of Capital is a tax-adjusted discount rate, intended to pick
up the value of interest tax shields by using an operations debt capacity. The
more complicated a companys capital structure, tax position, or fund-raising
strategy, the more details need to be worked out about the feasibility of the
application of WACC.
85
The analysts task is, firstly, to forecast expected future cash flow, by period and
second, to discount the forecast to present value at the opportunity cost of funds.
Opportunity cost consists partly of time value, the return on a nominally risk-free
investment. This is the return you earn for being patient without bearing any risk.
Todays better alternative for valuing a business operation, is to apply the basic DCF
relationship to each of a businesss various kinds of cash flow, and then add up the
present values. This approach is most often called Adjusted Present Value or APV. It
was first suggested by Stewart Myers of MIT, who focused on two main categories
of cash flowsreal cash flows (such as revenues, cash operating costs and capital
expenditure) associated with the business operation, and side effects associated with
its financing program (such as the values of interest tax shields, subsidized financing,
issue cost, and hedges). APV relies on the principle of value additivity.
What are the practical payoffs from switching to APV from WACC? Both
approaches are skillfully applied in a large project situation.
Long term Projects and Valuation

The issues concerning the valuation methodology of large projects, which need to
be addressed are:
How much are the expected future cash flows worth, once the company
has made all the major discretionary investments?
What are the sources for investing in long term projects?
Regardless of the opportunities, the valuation tool should gear up to strengthen
the corporate capability to allocate and manage resources effectively. Cyclical
companies often commit themselves to big capitalspending on projects just when
prices are high, and the cycle is hitting its peak, and retrenching when prices are
low. Some of the companies develop business forecasting models that are quite
similar to those used by equity analysts for interpolating and extrapolating the
desired outcomes of the projects. Most aggressive managers aspire for trading approach
after attempting at risk analysis, preferably adopting option pricing mechanism.
Distributed generation, has tremendous promise for providing efficient,
technologically advanced and environmentallyfriendly electricity supplies in the
United States. There is an increasing interest in developing countries, in contracting
86
with NGOs and the non-profit private sector to deliver primary healthcare (PHC),
including nutrition and family planning services.
There are few bitter experiences in the low-income countries, in the sense that
the contracting will have high transaction costs, and be difficult for governments
to implement. When it comes to the provision of major infrastructure in Australia,
it seems that there are often alternative ways to deal with these situations, other
than government provision.
The transaction costs of negotiating such many-sided contracts may be sufficiently
low, and improvements in technology can also resolve these issues. Businesses
frequently solve free-rider problems, by developing means of excluding non-payers
from enjoying the benefits of a good or service. For example, new tolling technology
has made it easier to build private roads and charge tolls to road users.
Several major international Grid development projects are underway at present,
both within the European Community, and in the USA. All of these projects are
working towards the common goal of providing transparent access to the massively
distributed computing infrastructure, that is needed to meet the challenges of
modern data-intensive applications.
International Organization for Standardization (ISO), ISO 9000,

Quality Management and Quality Assurance Standards
The ISO 9000 collection is a suite of standards and guidelines, that help
organizations implement effective quality systems for the type of work they do.
Two items in the collection are most useful to organizations that design and build
software:
ISO 9001: Quality Systems Model for Quality Assurance in design,
development, production, installation and servicing.
ISO 9000-3: Guidelines for the Application of ISO 9001 to the development,
supply, and maintenance of software.
ISO 9001 covers the requirements for a quality system that supports the full product
life cycle, from initial agreement on a deliverable, through design, development, and
support of the product. ISO 9000-3 provides specific advice on how to interpret the
87
standard for developing a quality system of an organization whose product is primarily

software. This guideline has been very useful to software organizations, since the original
focus of ISO 9000 was for managing manufacturing and process control type of activities,
and interpreting the standards for software was sometimes difficult.
Standard practices have been developed through field experience, through
planning analyses, and from legal or regulatory directives. The government
responsibility to ensure that good construction practices are used on public lands,
and they apply to the surface-disturbing activities. Best management practices are
developed by the responsive government and federal laws permit such practices as
a well-accepted norms of the business enterprise.
Box 1: Best Practices in Large Consulting Companies
Take up internal studies of an industry or an issue, for purposes of both business development
and to push the boundaries of knowledge of internal professionals.
The process of developing the standard, provides a laboratory for professionals committed to
future marketing of the outputs of the commissioned work. An increasing number of
professionals are involved as a methodology progresses from development to implementation.
Carry out strategic studies, perhaps on a discounted basis, that would establish a firm as an
early leader in a field or as a proponent of a methodology. Learning activity is emphasized in
the first two or three projects in a new field.
Encourage extracurricular training or professional development sabbaticals. Specific initiatives

are tied to the results of project reviews that focus on identification of areas for improvement.
Valuing Opportunities: Option Pricing

Companies with new technologies, product development ideas, or access to
potential new markets have vistas of valuable opportunities. A common approach
is not to value them formally until they mature to the point where an investment
decision can no longer be deferred. Generally two types of cash flows matter i.e.,
cash for investing and cash for operation. R&D is a major factor for exercising
the option, and time also matters in two waysthe timing of the eventual flows
and how long the decision to invest may be deferred.
Real Options as a Tool for measuring Long-Term Projects

Generally for evaluating long-term projects, the widely accepted techniques are
accounting rate of return, payback period, net present value, modified internal
88
rate of return and real options. The first four methodologies ignore the value of
flexibility and embedded options, inherent in any large project.
Real Option is one of the important tools used for valuing the investment
opportunities under conditions of uncertainty, and to monitor, measure and adjust
decisions according to economic changes. It is a well-accepted simple valuation
technique under the Net Present Value method and principally the operation
takes place through option valuation.
Real option gives the right but not the obligation to undertake business
decisions, for venturing into private public partnerships, or for attempting to
fund large infrastructural projects. The technique can also be used for starting a
new venture, a hotel project in a hill resort, a new factory, an industrial establishment
or a long-term infrastructure project in transport, power or telecommunication.
The sponsors have more flexibility, since they can now scale up or switch a project
Generally, real options are used for scaling up or switching a project, which is a growth
option, apart from exercising scaling down options, learning options and abandonment
options. The concept of Real Option can be better understood from a long term
perspective. While assessing a long term project, the real option mechanism will act as
an important tool to evaluate, to judge and to bifurcate the projects into two dimensions,
i.e., the pilot project and the main project. If the pilot project fails, then the sponsor
can back out from funding such large non-result yielding projects.
Conclusion
Valuing mega projects, particularly, in infrastructure development and funding,
where the future is uncertain, problems are complex and the risks are immense,
calls for innovative valuation methodologies. In this context, the Real Option
Mechanism can be a better tool provided the following points are considered
before attempting to apply it:
Real option mechanism must not be viewed in isolation, but with other
time adjusted techniques preferably APV, MIRR.
Flexibility and change mechanisms are definite pre-emptive measures before
adopting a particular tool.
89
It should be viewed as one of the tools which will act as a means to a final
decision and not an end by itself.
(Prof. R Subramanian, is a post graduate in Commerce, in Public Administration,
in Business Administration, Master of Philosophy in Commerce, and presently pursuing
his Doctoral Programme in Accounting for Derivatives. He has two decades of industry
and academic experience and is presently a faculty in IBS Chennai, in the area of
Accounting and Finance. He can be reached at srirsmanian@yahoo.co.in).
Reference
1.
Tom Copeland, Timothy Koller, and Jack Murrin, Valuation: Measuring and Managing the
Value of Companies, third edition, New York; John Wiley & Sons.
2.
Stewart C Myers, Interactions of Corporate Financing & Investment Decisions

Implications for Capital Budgeting Journal of Finance, vol 29, March 1974.
3.
Harvard Business Review May-June 1997.
4.
Finance & Development, A quarterly magazine of the IMF, March 1999. vol. 36, No. 1.
Box 2: Some of the Accusations that were made against

Enron Dhabol Power Project were:
There was no competitive bidding for the projectthe deal was negotiated exclusively
between the Maharashtra government and Enron;
The project costs and power tariffs were higher than other power projects in India, and the
cost of electricity from the DPC project would significantly inflate prices in other areas;
The MSEB promised to buy all the high-priced power produced by Enron, whether there was
demand or not, and even if cheaper power were available from its own generating plants.
These contracted annual payments to Enron would amount to half of Maharashtras entire
budget expenditure;
The DPC was assured a post-tax return of 16 percent on capital investment, and there was no
limit on what Enron could make. Indian economists calculated that the after-tax rate of return
would actually be 32 percent, about three times the average rate in the US;
There were counter guarantees from the state and central governments for payments which
would have been due to DPC from the MSEB. However, the contract shields Enron from
Indian jurisdiction, as all disputes must be settled under English law in England;
An assurance was given that the project would not be nationalized;
The project authorities carried out no environmental impact assessment; and
Enron paid $20 million as educational gifts. Critics consider these payments as bribes to
clear the project.
90
Section III
Managing Project Risks
91
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8
The Nature of Credit Risk in
Project Finance1
Marco Sorge
In project finance, credit risk tends to be relatively high at project
inception and todiminish over the life of the project. Hence,
longer-maturity loans would be cheaper thanshorter-term credits.
or decades, project finance has been the preferred form of financing for
largescale infrastructure projects worldwide. Several studies have emphasised
its critical importance, especially for emerging economies, focusing on the link
between infrastructure investment and economic growth. Over the last few years,
however, episodes of financial turmoil in emerging markets, the difficulties
encountered by the telecommunications and energy sectors, and the financial
failure of several high-profile projects2 have led many to rethink the risks involved
in project financing.
1
I would like to thank Claudio Borio, Blaise Gadanecz, Mr Gudmundsson, Eli Remolona and Kostas Tsatsaronis for
their comments, and Angelika Donaubauer and Petra Hofer (Dealogic) for their help with the data. The views expressed
in this article are those of the author, and do not necessarily reflect those of the BIS.
Three spectacular recent financial failures are the Channel Tunnel linking France and the United Kingdom, the
EuroDisney theme park outside Paris, and the Dabhol power project in India.
Source: http://www.bis.org/publ/qtrpdf/r_qt0412h.pdf, Originally published in BIS Quarterly Review, Dec.2004.

The full publication is available free of charge on the BIS website. BIS Quarterly Review. Reprinted with permission.
94
The question whether longer maturities are a source of risk per se, is crucial to
understanding the distinctive nature of credit risk in project finance. Large-scale
capital-intensive projects usually require substantial investments upfront, and only
generate revenues to cover their costs in the long-term. Therefore, matching the
time profile of debt service and project revenue cash flows implies, that on an average,
project finance loans have much longer maturities than other syndicated loans.3
This special feature argues that a number of key characteristics of project finance,
including high leverage and non-recourse debt, have direct implications for the
term structure of credit risk for this asset class. In particular, a comparative econometric
analysis of ex ante credit spreads in the international syndicated loan market, suggests
that longer-maturity project finance loans are not necessarily perceived by lenders
as riskier compared to shorter-term credits. This contrasts with other forms of debt,
where credit risk is found to increase with maturity ceteris paribus.
Financing high-profile infrastructure projects not only requires lenders to commit
for longer maturities, but also makes them particularly exposed to the risk of political
interference by host governments. Therefore, project lenders are making increasing
use of political risk guarantees, especially in emerging economies. This special feature
also provides a cross-country assessment of the role of guarantees against political
risk, and finds that commercial lenders are more likely to commit for longer maturities
in emerging economies, if they obtain explicit or implicit guarantees from multilateral
development banks or export credit agencies. This is shown to further reduce project
finance spreads observed at the long end of the maturity spectrum.
After a brief review of the history and growth of project finance, the second
section illustrates the specific challenges involved in financing large-scale
capital-intensive projects, while the third section explains how project finance
structures are designed to best address those risks. The core of the analysis, in the
fourth and fifth sections, shows how the particular characteristics of credit risk in
project finance are consistent with the hump-shaped term structure of loan spreads
observed ex ante for this asset class. The conclusion summarises the main findings
and draws some policy implications.
3
The average maturity of project finance loans in the Dealogic Loanware database is 8.6 years, against only 4.8 years for
syndicated loans in general.
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Recent Developments in the Project Finance Market

Project finance involves a public or private sector sponsor investing in a
single-purpose asset through a legally independent entity. It typically relies on
non-recourse debt, for which repayment depends primarily on the cash flows
generated by the asset being financed.
Since the 1990s, project finance has become an increasingly diversified business
worldwide. Its geographical and sectoral reach has grown considerably, following
widespread privatization and deregulation of key industrial sectors around the world.
Graph 1: Project Finance Global Lending by Region (US$ bn)
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and region.
Source: Dealogic ProjectWare database.
In the years following the East Asian crisis (199899), financial turmoil in
emerging markets led to a global reallocation of investors portfolios from the
developing to industrialised countries. New investments, notably in North America
and western Europe, more than offset the capital flight from emerging economies,
such that total global lending for project finance rebounded from a two-year
slump, reaching a record high in 2000 (Graph 1).
Since 2001, the general economic slowdown and industry-specific risks in the
telecoms and power sectors have led to a substantial decline in project finance
lending worldwide (Graph 2). The power sector has been particularly hurt by
96
accounting irregularities and high volatility in energy pricesthe debt ratings of

ten of the leading power companies fell from an average of BBB+ in 2001 to B in
2003. Telecoms firms have been penalised for sustaining onerous investments in
new technologies (like fibre-optic transmission or third-generation mobile licences
in Europe), that have not yet generated the expected returns. Over 60 telecoms
companies filed for bankruptcy between 2001 and 2002, as overcapacity led to
price wars and customer volumes failed to live up to over-optimistic projections.
Despite the recent downturn, the long-term need for infrastructure financing
in both industrialized and developing countries remains very high. In the United
States alone, between 1,300 and 1,900 new electricity generating plants need to
be built in order to meet growing demand over the next two decades (National
Energy Policy Development Group (2001)). For developing countries, an annual
investment of $120 billion would be required in the electricity sector until 2010
(International Energy Agency (2003)).
Graph 2: Project Finance Global Lending by Sector (US$ bn)
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sector.
The Main Challenges of Financing Large-scale Projects

Projects like power plants, toll roads or airports share a number of characteristics
that make their financing particularly challenging.
97
First, they require large indivisible investments in a single-purpose asset. In

most industrial sectors where project finance is used, such as oil and gas and
petrochemicals, over 50% of the total value of projects consist of investments
exceeding $1 billion.
Second, projects usually undergo two main phases (construction and operation)
characterised by quite different risks and cash flow patterns. Construction primarily
involves technological and environmental risks, whereas operation is exposed to
market risk (fluctuations in the prices of inputs or outputs) and political risk,
among other factors.4 Most of the capital expenditures are concentrated in the
initial construction phase, with revenues instead starting to accrue only after the
project has begun operation.
Third, the success of large projects depends on the joint effort of several related
parties (from the construction company to the input supplier, from the host
government to the offtaker5) so that coordination failures, conflicts of interest and
free-riding of any project participant can have significant costs. Moreover, managers
have substantial discretion in allocating the usually large free cash flows generated
by the project operation, which can potentially lead to opportunistic behavior
and inefficient investments.
The Key Characteristics of Project Financing Structures

A number of typical characteristics of project financing structures are designed to
handle the risks illustrated above.
In project finance, several long-term contracts such as construction, supply,
offtake and concession agreements, along with a variety of joint-ownership
structures, are used to align incentives and deter opportunistic behavior by any
party involved in the project. The project company operates at the centre of an
extensive network of contractual relationships, which attempt to allocate a variety
of project risks to those parties best suited to appraise and control them. For
4
Hainz and Kleimeier (2003) identify three broad categories of political risk. The first category includes the risks of
expropriation, currency convertibility and transferability, and political violence, including war, sabotage or terrorism.
The second category covers risks of unanticipated changes in regulations or failure by the government to implement tariff
adjustments because of political considerations. The third category includes quasi-commercial risks arising when the
project is facing state-owned suppliers or customers, whose ability or willingness to fulfil their contractual obligations
towards the project is questionable.
The offtaker commits to purchase the project output under a long-term purchase (or offtake) agreement.
98
example, construction risk is borne by the contractor and the risk of insufficient
demand for the project output by the offtaker (Figure 1).
Figure 1: Typical Project Finance Structure
International organisations
or export credit agencies
Bank
syndicate
Sponsor
A
Non-recourse debt
Inter-creditor agreement
Labor
Input
(eg. gas)
Supply contract
Construction
equipment, operating
and maintenance
contracts
70%
Sponsor
B
Sponsor
C
Equity
Shareholder agreement
30%
Project company
(eg. power plant)
Output
(eg. power supply)
Offtake agreement
Host government
Legal system, property
rights, regulation, permits,
concession agreements
Note: A typical project company is financed with limited or non-recourse debt (70%) and sponsors
equity (30%). It buys labor, equipment and other inputs in order to produce a tangible output
(energy, infrastructure, etc). The host government provides the legal framework necessary for the
project to operate.
Source: Adapted from Esty (2003).
Project finance aims to strike a balance between the need for sharing the risk of
sizeable investments among multiple investors and, at the same time, the
importance of effectively monitoring managerial actions and ensuring a coordinated
effort by all project-related parties.
Large-scale projects might be too big for any single company to finance on its
own. On the other hand, widely fragmented equity or debt financing in the
capital markets would help to diversify risks among a larger investors base, but
99
might make it difficult to control managerial discretion in the allocation of free

cash flows, avoiding wasteful expenditures. In project finance, instead, equity is
held by a small number of sponsors and debt is usually provided by a syndicate
of a limited number of banks. Concentrated debt and equity ownership enhances
project monitoring by capital providers and makes it easier to enforce projectspecific
governance rules for the purpose of avoiding conflicts of interest or suboptimal
investments.
The use of non-recourse debt in project finance further contributes to limiting
managerial discretion by tying project revenues to large debt repayments, which
reduces the amount of free cash flows.
Moreover, non-recourse debt and separate incorporation of the project company,
make it possible to achieve much higher leverage ratios than sponsors could
otherwise sustain on their own balance sheets. In fact, despite some variability
across sectors, the mean and median debt-to-total capitalization ratios for all
project-financed investments in the 1990s were around 70%. Nonrecourse debt
can generally be deconsolidated, and therefore does not increase the sponsors
on-balance sheet leverage or cost of funding. From the perspective of the sponsors,
non-recourse debt can also reduce the potential for risk contamination. In fact,
even if the project were to fail, this would not jeopardise the financial integrity of
the sponsors core businesses.
One drawback of non-recourse debt, however, is that it exposes lenders to
project-specific risks that are difficult to diversify. In order to cope with the asset
specificity of credit risk in project finance, lenders are making increasing use of
innovative risk-sharing structures, alternative sources of credit protection and new
capital market instruments to broaden the investors base.
Hybrid structures between project and corporate finance are being developed,
where lenders do not have recourse to the sponsors, but the idiosyncratic risks
specific to individual projects are digressed by financing a portfolio of assets as
opposed to single ventures. Public-private partnerships are becoming more and
more common as hybrid structures, with private financiers taking on construction
and operating risks, while host governments cover market risks.
100
There is also increasing interest in various forms of credit protection. These

include explicit or implicit political risk guarantees,6 credit derivatives and new
insurance products against macroeconomic risks such as currency devaluations.
Likewise, the use of real options in project finance has been growing across various
industries.7 Examples include refineries changing the mix of outputs among heating
oil, diesel, unleaded gasoline and petrochemicals depending on their individual
sale prices; real estate developers focusing on multipurpose buildings, that can be
easily reconfigured to benefit from changes in real estate prices.
Finally, in order to share the risk of project financing among a larger pool of
participants, banks have recently started to securitize project loans, thereby creating
a new asset class for institutional investors. Collateralized debt obligations as well as
open-ended funds have been launched to attract higher liquidity to project finance.8
The Term Structure of Credit Spreads in Project Finance

The specific risks involved in funding large-scale projects and the key characteristics
of project financing structures, illustrated in the previous sections, (in particular,
high leverage and non-recourse debt) have important implications for the term
structure of credit spreads for this asset class.
First, based on the widely used framework for pricing risky debt originally
proposed by Merton (1974), we should expect to observe a hump-shaped term
structure of credit spreads for highly leveraged obligors (Graph 3). In this approach,
the default risk underlying credit spreads is primarily driven by two components:
(1) the degree of firm indebtedness or leverage, and (2) the uncertainty about the
value of the firms assets at maturity. Given Mertons assumption of decreasing leverage
6
The explicit guarantee is a formal insurance contract against specific political risk events (transfer and convertibility,
expropriation, host government changing regulation, war, etc) provided by some commercial insurers. The implicit
guarantee instead works as follows. The financing is typically divided into tranches, one of which is underwritten by
the agency. The borrower cannot default on any tranche without defaulting on the agency tranche as well. The agency
represents a G10 government or supranational development bank with a recognised preferred creditor status. Defaulting
on the agency has additional political and financial costs that the host country would not want to incur, since agencies
are usually lenders of last resort for host countries in financial distress.
Analogous to financial options, i.e., derivative securities which give the holder the right but not the obligation to trade
in an underlying security, real options provide management with the flexibility to take a certain course of action or
strategy, without the obligation to take it (in both cases options are exercised only if deemed convenient ex post).
Among the new capital market instruments used for project financing, revenue bonds and future-flow securitizations are
debt securities, backed by an identifiable future stream of revenues generated by an asset; compartment funds offer shares
with different levels of subordination, to different types of investors, and, are dedicated to make equity investments.
101
ratios over time, postponing the maturity date reduces the probability that the
value of the assets will be below the default boundary when repayment is due. On
the other hand, a longer maturity also increases the uncertainty about the future
value of the firms assets. For obligors that already start with low leverage levels, this
second component dominates, so that the observed term structure is monotonically
upward-sloping. For highly leveraged obligors, instead, the increase in default risk
due to higher asset volatility will be strongly felt by debt holders at short maturities,
but as maturity further increases, the first component will rapidly take over, thanks
to the greater margin for risk reduction due to declining leverage. This leads to a
hump-shaped term structure of credit spreads for highly leveraged obligors.9
Second, despite the extensive network of security arrangements illustrated in
Figure 1, the credit risk of non-recourse debt remains ultimately tied to the timing
of project cash flows. In fact, projects which are financially viable in the long run
might face cash shortages in the short term. Ceteris paribus, obtaining credit at
longer maturities implies smaller amortizing debt repayments due in the early
stages of the project. This would help to relax the project companys liquidity
constraints, thus reducing the risk of default. As a consequence, long-term project
finance loans should be perceived as being less risky than shorter term credits.
Third, the credit risk of non-recourse debt might be affected not only by the
timing, but also by the uncertainty of project cash flows and how the latter evolves
over the projects advancement stages. In fact, successful completion of the
construction and setup phases can significantly reduce residual sources of
uncertainty for a projects financial viability. Arguably, extending loan maturities
for any additional year after the scheduled time for the project to be completely
operational, might drive up ex ante risk premia but, only at a decreasing rate. 10
Finally, the term structure of credit spreads observed in project finance, is
likely to be affected by the higher exposure of large infrastructure projects to
political risk and by the availability of political risk insurance for long-term project
finance loans. While long maturities and political risk represent in principle separate
sources of uncertainty, commercial lenders are often willing to commit for longer
9
With leverage ratios approaching 100%, the second component completely dominates and the term structure becomes
downward-sloping.
10
This is consistent with the hypothesis of sequential resolution of uncertainty in Wilson (1982)
102
maturities in emerging economies, only if they obtain explicit or implicit guarantees

from multilateral development banks or export credit agencies. As political risk
guarantees are most often associated with longer maturities,11 lenders should not
necessarily perceive political-risk-insured long-term loans as being riskier than
uninsured short-term loans, ceteris paribus.
Graph 3: Term Structure of Credit Spreads
In basis points
20% leverage
50% leverage
400
300
200
100
0
10
25
Maturity (years)
Note: Volatility of firms asset value is set at 20% per unit of time. Leverage is defined as the
ratio of debt to the current market value of the assets, where debt is valued at the riskless
rate.
Source: Merton (1974).
A Comparative Analysis of Credit Spreads in the International

Syndicated Loan Market
As argued above, several peculiar characteristics of project finance would imply
that the term structure of credit spreads for this asset class, need not be monotonically
increasing as observed for other forms of financing. This section will attempt to
substantiate this claim empirically.
Graph 4 illustrates the pricing of a few representative loans for projects both in
industrialised and in emerging economies, which have received funding in tranches
11
For example, the World Bank has launched a programme of partial credit guarantees, that cover only against default
events occurring in the later years of a loan. This encourages private lenders to lengthen the maturity of their loans.
103
with different maturities. The general pattern shown in the graph suggests that
the term structure of loan spreads in project finance may be hump-shaped.
In order to test this hypothesis, the ex ante credit spreads over Libor for a large
sample of loans12 are extracted from the Loanware database compiled by Dealogic,
a primary market information provider on syndicated credit facilities.
They are regressed on several micro characteristics of the loans (such as amount,
maturity, third-party guarantees, borrower business sectors, etc) along with several
control variables including the macroeconomic conditions (eg real GDP growth,
inflation and current account balance) prevailing in the country of the borrower
at the time of signing the loan, plus global macroeconomic factors (such as world
interest rates and the EMBI index).
Graph 4: Term Structure of Loan Spreads in Project Finance
Spread over Libor, in basis points
Emerging markets
Industrial countries
United Kingdom
United States
250
200
150
500
400
Croatia
Philippines
India
300
100
200
50
100
0
3
16.5
20
5
7
Maturity (years)
0
8
10
12
16
Note: The connected diamonds represent different loans to the same project. Five representative
projects are illustrated from both industrial and emerging economies. The shaded points indicate
coverage by political risk guarantee.
12
International syndicated bank loans accounted for about 80% of total project finance debt flows over the period
19972003 (source: Thomson Financial).
104
Estimated coefficients for loan maturity and its logarithmic transformation

reported in Table 1, suggest that the relationship between ex ante spread and
maturity for project finance loans is indeed hump-shaped,13 while for all other
loans it appears instead monotonically increasing. 14 This result applies to
industrialised as well as emerging economies and is found to be robust to a large
number of sensitivity tests.15
The regressions in Table 1 also control the impact on loan spreads of political
risk and political risk guarantees. Political risk is proxied by the corruption index
provided by Transparency International.16 Results suggest that while corruption
is not a significant problem for project finance in industrialised countries, lenders
financing projects in emerging markets, systematically charge a higher premium
on borrowers from countries characterised by a higher political risk. However,
this risk appears to be effectively mitigated by the involvement of multilateral
Table 1: Microeconomic Determinants of Loan Spreads
Project finance loans
Dependent Variable: Spread
Industrialized
countries
Emerging markets
Other loans
Maturity
5.258**
5.039*
7.066**
Log maturity
52.426**
33.184**
0.761
Corruption index
0.792
19.340**
13.339**
Agency guarantees
11.872
58.324**
48.147**
331
687
12,393
0.259
0.337
0.329
Number of observations
Adjusted R2
Note: Only regressors of interest are shown. * and ** indicate statistical significance at the 5%
and 1% confidence levels, respectively.
Source: Sorge and Gadanecz (2004).
13
At short maturities, the positive logarithmic term prevails and accounts for the upward-sloping part of the term
structure. As maturity increases, the negative linear term dominates and explains the downward-sloping section of the
term structure.
14
The corresponding estimated coefficient on log maturity in Table 1 is not statistically significant. The same result is
found using alternative non-linear functions of maturity (eg. quadratic or square root).
15
Including tests for endogeneity and sample selection as well as robustness checks for the range of maturities analysed, repayment
schedules, bond ratings, loan covenants and fixed vs floating rates. See Sorge and Gadanecz (2004) for more details.
16
In the reported regression, a higher score on the index indicates a higher degree of corruption in the political system of
the host country.
105
development banks or export credit agencies. In fact, Table 1 shows that loans
with political risk guarantees from these agencies are priced on average about
50 basis points cheaper, ceteris paribus.
The evidence also suggests that the availability of agency guarantees effectively
lengthens maturities of project finance loans in emerging markets. However, even
taking this effect into account through the inclusion in the regressions in Table 1
of an interaction term between maturity and agency guarantees, the estimated
relationship between spread and maturity for project finance loans remains
hump-shaped.17 This is consistent with the hypothesis that, while it is true that
lenders especially use political risk guarantees for longer-term loans, the observed
hump-shaped term structure of credit spreads may be due to more fundamental
characteristics of project finance.
Conclusion
This special feature has analysed the peculiar nature of credit risk in project finance.
Two main findings have emerged, based on the analysis of some key trends and
characteristics of this market. First, unlike other forms of debt, project finance
loans appear to exhibit a hump-shaped term structure of credit spreads. Second,
political risk and political risk guarantees have a significant impact on credit spreads
for project finance loans in emerging economies.
These results need to be taken with some caution. In the absence of projectspecific ratings, the analysis relies on a number of micro- and macroeconomic risk
characteristics that are admittedly imperfect proxies for the credit quality of
individual projects. Moreover, loan spreads at origination are only ex ante measures
of credit risk. In the future, the development of a secondary market for project
finance loans would allow more light to be shed on the time profile of credit risk
for this asset class.
A deeper understanding of the risks involved in project finance and their
evolution over time is important for both practitioners and policymakers. In
particular, further research in this area might help in the implementation of
risk-sensitive capital requirements providing market participants with the incentives
17
See Sorge and Gadanecz (2004) for more details.
106
for a prudent and, at the same time, efficient allocation of resources across asset
classes. This is particularly relevant, given the predominant role of internationally
active banks in project finance and the fundamental contribution of project finance
to economic growth, especially in emerging economies.
(Marco Sorge is Economist at Bank of International Settlement. The author can be
reached at marco.sorge@bis.org).
References
1.
Esty B (2003): The Economic Motivations for Using Project Finance, mimeo, Harvard
Business School.
2.
Hainz C and S Kleimeier (2003): Political Risk in Syndicated Lending: Theory and Empirical
Evidence Regarding the Use of Project Finance, LIFE working paper 03014, June.
3.
International Energy Agency (2003): World Energy Investment Outlook, Paris.
4.
Merton R C (1974): On the Pricing of Corporate Debt: The Risk Structure of Interest
Rates, Journal of Finance, 29(2), pp 44970.
5.
National Energy Policy Development Group (2001): US National Energy Policy,

Washington DC.
6.
Sorge M and B Gadanecz (2004): The Term Structure of Credit Spreads in Project finance,
BIS Working Papers, no 159.
7.
Wilson R (1982): Risk Measurement of Public Projects, in Discounting for time and risk in
energy policy, Resources for the Future, Washington DC.
Refinancing Risk Permutations of Project Finance Structures
107
9
Refinancing Risk Permutations of
Project Finance Structures
Increasingly, refinancing risk is creeping into the financing of
single revenue-generating assets, often with debt structures more
commonly associated with corporate and structured finance than
traditional or classic project finance. Refinancing risk, in some
instances, has arisen from financings that aim to avoid some of
the restrictions commonly imposed by the terms of project
financings, such as stringent limits on additional debt or from the
implementation of a debt structure that finances a project that is
changing in design or scope. More frequently, refinancing risk
has resulted from the limited term or tenor available in a particular
debt market. The sources of refinancing risk and some of the
mitigating tools that can be employed in single-asset financing are
discussed sequentially in this report. Assets and projects with strong
economics, that are financed subject to covenants or structural
elements have been observed to mitigate refinancing risk
adequately.
Source: http://www.fitchratings.com.au/projresearchlist.asp 21 Oct, 2004. 2004 Fitch Ratings, Ltd. Reprinted by

permission of Fitch Inc.
108
Refinancing Risk Creeps Into Project Finance

A wide diversity of assets in a variety of economic sectors and industries worldwide
including mining, oil and gas, power, transport and public infrastructurebenefit
from project finance techniques. Project finance structures have been successfully
employed in the construction of facilities, the refinancing of assets in operation,
the acquisition of assets through a combination of leverage and equity, or the financing
of portfolios of assets. The legal structure supporting the financing of projects typically
aims to achieve a few of the following common goals:
Mitigate construction risk (if applicable).
Restrict the activity of the borrower (usually, but not always, through a
special-purpose vehicle (SPV)) to avoid diversion of funds for uses unrelated
to the functioning of the financed facility, and to protect the project against
corporate bankruptcy and consolidation risk.
Provide some form of security or collateral for the benefit of the lenders.
Safeguard the projects cash flow and liquidity, usually the only sources of
debt repayment.
Fully repay the debt by its final maturity, which is usually within a term that
is consistent with the useful life of the project. The projects term of debt is
commonly constrained either by the physical characteristics of the project
(power plants, upstream oil, and gas, and mining), by contractual terms
(concessions, public private partnerships (PPPs), offtake agreements, etc.) or
by a combination of these factors. In this respect, project finance, unlike
corporate finance, traditionally is viewed as having quite limited room to
accommodate refinancing risk, particularly at investment-grade levels.
Nevertheless, Fitch observes that, increasingly, refinancing risk is creeping into
the financing of single revenue-generating assets, often with debt structures more
commonly associated with corporate and structured finance than traditional or
classic project finance. Given the wide variety of asset types and circumstances
associated with refinancing risk, it is impossible to generalize on the credit implications
of these trends. Refinancing risk, in some instances, has arisen from financings
that aim to avoid some of the restrictions commonly imposed by the terms of
project financings, such as stringent limits on additional debt. In other instances,
109
refinancing risk arises from the implementation of a debt structure that finances
a project that is changing in design or scope (expansion of a toll road or pipeline
network). More frequently, refinancing risk has resulted from the limited term or
tenor available in a particular debt market.
Instead of generalizing a credit approach to refinancing risk and sentencing all
projects subject to it to either unrateable or non investment-grade status, Fitch
analyzes the effect on a projects risk profile and determines the extent to which it
will diminish credit quality on a case-by-case basis. In some cases, refinancing
risk can be mitigated by an assets quality and specifications, low probability of
technical obsolescence, strong economics and long useful life, as well as its ability
to reduce leverage prior to a needed refinancing. It can also be mitigated by certain
elements adopted in the financing structure. The sources of refinancing risk and
some of the mitigating tools that can be employed in single-asset financing are
discussed sequentially in this report.
Traditional Project Finance: Monolithic?

Traditionally, projects are financed on a non-recourse basis (i.e., relying only on
the cash flows generated by the asset to meet debt-service payments without the
benefit of support from a corporate or government entity). The financing structures
have either mitigated or completely eliminated refinancing risk. In fact, a
fundamental characteristic of such non-recourse financing has been the avoidance
of refinancing risk altogether. Traditional project finance is, however, characterized
by certain rigidities. Due to the considerable risks inherent in the asset and the
reliance solely on the assets cash flows for debt repayment, as well as the
usual existence of substantial leverage, especially during construction or at the
point of acquisition of an asset, traditional project finance will impose a variety
of constraints. These constraints include limits on activity, additional indebtedness
and distribution of cash to the projects owners. Dilution of some of these rigidities
is among the factors engendering refinancing risk.
Limit on Activity, Acquisitions, Disposals and Ownership

In conventional project finance, the borrower usually undertakes to limit its activity
to the construction and operation of the specific asset being financed. In addition,
acquisition and disposal of assets by the borrower, or engaging in ancillary or
110
unrelated businesses, are usually restricted. The motivation underpinning these

conventional limitations is to safeguard the projects cash flows, which if used
for unrelated purposes, could erode the projects capacity to repay its debt.
However, in some cases, expansion of activity will be permitted or even encouraged,
which in turn may contribute to higher refinancing risk. This can include, for instance,
additions to an existing oil pipeline or, particularly, changes in the design of government
concessions for public infrastructure. With more private-sector participation in
the development of public infrastructure worldwide, some of the traditional limitations
of project finance could change to fit more adequately, the characteristics of the asset,
ownership or management model, as well as government concerns. To illustrate, in
recent years Chiles public toll road concessions have evolved from fixed to variable
terms, and have instituted minimum revenue-guarantee mechanisms to encourage
sponsors to undertake additional capital programs for road expansions beyond the
initially specified scope. In this sense, the projects are no longer static or rigid but
instead are assets with physical characteristics that change and conform to a varying
service scope or design. The variable nature of the projects is then reflected in the
structure of the financings, with longer amortization periods but also the option of
taking on additional debt to finance the new capital programs demanded by the
concession agreement or to refinance existing debts originally used to fund the initial
construction. Without a strong project that benefits from access to fresh liquidity
in the capital or bank markets as needed, holders of the original debt could assume
considerable refinancing and credit risk.
Ownership limitations tend to impede the sale or transfer of project-financed
facilities, reflecting the concerns of creditors who typically demand security
or collateral against an asset. In some cases, particularly in the oil and gas sector,
the original owners must hold the asset until at least the end of the
construction period and sometimes until the debt is fully repaid. A recent project
financing for Qatargas II, a new liquefied natural gas (LNG) terminal developed
by a joint venture between ExxonMobil and Qatar Petroleum, was structured
with this limitation. Although consistent with tradition and at the same time a
bit unusual in form, the Qatargas II limitations run contrary to the strong trend
among institutional investors toward project debt and equity investments, as well
as acquisitions, divestitures and consolidation of the physical projects or portfolios
of projects, especially in the US power sector.
111
Contrary to convention, specialized investment funds and other investors in

existing assets with successful operating histories, such as profitable pipelines,
power plants or other projects in the United States, are designing capital structures
that address a number of competing concerns. These concerns include complying
with regulatory capital requirements for certain assets in the power market, enabling
the acquisition of various projects in investment portfolios under one holding entity
(groups of power plants), accommodating debtholder concerns and maximizing
leverage to the fullest degree possible for a targeted rating level.
In some of these cases, refinancing risk may arise. Equity investors may leverage
the asset to fund the acquisition and minimize the required cash or
equity contribution to no more than 25%30% of the acquisition cost. The
transaction might comprise a holding company (Holdco)/operating company (Opco)
capital structure so that the operating asset or project (pipeline or power plant) is
owned by the Opco, a subsidiary of a special- or sole-purpose Holdco. Depending
on the amount of leverage required or desired to fund the acquisition and the effect
of debt-service coverage on sustainable cash flow, tranches or classes of debt will be
allocated to the Holdco and others to the Opco. Debt of the Opco will rank senior,
with debtholders benefiting from a security pledge, as well as first position on cash
flows from the project. However, the Opco debt might not fully amortize by the
final maturity date, particularly when the project is regarded by the equity investors as
sufficiently strong, economically, to stand on its own for a relatively long period.
Opco debtholders will have assumed refinancing risk, or stated another way, they
will assume that the useful life of the asset and its economic viability will enable the
project to meet financial obligations indefinitely into the future. Holdco obligations,
which are structurally subordinated to the Opco debt, will usually be structured to
amortize, completely or almost completely, by the maturity dates and are usually
of shorter life than the Opco debt.
Limit on Indebtedness
In most project finance transactions, the ability of the borrower to raise additional
debt beyond the original financing is controlled more tightly than for
corporate loansMost projects are of a certain economic value, which will not be
increased by additional leverage (unless this debt is incurred to fund value-enhancing
investments). At the most stringent end of the spectrum, the imposed additional debt
112
test or limit will impede any other indebtedness above a certain minimal amount
associated with mandated expenditures (legal or regulatory requirements)
or expenditures necessary to maintain the integrity and the satisfactory operations
of the asset.
However, to facilitate additional financing, in some cases, the indebtedness
limitations will permit the borrower to raise additional pari passu senior debt,
if certain financial covenants are satisfied or specific minimum ratings are achieved
after taking into account the additional debt. In other cases possessing less favorable
financial and economic profiles, senior debt investors may not have an appetite
for the implied refinancing risk. In such cases, subordinated debt may be employed
to lessen senior debt refinancing risk, thus potentially benefiting, or at least not
degrading, the credit quality at the senior level. To the extent that a default of
subordinated debt can cause a default of the senior debt, or if the subordinated
debt is not subject to payment restrictions similar to those applicable to
equity distributions (as discussed later), additional subordinated debt could
jeopardize the rating of the senior debt. Thus, proper structuring of
employed subordinated debt is critical. (For more information on Fitchs approach
to subordinated project debt, please refer to the criteria report, Layer It On
The Essentials of Rating Project Subordinated Debt, dated Sept. 9, 2002, and
available on Fitchs Website at www.fitchratings.com).
Consistent with project finance conventions, Express Pipeline, a Canadian-US
project, is subject to a comprehensive set of restrictive covenants, which limit
managements options to fund anticipated expansions to the pipeline network
(Graph 1). The projects owners (one operating sponsor and two financial investors)
view the pipeline as a strong asset capable of standing on its own and requiring no
additional equity support; the ultimate financing decision for the pipelines
expansion thus resulted in the issuance of Holdco-level, structurally subordinated
debt. These new notes carry the option to convert into senior project-level debt
ranking pari passu to the original senior notes upon completion of the expansion
by the end of 2005. Like the existing notes, the new notes rely on the projects
cash flow (in the form of equity distribution payments from the pipelines
Opco owner) to service debt interest. Principal is due as a bullet in 15 years. The
legally inspired use of Holdco-level debt with a bullet maturity (unrated) satisfied
the restrictive covenants, as the bullet repayment structure allows the project to
113
maintain debt-service coverage margins consistent with the A rating on the Opco
notes and withstand periods of significant stress. The risk of refinancing the
bullet maturity is expected to be modest, as it is due after the full repayment of
existing Opco senior and subordinated notes (the latter rated BBB). If properly
maintained, the pipeline should enjoy a long useful life, and strong demand for
Canadian oil throughout North America further mitigates Holdco refinancing
risk. In sum, in Express Pipelines case, a traditional project finance limitation on
additional debt was successfully and sensibly overcome with a viable project and
legal structure that mitigated the refinancing risk incorporated in the
expansions financing.
Graph 1: Express Pipeline Debt-Service Schedule
120
Principal Payment
($ Mil.)
Interest Expense
100
80
60
40
20
19
20
18
17
20
16
20
15
20
14
20
13
20
20
11
20
12
10
20
20
09
08
20
07
20
06
20
05
20
04
20
20
20
03
Source: Terasen.
Restricted Payments
While project finance aims to restrict diversion of cash, it usually allows payment
of equity distributions if certain tests are met. This restriction differentiates project
finance from, for example, leverage finance, where all cash generated by the asset
is often used completely for the benefit of lenders. This difference stems from the
fact that equity investors in project-financed assets usually demand current
cash returns once a project achieves a steady state of operations.
Customarily, project finance transactions include restricted payment provisions
controlling whether equity distributions (or subordinated debt payments) can be
paid. These payments are normally more tightly defined than those for corporate
114
finance and are of key interest to Fitch, especially in project acquisitions. As stated
previously, in their quest for returns, equity investors are increasingly resorting
to leverage in ways that substantially heighten the debtrefinancing risk of
long-lived projects. Therefore, Fitch pays special attention to restricted
payment provisions, which typically include the following:
Maintenance of certain minimum dedicated cash balances (in particular, the
debt-service reserve account (DSRA) and the maintenance reserve account
(MRA)), which may not be distributed, is a standard structural element in
most project financings.
Payment of dividends or principal and interest on subordinated debt is normally
subject to compliance with certain financial covenants, usually a minimum
DSCR or a bond life coverage ratio (BLCR, also known as a lock up). To be of
value, these covenants will usually be forward looking, preventing
the distribution of dividends unless the projects covenant threshold is reached.
This was the case for AES Drax Holding, Ltd., a UK power project rated by
Fitch, which could not meet its subordinated debt payment from cash flow
in February 2002 because, based on the market consultants price forecast, the
company would be below its DSCR covenant level in future periods. This cash
retention occurred 10 months before the borrower defaulted on its senior debt as
a result of the default of its power offtaker, TXU Europe.
Repayment Structure as Source of Refinancing Risk
Refinancing risk can arise from the need to surpass stringent constraints in project
finance or from the design of the projects debt repayment structure (Graph 2).
A wide variety of repayment modes can be employed in the financing of assets,
including fixed amortization, indexed-linked bonds, and bullets and balloons,
as well as, increasingly, debt deferral and flexible amortization structures, which
sometimes incorporate cash-sweep mechanisms. The choice of structure is driven
by the need to address competing concerns of sponsors and debtholders, as well
as the inherent nature and characteristics of the asset.
Fixed or Sculpted Amortization
Project finance assets usually have a limited life and are, therefore, generally less
capable than corporates of withstanding refinancing risk. For this reason, many
115
Graph 2: Classic Repayment Debt Schedule

120
($ Mn.)
Annual Principal Payment
Outstanding Debt Balance
100
80
60
40
20
0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
project finance loans amortize fully according to a fixed amortization schedule in

conformity with the indenture maturity date.
Typically, mining and oil projects, as well as other projects affected by
commodity-price risk, will be structured such that debt principal is fully
repaid within the term of the debt. Lenders are keen to be repaid in full and will
ensure that the debt will mature well in advance of the tail end of the
mines recoverable reserves. Therefore, in properly structured mining transactions,
the debts amortization will be front loaded, of relatively short duration and not
subjected to refinancing risk. A trade off does materialize, however, as front
loading can significantly burden a mining projects cash flows and hinder debt
repayment capacity when substantial development or construction is
required before revenues reach steady state. Therefore, the debt repayment profile
will often be sculpted to match the expected output production and
cash generation of the project, while leaving a sufficient tail reserve after debt
maturity to cover contingencies. (Graph 3)
Indexed-Linked Bonds
The market for indexed-linked bonds has been growing rapidly in Europe in the
past few years, fueled by the growth of the PPP sector. These bonds are suitable
investments for asset-liability matching, particularly long-dated pension
obligations. The bonds repayment tends to be back ended, which increases the
average life of the bond, especially in high inflation periods. Nevertheless, this is
not necessarily a source of concern, especially when the net cash flow generated
116
by the project follows the bonds amortization repayment pattern. In

addition, indexed-linked bonds issued for PPP projects are typically fully
amortizing within the legal maturity term and are thus not significantly exposed
to refinancing risk.
Bullet or Balloon Repayments
Shorter term, bullet maturity loans might be taken, with the expectation that
the financed assets life will extend sufficiently beyond the maturity of the
bullet loan to support a refinancing. During the 1990s, this type of financing
(sometimes nicknamed miniperm) was popular in the US power sector. However,
the ensuing deterioration of this market in the latter half of the decade highlighted
the pitfalls associated with refinancing risk. These structures are, however, back
in favor in the infrastructure sector. In Spain, recent toll roads were financed by
banks with miniperm-like financing that included relatively short maturities
but were underpinned by long-term concessions.
Generally, a bullet1 or balloon 2 structure arouses concern, as it exposes the
project to refinancing risk. Bullets or balloons can, therefore, sometimes be expected
Graph 3: Derby Healthcare PLC Amortization Schedule
60,000
Principal Payment
(GBP 000)
Interest Expense
50,000
40,000
30,000
20,000
10,000
Payment Periods
GBP British pound.
Source: Derby Healthcare PLC.
1
Bullet - 100% of initial amount is due at maturity
Balloon - The credit is only partially repaid during its term and presents a lumpy repayment at maturity.
76
70
73
67
61
64
58
55
49
52
46
40
43
34
37
31
28
22
25
16
19
7
10
13
117
to have a negative effect on credit quality. However, this type of repayment structure
can achieve an investment-grade or near investment grade rating if the financed
asset has a long, useful life and strong economics. This has been the case for certain
Australian and New Zealand transportation and infrastructure transactions, which
have been backed by strong assets generating cash flows that allow for debt to be
paid or refinanced within the concessions term while maintaining robust coverage
levels. A common characteristic of these transactions is the relatively modest size
of the refinancing requirement or leverage relative to the availability of credit from
either banks or bond investors in these markets; therefore, the bullet maturities
are likely to be refinanced successfully at or prior to their due dates. Alternatively,
as illustrated by the Coleto Creek project, a cash-sweep mechanism, whereby excess
project cash flows beyond what is required to satisfy certain fixed costs, are applied
to debt principal prepayments prior to the bullet payment date, can assure that
the refinancing will be accomplished with less risk than relying simply on the
timely access to credit.
Fitch notes that recent infrastructure and PPP transactions in the UK have
fully amortizing loans or bonds. However, these loans and bonds amortize over a
very long period and effectively do not repay much more than a shorter bullet
loan during the first 810 years. For instance, Derby Healthcare PLC, a UK hospital
under a PPP, rated BBB (unenhanced) by Fitch, pays down only 0.3% of the
bond debt during the first ten years after financial close. This project benefits
from a 40-year concession and a predictable cash flow stream, which enables the
back-ended amortization. In this respect, Fitch notes that with the small
repayments during the first ten years, the amortization profile of the bond is not
materially different from that of a bullet loan. Unlike a bullet structure, the project
is in fact not exposed to refinancing risk, with debt serviced from the start.
Flexible Repayment and Debt Deferral
In between the two ends of the repayment-risk spectrum (scheduled amortization
fully within the maturity term and bullet or no periodic amortization), the range
of possible repayment structures is quite wide, limited only by the imagination of
bankers, sponsors and investors.
118
Coleto Creek WLE, LP

An illustrative case of an unorthodox repayment structure affected by refinancing risk is Coleto
Creek WLE, LP(Coleto Creek). Fitch assigned a rating of BB to a $205 million secured term loan
due 2011 (first-lien B loan)and BB to a $150 million secured loan due 2012 (second-lien C loan).
Coleto Creek, a project domiciled inTexas, consists of a net 632-MW generating facility comprising
a coal-fired boiler, a steam turbine with anameplate capacity of 570 MW and ancillary facilities.
Due to the design of the loan repayment structure, ColetoCreek faces refinancing risk, as
scheduled principal payments are insufficient to repay the loans fully upon theirrespective legal
maturity dates. In fact, no principal payments are scheduled for the C loan, and payments on theB
loan are minimal, amounting to a mere $1 million annually (20052011). In its analysis, Fitch
assumed that arealistic refinancing scenario would include the aggregate amounts due, under
both the B and C loans.
To mitigate the risk, a cash-sweep mechanism in the credit agreement provides for the
prepayment, or additionalprincipal payment, of the loans, above the scheduled amounts. This
annual cash sweep captures 75% of excessproject cash flow, which is defined as cash available
after operating expenses, capital expenditures, interest andscheduled principal, replenishment
of a debt-service reserve and reimbursement of sponsors income taxpayments. Swept cash is
first used to prepay the outstanding balance of the B loan. Once the B loan is fullyrepaid, swept
cash is applied against the principal balance of the C loan. Implicit in the Fitch base case, all of
thescheduled and swept cash will be applied to the amortization of the B loan. The cash-sweep
mechanismsubstantially increases the amount of actual debt repayment relative to the scheduled
amounts, thus improvingthe credit quality of the project, as well as refinancing prospects.
The outstanding balance subject to refinancingby the legal maturity date of the B loan in 2011
will constitute approximately 57% of the combined issue. Thenon investment-grade ratings
assigned to the loans consider both the credit strengths of the project (reliableoperations, low
fuel supply risk and highly competitive cost structure) and the credit concerns (refinancing
risk,merchant price risk and interest rate risk). The BB rating of the C loan reflects the loans
balance at maturityin 2012 (original full amount, unamortized) and priority position in the cash
sweep relative to the B loan. A moredetailed analysis is summarized in the new issue report on
Coleto Creek that is dated Oct. 20, 2004, andavailable on Fitchs Web site at www.fitchratings.com.
Fitch anticipates that the Coleto Creek repaymentstructure will be employed with increasing
regularity for certain power projects in the United States.
One example would be debt with a target and a minimum repayment profile.
In this instance, flexibility is provided in the repayment structure without
adverse consequences, as long as the project meets the minimum repayment
schedule. Such flexible repayment structures are more commonly seen in project
finance bank loans than in bonds, as the majority of projects financed with bonds
typically incorporate fixed-amortization terms, although, as noted, this is changing.
119
Another source of flexibility is the capacity, whether limited or not, to defer

some principal repayment. The deferred principal repayment, also known as a
soft bullet, is commonly employed in structured finance. Assets monetized in
this manner can vary widely in terms of their nature and characteristics, but
mainly include financial assets (mortgages, loan portfolios and future payments
on export receivables). It is still rare to see such structures employed in the financing
of projects, although the use of soft bullets has become increasingly popular to
mitigate refinancing risk.
In cases where debt repayment deferral is permitted, the rating still addresses
probability of default, though not of timely payments but whether they are made
by the legal maturity date. A structure allowing for partial or full deferral of principal,
will sometimes have the effect of lowering the probability of default. Consequently,
such flexibility can potentially permit the project to achieve a higher rating than
would have been achieved without the deferral feature, but only to the extent that
lenders retain adequate control over the cash generated by the asset and refinancing
risk is minimized. To illustrate, Fitch rated the various tranches of the refinancing of
Tube Lines (Finance) PLC (Tube Lines), a company managing one-third of the
London Underground infrastructure under a PPP contract with Transport for London.
In all of the 20 sensitivity tests prepared, the investment-grade rated tranches will
be fully repaid before final maturity. In the most severe case, however, the DSCR
will fall below 1.0 times (x) on the BBB tranche in two periods. This suggests
that the SPV would have to draw on cash reserves (which are expected to be more
than adequate due to the implementation of the cash lock-up provision) or defer a
payment during those periods. In these circumstances, the capacity to defer a
payment reduces the risk of default on that tranche.
A key consideration in the Tube Lines case, which is consistent with Fitchs
approach to US toll roads and other long-lived projects (for example, the Pocahontas
Parkway in Virginia), is the availability of an amply funded reserve. From
Fitchs perspective, draws on a liquidity and debt-service reserve for short-term
needs do not necessarily preclude an investment-grade rating, provided that full
depletion of the reserves at any time during the debts life is highly improbable
and the ability to replenish the reserves in a timely manner can be demonstrated.
In fact, the reverse might be the casea reserve for liquidity can shield against
not only downgrades but also refinancing risk.
120
While a flexible amortization profile can lower the probability of default, it

can negatively affect debt recovery to the extent that lenders do not
retain appropriate control. To mitigate this, such flexibility is more suitable when
accompanied by cash lock-up provisions, and the ability to accelerate amortization if
forward-looking DSCRs fall below certain levels. In Fitchs opinion, investmentgrade transactions are likely to have only limited deferral capacity. If there is no
limit in the number of times that the deferral can take place (or in the cumulative
deferral amount), then the amortizing structure, if misused, can effectively become
a bullet structure, exposing the project to unmitigated refinancing risk.
Graph 4: Coleto Creek Debt-Repayment Profile
Cash-Sweep Amortization
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04
350
300
350
200
150
100
50
0
Term Loan C
20
12
12 Term Loan B
($ Mil.)
400
Source: Coleto Creek WLE, LP.
Benefits of Traditional Project Finance Structures

As outlined in this report, the risk of refinancing project obligations may arise
from a variety of sources, including the structural limitations imposed by traditional
project finance, as well as debt repayment profiles adopted for assets
with characteristics that may or may not be in conflict with them. Fitch continues
to look favorably upon restrictive covenants that traditionally conform to project
finance. Assets and projects with strong economics that are financed subject to
covenants or structural elements, such as the following, have been observed to
mitigate refinancing risk adequately:
A cash flow lock up, which effectively causes cash to be retained in the
projects SPV for the benefit of lenders, is obviously positive.
121
Fitchs ratings, especially at the lower BBB level and below, reflect an assessment
of the probability of default and, sometimes, take into account the potential
for loss upon default. Fitch views tight covenants as providing early warnings
for the lenders of any deterioration in the projects creditworthiness, thereby
allowing for corrective actions (including retention of cash) at an earlier stage.
In this respect, tighter covenants can enhance recovery prospects.
Lane Cove Tunnel Finance Pty Ltd.
The Lane Cove Tunnel project (the project) illustrates a repayment structure affected by refinancing
risk, whichis more commonly assumed by investors in Australia and New Zealand than in North
America or other highlydeveloped project finance markets. Fitch assigned a BBB rating to the
standalone credit quality of the bonds(and AAA with the guarantee provided by MBIA Insurance
Corp.). Lane Cove Tunnel Finance PtyLtd. (LCTF), the issuer, is a special-purpose finance company of a
consortium contracted by the New SouthWales Roads and Traffic Authority to design, build, operate
and maintain the project. The tunnel is an integrallink in Sydneys orbital motorway network.
The projects debt comprises senior secured bonds issued, to date, in four tranches ranging
in terms from 1025years for a total of AUD690.83 million. A fifth tranche for AUD451.2 million
is expected to be issued byDecember 2004. The LCTF financing structure incorporates the
expectation of a significant degree ofrefinancing, with bullet repayments on all bonds (except
bond 1 for AUD126.83 million).
The risk of refinancing these bullet payments is partly mitigated by the reasonably
well-spread maturity profileof the bonds and also by a soft bullet structure, which provides for a
two-year extension to the final maturity. Onbond 3 (for AUD191.76 million) and bond 4 (for
AUD259.44 million), a call option also provides a four-yearperiod of flexibility to refinance a
major portion of the debt due. Further, the LCTF consortium is obligated tocommence the
refinancing arrangements of maturing obligations at least 12 months prior to scheduled
maturity,and penalties are imposed on the consortium for refinancing after scheduled maturity.
In its analysis, Fitch undertook a wide variety of sensitivity tests to determine the projects
ability to withstandthe effect of certain stresses. Important structural elements supporting the
financing are reserve accounts forliquidity that are to be drawn upon under stress. A cash-trap or
lock-up provision also helps to ensure that the projectmaintains liquidity and the ability to
effectively deliver (on a net basis) in periods of lower debt-service margins.Therefore, in spite of
the refinancing risk, Fitch concludes that the projects financing structure possessesadequate
capacity for timely payment of interest and principal on the bonds.
Fitchs BBB rating balances the projects credit strengths and concerns. Among the strengths
are thecharacteristics of the transport corridor served by the tunnel and its effect on time
savings; low traffic risk, as theexisting road link is well known; strong counterparties; and the
structural enhancements in the financing,including cash reserves and cash-trap provisions. Among
the credit concerns are refinancing risk (mitigated bythe soft bullet maturity structure), high
leverage and construction risk. A more detailed analysis is summarized inthe credit analysis on
this project dated Jan. 30, 2004, and available on Fitchs Website at www.fitchratings.com.
122
In Fitchs view, traditional covenants that may seem severely restrictive in certain
situations provide valuable signals and control for creditors. However, it is not
necessarily the case, that tight covenants will automatically improve the rating.
The documentation should be carefully tailored to each specific situation.
Fitch acknowledges the trade offs and tensions generated by sponsor or project
owner motivations and interests, commodity market conditions, changes in asset
specifications or scope, economic environment and availability of long-term
financing at reasonable cost, among other variables. In addressing these
wide-ranging concerns, which may engender refinancing risk, a variety of
repayment and other structural elements, may be considered such as the following:
Front-loading amortization in the early years, increasing default probability
but also improving recovery prospectsThis is a sensible approach for mining
and other resourcerelated projects, as well as power plants. Alternatively, a
cash sweep can be used to ensure timely repayment of the debt without
increasing probability of default.
Back-loading amortization, decreasing default probability versus increasing
debt costsToll roads, which are affected by the uncertainties of traffic
flows in the early years but have long economic lives and a growing revenue
stream, might benefit from this repayment structure.
Providing for soft bullet maturitiesThis approach is analogous to the
repayment models of structured finance. Limited deferral of debt principal can
be an effective tool to providing financial flexibility without
exacerbating refinancing risk, as was the case of Tube Lines with the lowest
rated tranche, rated BBB. In some cases, Fitch might require the availability of
a fully funded cash reserve in order to achieve investment-grade ratings targets.
Tranching bullet paymentsInstead of one large bullet maturity, smaller
payments fall under various maturity buckets, limiting refinancing risk in
any one year. In Australias Transurban and Lane Cove Tunnel projects, this
element is employed, making refinancing risk more manageable.
Diversifying source of financingRefinancing risk, especially in
markets vulnerable to a credit crunch or in which longterm maturities are not
available, a combination of bank loans, bonds fully enhanced or
wrapped, unenhanced bonds, and domestic and international credit, among
123
other sources, can mitigate credit and refinancing risk. For Chiles 30-year toll
road projects, a combination of financing sources is relied upon to
limit refinancing and credit risk.
Providing for mandatory prepayment and forward-looking cash lock up
These mechanisms, if implemented properly, can effectively deliver a project
on a net-debt basis (especially where performance is below the base), and
the build up of cash can be used to reduce the level of debt to be refinanced
and, hence, reduce refinancing risks.
Providing for a cash-sweep mechanismThe likelihood that a bullet or
substantial principal payment is due before the projects cash flow has fully
amortized the debt, constitutes a refinancing risk. A viable mitigating mechanism
is a cash sweep, through which excess project cash flow is applied periodically
to the prepayment, or more rapid amortization of principal than provided for in
the credit agreement schedule (as with the Coleto Creek project).
Employing callable debtAt the issuers option, the projects debt would be
called, allowing for a refinancing at a date favorable to the project. Callable
bonds and bank loans are commonly employed for Australian projects.
Limiting the size of the bullet paymentExpress Pipeline is expected to
successfully refinance the Holdco bullet debt, as the bullet payment is due
after the initial project debt is fully repaid. The pipeline also enjoys a
long economic life and access to both the Canadian and US debt markets.
Ostensibly, finding the most suitable repayment structure remains somewhat of
a trial-and-error and evolutionary process. The choice of financing mode for a specific
project is often as much driven by investors concerns and preferences and
market conventions as it is by the projects intrinsic risk profile. From Fitchs viewpoint,
acceptable flexibility in the repayment structure can have a beneficial effect on project
credit quality, assuming that creditors, as provided for by indentures, remain
in control of the asset and the cash flow it generates.
(Fitch Ratings is a leading global rating agency committed to providing the worlds
124
10
Exchange Rate Risk
Philip Gray and Timothy Irwin
Each year developing countries seek billions of dollars of
investmentin their infrastructure, and private investors, mostly
in richcountries, seek places to invest trillions of dollars of new
savings.Private foreign investment in the infrastructure of
developingcountries would seem to hold great promise. But foreign
investorsmust cope with volatile developing country currencies.
Many attemptsto do so have created as many problems as they
have solved. ThisNote proposes that investors take on all
financing-related exchangerate risk, even though this may mean
higher tariffs for consumers asa premium for bearing that risk.
he standard advice on allocating riskto assign it to the party best able to

manage ithas controversial implications for the allocation of exchange rate
risk in a private infrastructure project. Three parties can bear the risk of exchange
rate movements in the first instancethe private investors (whether foreign or
local equity-holders or creditors), the host country government (ultimately, its
taxpayers), and customers of the service. Some argue that investorsor at least
their ultimate shareholdersshould bear the risk because they can diversify away
country-specific exchange rate risk. Others argue that the government should bear
Source: http://rru.worldbank.org/PublicPolicyJournal/Summary.aspx?id=262. 2003, World Bank publication.
Reprinted with permission
Exchange Rate Risk
125
the risk because it is responsible for macroeconomic policies that strongly influence
the exchange rate. Still others argue that customers should bear it because they
must ultimately pay for the cost of the service and the risk can be shared widely
to lessen the impact.
The allocation of exchange rate risk is often done through tariff adjustment
formulas that implicitly share risk through the way they adjust the tariff over
time. If indexation is allowed, tariffs can reflect the exchange rate in several ways:
Allowed prices or revenue can be fully or partially indexed to the exchange rate.
Input costs that depend on the exchange rate can be treated as a pass-through,
so that customers pay the actual costs of the inputs.
The contract can provide for a renegotiation of allowed prices or revenue if
the exchange rate moves outside a specified band.
At one extreme of the risk sharing spectrum, Argentina effectively indexed
100 percent of costs to the dollar. The implications of this are now being fought
out by the investors and the Argentine government, which has prevented significant
tariff increases since the devaluation of the Argentine peso. Most countries use
a hybrid approach to tariff adjustment. Part of the tariff is indexed to local inflation,
part is indexed to dollar inflation, and some costs are straight pass-throughs. But
there is still much debate about what share of the cost base should be indexed to
local inflation and what share to international costs. And tariff adjustment
mechanisms are not the only approachgovernments sometimes provide exchange
rate guarantees to cover repayment of foreign currency debt.
Nature and Sources of Exchange Rate Risk

To shed more light on the debate requires first looking more closely at the nature
and sources of the risk. Exchange rate risk, as defined here, is variability in the
value of a project, or of an interest in the project, that results from
unpredictable variation in the exchange rate.
There are two types of exchange rate riskproject and financing related. Project
exchange rate risk arises when the value of a projects inputs or outputs depends
on the exchange rate. Typical infrastructure projects sell their outputs domestically,
126
so, valued in local currency, revenues usually are not subject to exchange rate risk.
But any input that is tradable, even if it is not imported, will have a world price,
so its cost, measured in local currency, will vary inversely with the exchange rate.
The cost of fuel, for example, creates exchange rate risk for a thermal electricity
generator.
Financing choices affect the amount of exchange rate risk borne by different
participants in the project (shareholders, creditors, customers, taxpayers). In particular,
loans requiring repayment in foreign currency expose shareholders to exchange rate
risk. As a result, shareholders may seek to shape the contractual arrangements to pass
on some or all of the risk to the government or customers (through exchange rate
guarantees or indexation of the tariff to the exchange rate).
Optimal Allocation of Exchange Rate Risk

Parties can manage exchange rate risk in three ways:
They can influence the underlying source of the risk. Governments, for
example, can reduce the rate of depreciation and the volatility of the exchange
rate by keeping budget deficits small and inflation low.
They can influence the sensitivity of the value of a project or of their interest
in it to the risk. Project sponsors, for example, can reduce the sensitivity of
the value of their shareholding to the exchange rate by reducing the projects
reliance on foreign currency debt.
They can hedge or diversify away the risk. Hedging exchange rate risks is
possible in only a few developing countries. But most of the ultimate foreign
shareholders of the project companyindividuals with savings in
mutual funds, pension plans, and life insurancecan diversify their savings,
limiting their exposure to any one countrys exchange rate risk (as defined).
The principle of optimal allocation can therefore be restated as follows
Exchange rate risk should be allocated according to the parties ability and incentives
to influence the exchange rate, change the sensitivity of the value of the project (or
of their interest in it) to the exchange rate, and hedge or diversify away the risk.
Since the principle involves three types of management, its implications are not
clear cut (Table 1).
Exchange Rate Risk
127
Table 1: Ability of Customers, Shareholders,

and Government to Manage Exchange Rate Risk
Customers
Shareholders
Government
Influence over exchange rate
None
None
Great
Influence over sensitivity of
Limited, but can
Limited, but can
Little
project to exchange rate
change consumption
in response to changes
in the cost of tradable
inputs
sometimes change
inputs in response
to changes in the
cost of tradable
inputs
Ability to cope with risk by

hedging or diversification
Little
Great (through
diversification)
Little
None
None
Great
Influence over sensitivity of

value of investors interest in
company to exchange rate
None
Great (through
choice of financial
structure)
None
Ability to cope with risk by

hedging or diversification
Little
Project Risk
Financing-related Risk
Influence over exchange rate
Great (through
diversification)
Little
The governments influence over the exchange rate is one factor that, other
things equal, argues in favor of allocating project and financing-related exchange
rate risk to the government. But this argument should not carry too much weight.
Allocating the risk to the government is unlikely to improve the quality of
its decisions affecting the exchange rateboth because the relationship between
the exchange rate and the governments financial position is affected in complex
ways by many factors unrelated to the project and because governments do not
respond to financial incentives in the same way as firms and individuals do.
If the government does not assume the exchange rate risk, the risk must be
shared between customers and investors (shareholders). Neither can influence the
exchange rate, so the choice turns on the other two factors.
First, consider project exchange rate risk. Customers can sometimes influence
the sensitivity of a projects value to the exchange rate by changing their consumption
levels in response to changes in the cost of tradable inputs. When the cost of fuel
128
rises as the exchange rate depreciates, customers may be able to mitigate the adverse
effect on a power projects value by cutting their electricity consumption.
In other cases, investors may be better placed to mitigate project exchange rate risk.
For example, they may be able to change the mix of inputs (using more hydro and
less thermal power) to soften the effect of depreciation. Shareholders are also better
placed than customers to diversify away or hedge exchange rate riskbecause of
their ability to diversify risk in equity markets and, in a few developing countries, to
hedge risk using exchange rate derivatives.
This suggests that project exchange rate risk should be shared between investors
and customers according to their ability to respond in value-enhancing ways to
changes in the exchange rateerring toward investors, given their greater ability
to hedge or diversify away the risk. For many infrastructure projects, however,
project exchange rate risk is small. Financing-related exchange rate risk tends to
loom much larger. Should investors or customers bear this risk?
Customers are in a poor position to manage the risk because they have no influence
over the sensitivity of the value of shareholders interest in the project, to the exchange
rate (they have no control over whether the investors decide to use financing that
creates exchange rate risk). Moreover, most customers have no good natural hedges
against the risk of currency fluctuationsand in most developing countries no
realistic opportunities to acquire hedges or diversify away the risk. Indeed, because
exchange rates tend to fall during macroeconomic crises, their ability to pay higher
tariffs is likely to be lowest just when the exchange rate has fallen.
Investors, however, choose financing and thus control the extent of financingrelated exchange rate risk; and their ultimate shareholders are well placed to diversify
away much of the risk they choose to take on.
Implications for Prices and Financing

Although investors should generally face some project and all financing-related
exchange rate risk, they still need to be able to recoup their costs and make a
return that is reasonable, given the risks they take. Not protecting investors from
exchange rate risk may well imply higher tariffs. Moreover, if tariffs are not linked
to the exchange rate, they need to be linked to an index of local inflation, possibly
adjusted to reflect the cost of inputs more closely. For example, an electricity utilitys
Exchange Rate Risk
129
tariffs might be linked to an index, in which the price of fuel has greater weight
than in the consumer price index. Over the long-term, the effect on prices will be
similar whether tariffs are linked to local inflation or to the exchange rate (see the
companion Note). But with a link to local inflation, currency crises will tend not
to cause such immediate, politically perilous price increases.
What are the implications for financing if neither the host country government
nor customers, protect foreign investors from financing-related exchange rate risk?
Unless the government provides explicit subsidies in place of the implicit subsidies
where taxpayers or customers bear the exchange rate risk:
Projects may be able to raise less financing, with shorter terms and higher
initial rates.
Traditional project finance deals, with dollar-denominated debt financing
a large share of the project cost, may be less feasible, leading to greater use
of local currency debt and local and foreign equity and therefore higher
initial rates of return and higher project prices.
In East Asian and other countries with high savings rates, the prospects for
raising more local equity and debt for infrastructure seem promising. Elsewhere,
progress will take longer. But governments can help by facilitating the
development of local capital markets and contractual savings institutions, such
as pension funds and insurance companiesby ensuring that tariff formulas
do not implicitly discourage local currency financing.
While foreign debt financing will be scarcer, innovative financing structures
offer solutions. The Tiet project in Brazil illustrates one approach to mitigating
investors exposure to financing-related exchange rate risk. To finance the generating
facilities, AES (the US parent company of the operator, AES Tiet) issued US$300
million in US dollar bonds with an average maturity of ten years, at rates less than
those paid by the Brazilian government for debt of an equivalent maturity. The
project sells power at prices indexed to local inflation with no provision for changes
in the exchange rate. If the exchange rate declines substantially and AES Tiet has
insufficient cash to pay its debt service, however, it may draw on a US$30 million
liquidity facility (revolving loan) provided by the US Overseas Private Investment
Corporation. Once local inflation has caught up with the exchange rate reduction,
130
AES Tiet will repay the advances from cash that would otherwise have gone to
shareholders.
Conclusion
Despite the drawbacks of high levels of foreign currency debt, the argument for
foreign capital remains. Developing countries need investment in infrastructure,
and local debt and equity investors may well be unable to meet all the costs of the
investment efficiently. The problem with many deals is the mix of foreign capital
many projects have too much dollar-denominated debt, which drives the demand
for allocating exchange rate risk to governments and consumers. While allocating
the risk this way keeps the initial financing costs low, it risks a blowup in the
longer term. Reducing reliance on foreign debt may mean that the volumes of
private finance mobilized in the 1990s for greenfield projects and privatizations
in developing countries will not be forthcomingand that the initial costs of
finance will be higher. But the benefits may be longer-lived, and more robust
investments that can weather the vagaries of emerging markets.
(Philip Gray (pgray@worldbank.org) is a senior private sector development specialist,
and Timothy Irwin (tirwin@worldbank.org) a senior economist, at the World Bank.)
Note
This Note is a companion to Philip Gray and Timothy Irwin, Exchange Rate Risk: Reviewing the Record
for Private Infrastructure Contracts, Viewpoint 262 (World Bank, Private Sector and Infrastructure
Network, Washington, DC, 2003). For different perspectives on the issue, see Ignacio Mas, Managing
Exchange Rateand Interest RateRelated Project Exposure: Are Guarantees Worth the Risk? in Timothy
Irwin, Michael Klein, Guillermo E Perry, and Mateen Thobani, eds., Dealing with Public Risk in
Private Infrastructure, Latin American and Caribbean Studies Viewpoint (Washington, DC: World Bank,
1997); and Joe Wright, Tomoko Matsukawa, and Robert Sheppard, Foreign Exchange Risk Mitigation
for Power and Water Projects in Developing Countries, Energy and Mining and Water and Sanitation
Sector Boards Discussion Paper (World Bank, Washington, DC, 2003).
Contingent Liabilities for Infrastructure...
131
11
Contingent Liabilities for Infrastructure
Projects: Implementing a Risk
Management Framework for Governments
Christopher M Lewis and Ashoka Mody
To manage their exposure arising from guarantees to
infrastructure projects, governments need to adopt modern risk
management techniques. As guarantees come due only if particular
events occur and involve no immediate cost to the government,
they rarely appear in the government accounts or have funds
budgeted to cover them. This Note introduces an integrated risk
management system that draws on recent advances in the private
sector. The system, adapted for use in the public sector, enables
governments to budget for expected losses and to set aside reserves
against unexpected losses, thus avoiding the budgetary stress
associated with redirecting scarce public resources to cover a
sudden increase in costs.
Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/148mody.pdf. World Bank publication. Reprinted

with permission. This Note is based on a longer paper by the authors in Timothy Irwin, Michael Klein, Guillermo
E Perry, and Mateen Thobani, eds., Dealing with Public Risk in Private Infrastructure (Latin American and
Caribbean Studies, Washington, D.C.: World Bank, 1998).
132
ver the past several years many large multinational firms, including Bankers
Trust, Chase Manhattan, and Microsoft, have implemented enterprisewide
systems for risk management. For each risk identified as important, these firms
determine the best approach for improving their management of exposure, whether
by insuring, transferring, mitigating, or retaining the risk. The goal is not just to
hedge a fixed set of risk exposures, but to determine the areas and lines of business
in which a company is willing to retain risks in order to generate target returns.
Adapted to the public sector environmentand customized to reflect the
governments budgetary and regulatory processes, the legislative and legal
environments, and the risks being evaluatedthis approach can be used to manage
a governments exposure to risk, particularly contingent liability risk. The model
broadly involves six steps:
Identifying the governments risk exposures.
Measuring or quantifying expected and unexpected exposures.
Provisioning for expected costs in the budgetary process.
Assessing the governments tolerance for bearing risk.
Using the governments risk tolerance as a basis for establishing policies
and procedures for structuring reserves against unexpected losses.
Implementing risk mitigation and control mechanisms to prevent unintended
losses on those risks and establishing systems to continually monitor and
reassess the governments risk exposure over time.
As in the private sector, these steps should be applied to four general categories
of riskfinancial, operational, business, and event risk.
Measuring Risk
A governments exposure to loss can arise from a wide variety of events, and attempting
to account for every source of exposure is not feasible. A better approach, and that
followed in the private sector model, is to first examine general categories of risk and
then focus on the areas of highest risk (see Figure 1 for a lattice of generic risks). The
next step is to value the expected and unexpected losses (see Box 1 for a definition of
expected and unexpected losses). The valuation techniques used will depend on the
133
type of risk being analyzed and the data available. Actuarial and econometric models
can be used to estimate exposures, but both techniques require substantial data on
the performance of a program (or on a comparable program). For project finance,
where deals are unique and data records often missing or of low quality, more advanced
modeling approaches are required. The most powerful are those commonly used to
value options in financial markets; these can be applied to value direct loans, loan
guarantees, and insurance contracts granted to support infrastructure liabilities.
Figure 1: Risk Identification Lattice

Government Risk Exposure
Financial Risk
Business Risk
Opurational Risk
Event Risk
Market Risk
Strategic Risk
Production Risk
Political Risk
Liquidity Risk
Management Risk
Legal Risk
Exogenous Risk
Credit Risk
System Risk
Budgeting for Expected Costs

Armed with a measure of risk exposure for expected costs, a government can use
the information as a budgetary control mechanism and work out how to improve
the budgetary process to provide stronger incentives for risk management. The
government could publish its risk exposure in the national budget, use it to
establish exposure limits or credit limits, or use it to develop risk-adjusted
performance measures. (Such measures could be applied to reward programs that
deliver social benefits with the least risk to the public budget.)
The main impediment to implementing these options is the cash budget
accounting system used by most governments. While private institutions compute
virtually all investment decisions, expenditures, plans, and budget forecasts on a
present value basis, most government bodies account for credit and insurance
products using a simple cash-based system of budgeting. Cash-based budgeting
misrepresents and masks the aggregate exposure associated with loan guarantees and
134
government insurance programs, and creates perverse incentives for selecting one form
of financing assistance over another. To see how these incentives skew
decision-making, consider the different ways in which a government could help
finance a US$100 loan to a private infrastructure provider. If the government provides
a ten percent loan subsidy, the cash budget cost would be US$10 in year one. If
it provides the loan directly, the cash budget cost in year one would be US$100
the full face value of the loan. And if it agrees to guarantee a loan by a private bank,
the budgetary cost would be zero (or negative if a guarantee fee is collected) in the
first year. Thus while the economic and financial values of the three forms of
financial assistance are equal, a legislative body would favor the guarantee option.
Only by enforcing budgetary controls at the time the financial assistance is
committed, can the budgetary incentives be realigned to eliminate this effect.
Many governments face significant legal, regulatory, and political hurdles in
moving from current budgetary practices to a full accounting of the risks of
contingent liabilities. Often governments prefer incremental changes or interim
steps to smooth the transition. Implementing risk-adjusted performance measures
allows governments to manage their exposures to contingent liabilities, even if an
immediate change in national budgetary policy is not feasible. Nonbudgetary
Box 1: Defining Expected and Unexpected Losses
Consider a government loan guarantee program
Probability
Exposure
(Percent)
(millions of US dollars)
Probability distribution. While the expected
costs of the program (the mean of the
distribution) are US$10, losses
15
will exceed this expectation
15
35 percent of the time. That means that if the
25
10
government sets reserves only to cover expected
15
12
losses, it will have to request outcomes of the
14
guarantee. For a portfolio of thirty similar
16
programs and with five-year guarantees, the
18
central government would have to go to the
2.5
20
legislature twice a year for additional funds.
2.5
30
characterized by the following very simple
135
control mechanisms for contingent liabilities (publishing information, establishing

credit quotas or exposure limits, and earmarking future funds to cover guarantee
costs) also could be used during a transition to a new budgetary system. And
they could be used on a permanent basis for liabilities grandfathered during a
change in budgetary policy or as a permanent management solution if the
government fails to enact a change in the budget law.
Reserving for Unexpected Costs

In addition to budgeting for the full expected present value of costs, governments
need to set aside reserves against unexpected losses. For a private firm with multiple
lines of business, determining the appropriate level of capital or reserves is a complex
procedure that takes into account both the variability of losses for each product line
and the correlation between product returns and the opportunity cost of capital.
A private firm must also weigh the expectations of shareholders and stakeholders,
rating agencies, and business partners in determining the optimal level of capital.
The capital or reserves held by an enterprise reflect its relative risk aversion and its
ability to withstand a specific level of unexpected losses. Thus, a firm seeking a
AAA rating will hold considerably more capital against unexpected losses
(say, capital to cover a 99 percentile event over a one-year period), than a firm
seeking an A rating (capital to cover a 90 percentile event).
Similar pressures come into play in assessing government tolerance for risk.
But the assessment must also consider the unique question of how often the
executive wants to go to the legislature for funds. Once the proper valuation
tools are in place, the government can set reserve policy, based on an assessment
of its aversion to making frequent funding requests. The governments leverage
considerations will also be different from those in the private sector. Holding more
funds in reserve increases the liquidity of the guarantees that the reserve supports,
increasing their value and allowing the government to leverage more private
funding in the guarantee program. But, reserving funds in a separate
account reduces the money available for other public sector projects and services.
If the net benefits of additional public spending exceed the liquidity benefits of
adding to the guarantee reserve, the government may want to direct
additional funds toward public spending.1
136
Setting Reserves
Having assessed which risks and what level of loss it is willing to bear, the
government can set its reserves against unexpected losses (risk capital) in its
credit and insurance programs. But first, it needs to determine whether reserves
will be set based on the additive unexpected loss exposure of each guarantee or on
a portfolio value-at-risk approach to account for portfolio diversification, what
the investment policy of the reserves will be, and where the reserves should reside.
Under an additive reserve standard, the government calculates the unexpected
loss exposure of each of its contingent liabilities independently (that is, examines
the sensitivity of each guarantee valuation to changes in the underlying factors).
Then, for a given confidence level and time interval, it determines the amount
of unexpected loss it wishes to cover for each guarantee, taking into consideration
the opportunity cost of capital. It then identifies the average cash reserve required
to fund these unexpected losses. Finally, it aggregates the individual cash reserve
balances to arrive at a total unexpected loss reserve.
The problem with the additive approach is that it fails to account for portfolio
diversification the fact that pooling imperfectly correlated risks will reduce the
variance in the expected loss of a portfolio. As a result the risk of the overall portfolio
will be overstated, and more protection against unexpected losses provided
than originally sought by the government. The alternative is to calculate the aggregate
loss distribution of the governments portfolio of risks, using a value-at-risk approach
that incorporates cross-correlations between guarantee exposures, and then set reserves
to cover unexpected losses based on the unexpected loss profile of the entire portfolio.
Investing Reserves
The objective in investing the reserve funds should be to maximize the value of the
assets when the costs to the government increase that is, to invest the reserve
funds in assets that provide the best hedge against the governments cost for a given
return. In doing this, the government may achieve better results by managing its
assets and liabilities at the balance sheet level rather than on a program basis.
The government also needs to decide whether to hold its reserves offshore, in
a foreign currency, or domestically, in the domestic currency. If the guarantees
137
are denominated in dollars, the government should consider investing the reserve
fund in dollar assets and possibly keep the reserve offshore to circumvent
convertibility risk issues. This strategy would greatly enhance the market value of
the guarantees and provide the government with greater leverage from the guarantee
program. However, decisions on the location of the reserves must be made in the
context of the governments broader foreign currency risk management program.
Next Step
This approach to risk management also provides a mechanism for governments to
critically assess the distribution of risks within a loan guarantee or insurance
program and come up with better designed contracts and fewer and smaller calls
on guarantees. And as risks change over time, the framework provides a basis for
easy reestimation and quick adjustments to the budgetary and reserve system.
(Christopher M Lewis is Managing Director of Fitch Risk Advisory, a division of
Fitch Risk. Ashoka Mody (amody@worldbank.org) is Project Finance and Guarantees
Department, World Bank.)
Endnote
1
When a private company assesses the tradeoff between holding reserves and investing in other
programs, it usually has a targeted economic return that helps guide its capital policy. For a
government the comparable concept is social return. Calculating social return requires a complete
asset-liability management program that goes beyond the valuation of infrastructure liabilities or
other forms of direct loans, loan guarantees, and insurance. This Note focuses on reserving against
contingent liabilities without considering a broader asset-liability management policy.
138
The Syndicated Loan Market: Structure, Development and Implications
Section IV
Financing Projects
139
140
141
12
The Syndicated Loan Market: Structure,
Development and Implications1
Blaise Gadanecz
This special feature has presented a historical review of the
development of the market for syndicated loans, and has shown
how this type of lending, which started essentially as a sovereign
business in the 1970s, evolved over the 1990s to become one of the
main sources of funding for corporate borrowers. The syndicated
loan market has advantages for junior and senior lenders. It
provides an opportunity to senior banks to earn fees from their
expertise in risk origination and manage their balance sheet
exposures. It allows junior lenders to acquire new exposures without
incurring screening costs in countries or sectors where they may
not have the required expertise or established presence. Primary
loan syndications and the associated secondary market therefore
allow a more efficient geographical and institutional sharing of
risk origination and risk-taking.
The views expressed in this article are those of the author and do not necessarily reflect those of the BIS. I would like
to thank Claudio Borio, Mr Gudmundsson, Eli Remolona and Kostas Tsatsaronis for their comments, Denis Ptre for
help with database programming, and Angelika Donaubauer for excellent research assistance.
Source: http://www.bis.org/publ/qtrpdf/r_qt0412g.pdf. December 2004. BIS Quarterly Review. Reprinted with

permission. The full publication is available free of cost on the BIS website.
142
he syndicated loan market allows a more efficient geographical and institutional

sharing of risk. Large US and European banks originate loans for emerging
market borrowers and allocate them to local banks. Euro area banks have expanded
pan-European lending and have found funding outside the euro area.
Syndicated loans are credits granted by a group of banks to a borrower. They

are hybrid instruments combining features of relationship lending and publicly
traded debt. They allow the sharing of credit risk between various financial
institutions without the disclosure and marketing burden that bond issuers face.
Syndicated credits are a very significant source of international financing, with
signings of international syndicated loan facilities accounting for no less than a
third of all international financing, including bond, commercial paper and equity
issues (Graph 1).
This special feature presents a historical review of the development of this
increasingly global market and describes its functioning, focusing on participants,
pricing mechanisms, primary origination and secondary trading. It also gauges its
degree of geographical integration. We find that large US and European banks
tend to originate loans for emerging market borrowers and allocate them to local
banks. Euro area banks seem to have expanded pan-European lending and have
found funding outside the euro area.
Development of the Market

The evolution of syndicated lending can be divided into three phases. Credit
syndications first developed in the 1970s as a sovereign business. On the eve of
the sovereign default by Mexico in 1982, most of developing countries debt
consisted of syndicated loans. The payment difficulties experienced by many
emerging market borrowers in the 1980s resulted in the restructuring of Mexican
debt into Brady bonds in 1989. That conversion process catalysed a shift in patterns
for emerging market borrowers towards bond financing, resulting in a contraction
in syndicated lending business. Since the early 1990s, however, the market for
syndicated credits has experienced a revival and has progressively become the
biggest corporate finance market in the United States. It was also the largest source
of underwriting revenue for lenders in the late 1990s (Madan et al., 1999).
143
The first phase of expansion began in the 1970s. Between 1971 and 1982,
medium-term syndicated loans were widely used to channel foreign capital to the
developing countries of Africa, Asia and especially Latin America. Syndication
allowed smaller financial institutions to acquire emerging market exposure without
having to establish a local presence. Syndicated lending to emerging market
borrowers grew from small amounts in the early 1970s to $46 billion in 1982,
steadily displacing bilateral lending.
Graph 1: Syndicated lending since the 1980s
Gross signings, in billions of US dollars
Total
International
12
12 Syndicated credits
12
12
1 Money market instruments
1,500
1,000
500
86
90
1
94
98
02
1
12
and notes
12Bonds
Equities
3,000
12
12
12
12
11
12
11 12
12 12
12 2,000
12 1 12
12 1212
11 1212
1
12
12
1212
12 11 11 1212
12 12
1
12
12
1
12
12
1
1212
12
112
1212
12
1 12
12
1
1
1
1
12
12
12
1
12
121 1 1212
12 12
12 12
12
1
1
12
1
12
1
12
12
1
12 1 1212
1 1212
12
12
12 1,000
12
112
1121 1212
112
12
121211 1 12
1 1 12
12
12
112
1212
11212
1212
12 12
12
1
12
12
1
12
1
12
12
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1
12
12
12
1
12
1
12
1
12
1
12
12
12
1
12
12
12
1
12
1
12
12
12
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12
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1
12
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1
12
1212
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1212
12
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1 1212
1 1212
1 1212
12
12
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1
112
112
112
112
112
12
12
12
1112
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1121 12
1 1 12
12
1 1 12
12
12
12
112
12
12
12
12
12
12
12
12
12
1
12
1
12
12
1
1
1
12
1
1
12
12
12
12
1
1
12
1
12
12
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1
12
12
1212111212
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12 12
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1
12
12
12
11 1 1212
11 1 1212
1
12
12
1
12
1
94
96
98
12
00
12
02
Of international and domestic syndicated credit facilities.
Sources: Dealogic Loanware; Euromoney; BIS.
Lending came to an abrupt halt in August 1982, after Mexico suspended

interest payments on its sovereign debt, soon followed by other countries including
Brazil, Argentina, Venezuela and the Philippines. Lending volumes reached their
lowest point at $9 billion in 1985. In 1987, Citibank wrote down a large proportion
of its emerging market loans and several large US banks followed suit. That move
catalysed the negotiation of a plan, initiated by US Treasury Secretary Nicholas
Brady, which resulted in creditors exchanging their emerging market syndicated
loans for Brady bonds, eponymous debt securities whose interest payments and
principal benefited from varying degrees of collateralisation on US Treasuries.
The Brady plan provided a new impetus to the syndicated loan market. By the
beginning of the 1990s, banks, which had suffered severe losses in the debt crisis,
144
started applying more sophisticated risk pricing to syndicated lending (relying in

part on techniques initially developed in the corporate bond market). They also
started to make wider use of covenants, triggers which linked pricing explicitly to
corporate events such as changes in ratings and debt servicing. While banks became
more sophisticated, more data became available on the performance of loans,
contributing to the development of a secondary market which gradually attracted
non-bank financial firms, such as pension funds and insurance firms. Eventually,
guarantees and unfunded2 risk transfer techniques such as synthetic securitisation
enabled banks to buy protection against credit risk while keeping the loans on the
balance sheet. The advent of these new risk management techniques enabled a
wider circle of financial institutions to lend on the market, including those whose
credit limits and lending strategies would not have allowed them to participate
beforehand. Partly, lenders saw syndicated loans as a loss-leader for selling more
lucrative investment banking and other services. More importantly, in addition
to borrowers from emerging markets, corporations in industrialised countries
developed an appetite for syndicated loans. They saw them as a useful, flexible
source of funds that could be arranged quickly and relied upon to complement
other sources of external financing such as equities or bonds.
As a result of these developments, syndicated lending has grown strongly from
the beginning of the 1990s to date. Signings of new loansincluding domestic
facilitiestotalled $1.6 trillion in 2003, more than three times the 1993 amount.
Borrowers from emerging markets and industrialised countries alike have been
tapping the market, with the former accounting for 16% of business and, for the
latter, an equal split between the United States and western Europe (Graph 2).
Syndicated lending in Japan reportedly makes up just a smallalbeit growing
fraction of total domestic bank lending, not least because of the traditional
importance of main banks for corporations.
Syndicated credits have thus become a very significant source of financing.
The international market3 accounts for about a third of all international financing,
including bond, commercial paper and equity issues. The proportion of merger,
2
In an unfunded risk transfer, such as a credit default swap, the risk-taker does not provide upfront funding in the
transaction but is faced with obligations depending on the evolution of the borrower's creditworthiness.
An international syndicated loan is defined in the statistics compiled by the BIS as a facility for which there is at least
one lender present in the syndicate whose nationality is different from that of the borrower.
145
acquisition- and buyout-related loans represented 13% of the total volume in

2003, against 7% in 1993. Following a spate of privatisations in emerging markets,
banks, utilities, and transportation and mining companies4 have started to displace
sovereigns as the major borrowers from these regions (Robinson (1996)).5
Graph 2: Syndicated Lending by Nationality of Borrower
Gross signings, in billions of US dollars
Industrial Countries
Emerging markets
Other
123
123Euro area
12
12Japan
Middle East & Africa

12
12
Eastern Europe
123
200
123
123 Latin America
123
12312
12
2,000
123
123United Kingdom
123
123
1231234 123 1,500
123
1231234123123
123
123
123
123
123123
123123
1234123123
123
1234
123
123412
123
123
12
1231234123
123123
123123
123123
123
123
123
123
123
1234
123
123
123
123 1,000
12
123
123123
1234
123
123
123
123
123
123123
123
123
123
United States
123
12
123
123
123
123
123
93
500
95
97
99
01
03
123
123
123
123123
123123
1234
123
1234123
123123
123
1234
123
1234123123
123
1234
123
123
1234
123
1234123123
123
1234
123
1234123123
123
93
95
Asia-Pacific
123
123
123
123
123
123123
123
123123
123
123
123123
123
123123
123
123
123
123123
123
123
123123
123123
123123
123123
123
123123123
123
123
123123
123123
123
97
150
123
123
123
123
123
123
123
123
123
123123
123
123
123123
123
123
123123
123
123
123
123
123123
123
123
123123
123
123
123123
123123
123
99
01
123
123
123
123
123
123
123 100
123
123
123
123
123
123123
123
123
123123
123 50
123
123
123
123123
123
123
123123
123
03
Source: Dealogic Loanware.
A hybrid between relationship lending and disintermediated debt

In a syndicated loan, two or more banks agree jointly to make a loan to a borrower.
Every syndicate member has a separate claim on the debtor, although there is a
single loan agreement contract. The creditors can be divided into two groups.
The first group consists of senior syndicate members and is led by one or several
lenders, typically acting as mandated arrangers, arrangers, lead managers or agents.6
These senior banks are appointed by the borrower to bring together the syndicate
of banks prepared to lend money at the terms specified by the loan. The syndicate
is formed around the arrangersoften the borrowers relationship bankswho
retain a portion of the loan and look for junior participants. The junior banks,
4
Syndicated loans are widely used to fund projects in these sectors, in industrial and emerging market countries alike.
A feature article on page 91 of this BIS Quarterly Review explores the nature of credit risk in project finance.
Interestingly, for most of the 1990s, emerging market borrowers were granted longer-maturity loans, five years on
average, than industrialised country ones (three-four years).
These bank roles, enumerated here in decreasing order of seniority, involve an active role in determining the syndicate
composition, negotiating the pricing and administering the facility.
146
typically bearing manager or participant titles, form the second group of creditors.
Their number and identity may vary according to the size, complexity and pricing
of the loan as well as the willingness of the borrower to increase the range of its
banking relationships.
Thus, syndicated credits lie somewhere between relationship loans and
disintermediated debt (Dennis and Mullineaux, 2000). Box 1 below shows, in
decreasing order of seniority, the banks that participated in a simple syndicate
structure to grant a loan to Starwood Hotels & Resorts Worldwide, Inc in 2001.
Senior banks may have several reasons for arranging a syndication. It can be a
means of avoiding excessive single-name exposure, in compliance with regulatory
limits on risk concentration, while maintaining a relationship with the borrower.
Box 1: Example of a Simple Syndicate Structure Starwood
Starwood Hotels & Resorts Worldwide, Inc
$250 million
Two-year term loan, signed 30 May, 2001

Loan purpose: General corporate
Pricing: Margin: Libor + 125.00 bp; commitment fee: 17.50 bp
Mandated arranger
Deutsche Bank AG
Bookrunner
Deutsche Bank AG
Participants
Deutsche Bank AG
Bank One NA
Citibank NA
Crdit Lyonnais SA
UBS AG
Administrative agent
Deutsche Bank AG
Source: Dealogic.
mandated to originate,
structure and syndicate the
transaction
issues invitations to participate
in the syndication, disseminates
information to banks and
informs the borrower about the
progress of the syndication
banks providing funds
title given to the arranger of a

syndicated transaction in the US
market
147
Or it can be a means to earn fees, which helps diversify their income. In essence,
arranging a syndicated loan allows them to meet borrowers demand for loan
commitments without having to bear the market and credit risk alone.
For junior banks, participating in a syndicated loan may be advantageous for
several reasons. These banks may be motivated by a lack of origination capability
in certain types of transactions, geographical areas or industrial sectors, or indeed
a desire to cut down on origination costs. While junior participating banks typically
earn just a margin and no fees, they may also hope that in return for their
involvement, the client will reward them later with more profitable business,
such as treasury, management, corporate finance or advisory work (Allen (1990))7
Pricing Structure: Spreads and Fees

As well as earning a spread over a floating rate benchmark (typically Libor) on the
portion of the loan tha is drawn, banks in the syndicate receive various fees (Assen
(1990), Table 1). The arranger8 and other members of the lead management team
generally earn some form of upfront fee in exchange for putting the deal together.
This is often called a praecipium or arrangement fee. The underwriters similarly
earn an underwriting fee for guaranteeing the availability of funds. Other participants
(those at least on the manager and co-manager level) may expect to receive a
participation fee for agreeing to join the facility, with the actual size of the fee
generally varying with the size of the commitment. The most junior syndicate
members typically only earn the spread over the reference yield. Once the credit is
established and as long as it is not drawn, the syndicate members often receive an
annual commitment or facility fee proportional to their commitment (largely to
compensate for the cost of regulatory capital that needs to be set aside against the
commitment). As soon as the facility is drawn, the borrower may have to pay a per
annum utilisation fee on the drawn portion. The agent bank typically earns an agency
fee, usually payable annually, to cover the costs of administering the loan. Loans
sometimes incorporate a penalty clause, whereby the borrower agrees to pay a
prepayment fee or otherwise compensate the lenders in the event that it reimburses
7
In practice, though, these rewards fail to materialise in a systematic manner. Indeed, anecdotal evidence for the United
States suggests that, for this reason, smaller players have withdrawn from the market lately and have stopped extending
syndicated loans as a lossleader.
For this discussion, it has to be recalled that the same bank can act in various capacities in a syndicate. For instance, the
arranger bank can also act as an underwriter and/or allocate a small portion of the loan to itself and therefore also be a
junior participant.
148
Table 1: Structure of Fees in a Syndicated Loan

Fee
Type
Remarks
Arrangement fee
Front-end
Also called praecipium. Received and retained by the

lead arrangers in return for putting the deal together.
Legal fee
Front-end
Remuneration of the legal adviser.
Underwriting fee
Front-end
Price of the commitment to obtain financing during the

first level of syndication.
Participation fee
Front-end
Received by the senior participants.
Facility fee
Per annum
Payable to banks in return for providing the facility,

whether it is used or not.
Commitment fee
Per annum,
charged on
undrawn part
Paid as long as the facility is not used, to compensate the

lender for tying up the capital corresponding to the
commitment.
Utilisation fee
Per annum,
charged on
drawn part
Boosts the lenders yield; enables the borrower to

announce a lower spread to the market than what is
actually being paid, as the utilization fee does not always
need to be publicized.
Agency fee
Per annum
Remuneration of the agent banks services
Conduit fee
Front-end
Remuneration of the conduit bank1
Prepayment fee
One-off if
prepayment
Penalty for prepayment
The institution through which payments are channelled with a view to avoiding payment of
withholding tax. One important consideration for borrowers consenting to their loans being
traded on the secondary market is avoiding withholding tax in the country where the acquirer of
the loan is domiciled.
Source: Compiled by author.
any drawn amounts prior to the specified term. Box 1 above provides an example of
a simple fee structure under which Starwood Hotels & Resorts Worldwide, Inc has
had to pay a commitment fee in addition to the margin.
At an aggregate level, the relative size of spreads and fees differs systematically in
conjunction with a number of factors. Fees are more significant for Euribor-based
than for Libor-based loans. Moreover, for industrialised market borrowers, the share
of fees in the total loan cost is higher than for emerging market ones. Arguably this
could be related to the sectoral composition of borrowers in these segments.
149
Non-sovereign entities, more prevalent in industrialised countries, may have a keener

interest, for tax or market disclosure reasons, in incurring a larger part of the total
loan cost in the form of fees rather than spreads. However, the total cost (spreads,
front end and annual fees)9 of loans granted to emerging market borrowers is higher
than that of facilities extended to industrialised countries (Graphs 3 and 4). There
is also more variance in commitment fees on emerging market facilities. In sum,
lenders seem to demand additional compensation for the higher and more variable
credit risk in emerging markets, in the form of both spreads and fees.
Spreads and fees are not the only compensation that lenders can demand in
return for assuming risk. Guarantees, collateral and loan covenants offer the
possibility of explicitly linking pricing to corporate events (rating changes, debt
servicing). Collateralisation and guarantees are more often used for emerging market
borrowers (Table 2), while covenants are much more widely used for borrowers in
industrialised countries (possibly because such terms are easier to enforce there).
Graph 3: Spreads and Fees1
(In basis points)
Quarterly averages weighted by facility amounts. Front-end fees have been annualised over
the lifetime of each facility and added to annual fees.

9
One should note that the fees shown in Graphs 3 and 4 are not directly comparable. In Graph 3, for the purposes of
comparability with spreads, annual and front-end fees are added together by annualising the latter over the whole
maturity of the facility, assuming full and immediate drawdown. Graph 4, on the other hand, shows annual and frontend fees separately without annualising the latter.
150
Graph 4: Breakdown of Fees1
Quarterly averages weighted by facility amounts.

borrowers only.
Not annualised.
(In basis points)
Industrialised country
Primary and Secondary Markets: Sharing Versus Transferring Risk

While commercial banks dominate the primary market, both at the senior arranger
and at the junior funds provider levels, other institutions have made inroads over
time. Globally, there are virtually no non-commercial banks or non-banks among
the top 200 institutions that have around 90% market share. However, investment
banks have benefited from the revival of syndicated lending in the 1990s. They
have taken advantage of their expertise as bond underwriters and of the increasing
integration of bank lending and disintermediated debt markets10 to arrange loan
syndications. Besides the greater involvement of investment banks, there is also
growing participation by multilateral agencies such as the International Finance
Corporation or the Inter- American Development Bank.11
Syndicated credits are increasingly traded on secondary markets. The
standardisation of documentation for loan trading, initiated by professional bodies
such as the Loan Market Association (in Europe) and the Asia Pacific Loan Market
10
For instance, it is very common nowadays for a medium-term loan provided by a syndicate to be refinanced by a bond
at, or before, the loans stated maturity. Similarly, US commercial paper programmes are frequently backed by a
syndicated letter of credit.
11
This provides an opportunity for risk-sharing between public and private sector investors. It usually takes the form of
syndicated loans granted by multilateral agencies with tranches reserved for private sector bank lenders.
151
Table 2: Non-price Components in the Remuneration of Risk
Share of syndicated loans with covenants, collateral and guarantees, in percent, by nationality of borrower
Covenants
Collateral
Guarantees
Emerging
Industrialised
Emerging
Industrialised
Emerging
Industrialised
199396
16
40
15
31
19972000
24
49
16
22
200104 1
19
37
13
21
First quarter only for 2004.
Association, has contributed to improved liquidity on these markets. A measure

of the tradability of loans on the secondary market is the prevalence of transferability
clauses, which allow the transfer of the claim to another creditor.12 The US market
has generated the highest share of transferable loans (25% of total loans between
1993 and 2003), followed by the European marketplace (10%). The secondary
market is commonly perceived to consist of three segments: par/near par, leveraged
(or high-yield) and distressed. Most of the liquidity can be found in the distressed
segment. Loans to large corporate borrowers also tend to be actively traded.
Participants in the secondary market can be divided into three categories:
market-makers, active traders and occasional sellers/investors. The marketmakers
(or two-way traders) are typically larger commercial and investment banks,
committing capital to create liquidity and taking outright positions. Institutions
actively engaged in primary loan origination have an advantage in trading on the
secondary market, not least because of their acquired skill in accessing and
understanding loan documentation. Active traders are mainly investment and
commercial banks, specialist distressed debt traders and socalled vulture funds
(institutional investors actively focused on distressed debt). Non-financial
corporations and other institutional investors such as insurance companies also
trade, but to a lesser extent. As a growing number of financial institutions establish
loan portfolio management departments, there appears to be increasing attention
paid to relative value trades. Discrepancies in yield/return between loans and
other instruments such as credit derivatives, equities and bonds are arbitraged
away (Coffey (2000), Pennacchi (2003)). Lastly, occasional participants are present
on the market either as sellers of loans to manage capacity on their balance sheet
or as investors which take and hold positions. Sellers of risk can remove loans from
12
Transferability is determined by consent of the borrower as stated in the original loan agreement. Some borrowers do
not allow loans to be traded on the secondary market as they want to preserve their banking relationships.
152
their balance sheets in order to meet regulatory constraints, hedge risk, or manage
their exposure and liquidity.13 US banks, whose outstanding syndicated loan
commitments are regularly monitored by the Federal Reserve Board, appear to
have been relatively successful in transferring some of their syndicated credits,
including up to one quarter of their problem loans, to non-bank investors (Table.3).
Buyers of loans on the secondary market can acquire exposure to sectors or countries,
especially when they do not have the critical size to do so on the primary market. 14
Table 3: US syndicated credits1
Share of total credits 2
US
Foreign
Nonbanks banking banks
1
2
Total credits
($ bn)
US
banks
Percentage classified 3
Foreign
NonTotal
banking
banks credits
2000
48
45
1,951
2.8
2.6
10.2
3.2
2001
46
46
2,050
5.1
4.7
14.6
5.7
2002
45
45
10
1,871
6.4
7.3
23.0
8.4
2003
45
44
11
1,644
5.8
9.0
24.4
9.3
Includes both outstanding loans and undrawn commitments.

Dollar volume of credits held by each group of institutions as a percentage of the total dollar
volume of credits.
Dollar volume of credits classified substandard, doubtful or loss by examiners as a percentage
of the total dollar volume of credits.
Source: Board of Governors of the Federal Reserve System.
While growing, secondary trading volumes remain relatively modest compared

to the total volume of syndicated credits arranged on the primary market. The
biggest secondary market for loan trading is the United States, where the volume
of such trading amounted to $145 billion in 2003. This is equivalent to 19% of
new originations on the primary market that year and to 9% of outstanding
syndicated loan commitments. In Europe, trading amounted to $46 billion in
2003 (or 11% of primary market volume), soaring by more than 50% compared
to the previous year (Graph 5).
Distressed loans continued to represent a sizeable fraction of total secondary trading
in the United States, and gained in importance in Europe. Admittedly, this to some
extent reflects higher levels of corporate distress in Europe. But as the investment
13
The seller banks often enhance their fee income by arranging new loans to roll over facilities they had previously granted
to borrowers. They may sell old facilities on the secondary market to manage capacity on their balance sheet, which is
required to hold some of the new loans.
14
For example, minimum participation amounts on the primary market may exceed the bank's credit limits.
153
Graph 5: US and European Secondary Markets for Syndicated Credits

United States, by loan quality
Europe, by loan quality
1
2
Europe, by counterparty
1,3
In billions of US dollars. 2 As a percentage of total loan trading. For Europe, distressed and
leveraged. 3 From non-LMA members.
Sources: Loan Market Association (LMA); Loan Pricing Corporation.
grade segment matures, it is also indicative of sustained investor appetite and of the
markets improved ability to absorb a larger share of below par loans (BIS (2004)).
In the Asia-Pacific region, secondary volumes are still a tiny fraction of those in
the United States and Europe, with only six or seven banks running dedicated
desks in Hong Kong SAR, and no non-bank participants. In 1998, the Asian
secondary market was exceptionally active. That year, large blocks of loan portfolios
changed hands as Japanese banks restructured their distressed loan portfolios.15
Trading was more subdued in subsequent years,16 although banks interest appears
to have recently been rekindled by the secondary prices of loans, which have
decreased less than those of collateralised debt obligations and bonds. 17
Geographical integration of the market

As financial markets are becoming more integrated geographically, a question is
how this process manifests itself in syndicated lending in the form of crossborder
15
Banks tend to trade blocks of loans when they restructure whole portfolios. In normal times, loan by loan trading is more
common.
16
Nonetheless, Japanese banks have recently been very active in transferring loans on the Japanese secondary market.
According to a quarterly survey conducted by the Bank of Japan, for the financial year April 2003-March 2004, such
transfers totalled 11 trillion, 38% of which were non-performing loans. This was followed in the second quarter of
2004 by unusually weak secondary market activity by historical standards.
17
According to practitioners, major international banks with an Asian presence are among the main sellers of loans, while
demand comes from Taiwanese and Chinese banks.
154
deals. To answer this question, we examine the nationality composition of syndicates

on the primary market, where information is readily available about institutional
investors. We first perform this exercise at a global level and then within the euro
area, in order to assess any impact from the introduction of the single currency.
Table 4 shows the degree of international integration of syndicated loan markets,
measured by the share of loans arranged or provided by banks of the same country
or region as the borrower. At the senior arranger level, the nationality composition
is calculated based on the number of deals, and at a junior participant level based
on the dollar amounts provided by individual financial institutions. A number of
findings stand out.
First, unsurprisingly, there appears to be relatively little penetration by foreign
lenders in the market for loans to Japanese, euro area and US borrowers. The
senior arranger and junior funds provider banks in loan facilities set up for these
borrowers are often from the borrowers own country, with the share of deals
arranged or of funds provided by foreign institutions rarely exceeding 30%. 18
Second, foreign banks appear more present (with shares often in excess of 60%)
in syndicates set up for European borrowers from outside the euro area and, in
particular, the United Kingdom. It is interesting to note that Japanese borrowers
tend to pay higher fees on average than UK borrowers, whose market is characterised
by more foreign bank penetration. This may suggest that the market is more
contestable in the United Kingdom.
Third, with the possible exception of Asia, syndicates put together for emerging
market borrowers tend to be dominated by foreign lenders. Interestingly, for all
emerging market borrowers, but especially in the Middle East and Africa and
Asia-Pacific regions, domestic banks (ie from the same geographical area as the
borrower) are more present as junior funds providers than as senior arrangers. It
would appear typical for a major international bank to arrange the syndication
and then allocate the credit to regional lenders.19 Given that the presence of a
reputable major foreign arranger has a certification effect for banks which are
18
For US borrowers, the statement about low foreign penetration should be balanced by the relatively high share
approximately 45% since 2000of total syndicated credits held by foreign banking organisations, after allowing for
transfers on the secondary market (Table 3).
19
For more background and an extension of the analysis to bond markets, see McCauley et al (2002).
155
Table 4: International Integration of the Market

By Borrower Nationality
% of deals1 where the arranger % of funds1 provided by banks

is of the same nationality2 as of the same nationality2 as the
the borrower (based on
borrower (based on USD
number of deals)
amounts)
199398
19992004 3
199398
19992004 3
74
59
58
37
62
67
29
9
5
15
54
70
72
43
26
84
65
37
12
7
20
36
61
71
35
36
63
61
34
10
6
22
44
62
67
42
25
87
57
51
13
8
28
31
Austria
Belgium
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
5
17
26
48
43
7
20
34
10
24
31
64
42
22
13
50
46
29
18
53
8
29
27
51
33
31
16
45
57
8
16
39
30
28
30
64
42
16
9
46
44
24
14
48
7
25
23
49
Euro area5
39
42
43
38
Main countries and regions

United States
Euro area4
United Kingdom
Other western Europe
Japan
Other industrialised economies
Asia-Pacific
Eastern Europe
Latin America/Caribbean
Middle East & Africa
Offshore
Euro area countries
Calculated also including purely domestic deals. 2 From the same region, where regions are shown.
For 2004, first quarter only. 4 Borrower from any euro area country, arranger/provider from any
euro area country. 5 Borrower from same euro area country as arranger/provider, euro area average.
1
3
Sources: Dealogic Loanware; authors calculations.
ranked lower in the syndicate, this makes cross-border investment in a junior

funds provider capacity easier than the provision of screening and monitoring
services as a senior arranger.
Finally, the advent of the euro appears to have led to some integration in the
pan-European syndicated loan market, especially at the arranger level. The first
two columns of Table 4 show that within the euro area, the percentage of loans
arranged by banks from the same country as the borrower is about the same
156
before and after 1999 (39% versus 42%).20 Meanwhile, the overall share of euro
area arrangers rose from 59% to 72%, suggesting that euro area banks have been
arranging a higher share of loans for borrowers from euro area countries other
than their own. 21 At the same time, the additional credits arranged at a
pan-European level seem to have been funded largely by banks from outside the
euro area, since the share of euro area banks among junior funds providers has
remained relatively stable (last two columns of Table 4). This could reflect a greater
balance sheet capacity outside the euro area.
Conclusion
This special feature has presented a historical review of the development of the
market for syndicated loans, and has shown how this type of lending, which
started essentially as a sovereign business in the 1970s, evolved over the 1990s to
become one of the main sources of funding for corporate borrowers.
The syndicated loan market has advantages for junior and senior lenders. It
provides an opportunity to senior banks to earn fees from their expertise in risk
origination and manage their balance sheet exposures. It allows junior lenders to
acquire new exposures without incurring screening costs in countries or sectors
where they may not have the required expertise or established presence. Primary
loan syndications and the associated secondary market therefore allow a more
efficient geographical and institutional sharing of risk origination and risk-taking.
For instance, loan syndications for emerging market borrowers tend to be originated
by large US and European banks, which subsequently allocate the risk to local
banks. Euro area banks have strengthened their pan-European loan origination
activities since the advent of the single currency and have found funding for the
resulting risk outside the euro area.
However, we find that the geographical integration of the market appears to
vary among regions, as reflected in varying degrees of international penetration.
20
While the euro is widely used as a currency of denomination for European (including eastern European) borrowers, the US
dollar is still the currency of choice for syndicated lending worldwide (US dollar facilities represented 62% of total
syndicated lending in 2003, while the euro accounted for 21%, and the pound sterling and the Japanese yen for 6% each).
21
In a study of the bond underwriting market, Santos and Tsatsaronis (2003) show that the elimination of market
segmentation associated with the single European currency failed to result in an intensification of the business links
between borrowers and bond underwriters from the euro area. It must be stressed, though, that bond underwriting and
syndicated loan markets are quite different, as bonds are sold to institutional investors and loans mainly to other banks.
157
While these differences could also be related to disparities in the sizes of national
markets, further research is needed to improve our understanding of market
contestability by assessing whether they are systematically related to differences
in loan pricing, especially fees.
(Dr.Blaise Gadanecz, Monetary and Economic Department, BIS. The author can
be reached at blaise.gadanecz@bis.org).
References
1.
Allen T (1990): Developments in the International Syndicated Loan Market in the 1980s,
Quarterly Bulletin, Bank of England, February.
2.
Bank for International Settlements (2004): 74th Annual Report, Chapter 7, pp 133-4.
3.
Coffey M (2000): The US Leveraged Loan Market: From Relationship to Return, in

T Rhodes (ed), Syndicated Lending, Practice and Documentation, Euromoney Books.
4.
Dennis S and D Mullineaux (2000): Syndicated Loans, Journal of Financial Intermediation,

vol 9, October, pp 404-26.
5.
Madan R, R Sobhani and K Horowitz (1999): The Biggest Secret of Wall Street, Paine
Webber Equity Research.
6.
McCauley R N, S Fung and B Gadanecz (2002): Integrating the Finances of East Asia,
BIS Quarterly Review, December.
7.
Pennacchi G (2003): Who Needs a Bank, Anyway?, Wall Street Journal, 17 December.
8.
Robinson M (1996): Syndicated Lending: A Stabilizing Element in the Latin Markets,

Corporate Finance Guide to Latin American Treasury & Finance.
9.
Santos A C and K Tsatsaronis (2003): The Cost of Barriers to Entry: Evidence from the
Market for Corporate Euro Bond Underwriting, BIS Working Papers, no 134.
158
13
Equator Principles Why Indian Banks
Too Should be Guided by Them
Pratap Ravindran
What, exactly, does the adoption of the Equator Principles involve?
The banks, to begin with, agree upon a common terminology in
categorising projects into high, medium and low environmental
and social risk, based on the IFCs categorisation process. They
apply this to projects globally and to all industry sectors so as to
ensure consistent approaches in their dealings with high and
medium-risk projects. Second, the banks ask their customers to
demonstrate in their environmental and social reviews, and in their
environmental and social management plans, the extent to which
they have met the applicable World Bank and IFC sector-specific
pollution abatement guidelines and IFC safeguard policies, or to
justify exceptions to them. Recent reports on the decision by
ten leading banks from seven countries to adopt the Equator
Principles make for encouraging reading. However, it must be
said that the conspicuous absence of Indian banks from the list is
distinctly depressing.
Source: http://www.equator-principles.com/hindu1.shtml. July 2003. The Hindu. Reprinted with permission.
Equator Principles Why Indian Banks...
159
he Equator Principlesa voluntary set of guidelines developed for managing

social and environmental issues, related to the financing development
projectsapply only to projects which cost $50 million or more, as those costing
less represent only three percent of the market.
Recent reports on the decision by ten leading banks from seven countries to
adopt the so-called Equator Principles make for encouraging reading. However, it
must be said that the conspicuous absence of Indian banks from the list is distinctly
depressing. While Indian financial institutions (including banks) can hardly be
described as major players in the funding of infrastructure projects at a global
level, the fact remains that their adoption of the Equator Principles or other similar
ones to guide their lending within the country, would have given a major fillip to
Indias environmental initiative, such as it is. They may argue that they see no
need to adopt such principles as their lending to infrastructure projects is restricted,
to those that have secured the environmental clearances mandated by statute.
As these clearances can be purchased for a pittance, this argument is not particularly
convincing.
Unfortunately, the truth is that Indian financial institutions are concerned
to the exclusion of all other considerationsabout the ecology of their balancesheets and, therefore, focused on ever-greening their assets.
Banks adopting the Equator Principles undertake to provide loans only to projects,
whose sponsors can demonstrate their ability and willingness to comply with
comprehensive processes, aimed at ensuring that projects are developed in a socially
responsible manner and according to sound environmental management practices.
The banks which have taken the initiativeABN AMRO Bank, N V, Barclays PLC,
Citigroup, Inc., Credit Lyonnais, Credit Suisse Group, HVB Group, Rabobank,
Royal Bank of Scotland, WestLB AG, and Westpac Banking Corporationwill,
henceforth, apply the principles globally and to project financings in all industry
sectors, including mining, oil and gas and forestry.
Their adoption of the Equator Principles is significant in that these banks,
between them, underwrote approximately $14.5 billion of project loans in 2002,
representing a whopping 30 percent of the project loan syndication market globally.
160
According to a prepared statement of the International Finance Corporation

(IFC) Executive Vice-President, Mr Peter Woicke, presented at the Equator
Principles press conference in Washington DC on June 4, the adopting banks
have done something that financial institutions rarely doStep forward to take a
leadership role on global environmental and social issues. The adoption of the
Equator Principles confirms that the role of global financial institutions is changing.
More than ever, people at the local level know that the environmental and social
aspects of an investment can have profound consequences on their lives and
communities, particularly in the emerging markets where regulatory regimes are
often weak. And if financial institutions want to operate in these markets, there is
a bottom line value in having clear, understandable, and responsible standards for
investing.
It is possible that Indian financial institutions are under no pressure to factor
environmental considerations into their lending activities, because most people
are not aware of the Equator Principles.
They were evolved when the IFC convened a meeting of banks, in London in
October, 2002 to discuss environmental and social issues in project finance.
At that meeting, the banks present decided to try and develop a banking industry
framework for addressing environmental and social risks in project financing.
This exercise culminated in the drafting of the Equator Principles which, in essence,
represented an industry approach for financial institutions in determining, assessing
and managing environmental and social risks in project financing.
The preamble to the principles, states that project financing plays an important
role in financing development throughout the world. In providing financing,
particularly in emerging markets, project financiers often encounter environmental
and social policy issues.
We recognise that our role as financiers affords us significant opportunities to
promote responsible environmental stewardship and socially responsible
development.
The preamble goes on to add, In adopting these principles, we seek to ensure
that the projects we finance, are developed in a manner that is socially responsible
and reflect sound environmental management practices. We believe that adoption
161
of, and adherence to, these principles offers significant benefits to ourselves, our
customers and other stakeholders. These principles will foster our ability to
document and manage our risk exposures to environmental and social matters
associated with the projects we finance, thereby allowing us to engage proactively
with our stakeholders on environmental and social policy issues. Adherence to
these principles will allow us to work with our customers in their management of
environmental and social policy issues relating to their investments in the emerging
markets.
What, exactly, does the adoption of the Equator Principles involve? To begin
with, it is important to understand that the term adopt does not mean that the
banks sign an agreement of some kind. They do not. Instead, each bank that
adopts the principles individually declares that it has or will put in place, internal
policies and processes that are consistent with the Equator Principles.
The banks, to begin with, agree upon a common terminology in categorising
projects into high, medium and low environmental and social risk, based on the
IFCs categorization process. They apply this to projects globally and to all industry
sectors, so as to ensure consistent approaches in their dealings with high and
medium-risk projects.
Second, the banks ask their customers to demonstrate in their environmental
and social reviews, and in their environmental and social management plans, the
extent to which they have met the applicable World Bank and IFC sector-specific
pollution abatement guidelines and IFC safeguard policies, or to justify exceptions
to them. This practice allows them to secure information of the quality required
for them to make judgments. And then again, the banks insert into the loan
documentation for high- and medium-risk projects covenants for borrowers to
comply with their environmental and social management plans. If those plans are
not followed and deficiencies not corrected, the banks reserve the right to declare
the project loan in default.
What are the IFC safeguard policies and how do they differ from the World
Bank safeguard policies? Basically, the IFCs set of environmental and social policies
are based on the set used by the World Bank. However, some policies have been
adapted to better reflect their applicability to the IFCs private sector client base
162
while others have been retained in the World Bank format and, as such require,
careful interpretation for private sector projects. The safeguard policies provide
guidance on matters relevant to the IFCs operations, including environmental
assessment, natural habitats, involuntary resettlement and indigenous peoples.
The environmental assessment policy is a key umbrella policy for the IFC, and
various requirementsenvironmental and socialflow from it. In addition, to
reflect the fact that the IFC works with employers, it has adopted the Policy
Statement on Harmful Child and Forced Labour. The Banks safeguard policies
are geared to its public sector activities.
And what is the relationship between the IFC safeguard policies and the World
Bank and IFC guidelines? The safeguard policies generally represent an approach
to critical issues that cut across industry sectors, such as the protection of natural
habitats or the physical or economic displacement of people (resettlement), where
it is important to apply a consistent set of environmental and social principles.
The guidelines, on the other hand, are sector-specific environmental standards
that are applicable to the processes, technology, and issues that apply in specific
industries, and represent good practice within that sector. As such, the policies
and guidelines are mutually supportive of each another.
The Equator Principles apply to only projects which cost $50 million or more.
The question now arises: How many projects fall below $50 million and what
about them?
According to the IFC, a cut off point and some level of materiality are necessary.
Most of the sensitive project developments involve much larger sums. While the
league tables for project loans do not necessarily record all small project loans,
they indicate that projects costing less than $50 million represent only three
percent of the market.
Its proponents point out that a risk management rationale exists for banks to
adopt the Equator Principles in that they will be able to better assess, mitigate,
document and monitor the credit risk and reputation risk associated with financing
development projects. In any case, they say, the principles will not hurt banks
business as they have been championed by the project finance business heads of
163
banks. They believe that having a framework for the industry will lead to greater
learning among project finance banks on environmental and social issues, and
that having greater expertise in these areas will better enable them to advise clients
and control risks. Quite simply, they observe, the principles are good for business.
164
14
Synthetic Leasing
While originally structured for real estate transactions, the synthetic
lease can be readily applied to various types of energy-based assets,
including electric turbines and other generating assets or natural
gas and liquids pipelines. The synthetic lease has emerged as a
popular financing structure since it provides off balance sheet
treatment for book purposes, while allowing a company to retain the
tax benefits associated with asset ownership. When rating companies
that use synthetic leases, Fitch Ratings will effectively add the
financing back to the balance sheet and income statement by
adjusting leverage and other key credit ratios. In addition, Fitch
may also assign a rating to the lease debt, based on the credit rating
of the lessee and/or the value of the underlying asset(s).
Overview
The synthetic lease has emerged as a popular financing structure since it provides
off balance sheet treatment for book purposes, while allowing a company to retain
the tax benefits associated with asset ownership. This structure is frequently used
by energy firms to finance the acquisition of new assets or to refinance existing
assets. It provides an interim take-out to construction financing (usually five to
Source: http://www.fitchratings.com.au/projresearchlist.asp March 7, 2002. 2004 Fitch Ratings, Ltd. Reprinted by
permission of Fitch Inc.
Synthetic Leasing
165
seven years), and, like any interim financing, exposes the company to refinancing
risk at the end of the lease term.
When rating companies that use synthetic leases, Fitch Ratings will effectively
add the financing back to the balance sheet and income statement by adjusting
leverage and other key credit ratios. In addition, Fitch may also assign a rating to
the lease debt, based on the credit rating of the lessee and/or the value of the
underlying asset(s).
The Characteristics of Synthetic Leasing

While originally structured for real estate transactions, the synthetic lease can be
readily applied to various types of energy-based assets, including electric turbines
and other generating assets or natural gas and liquids pipelines. The synthetic
lease moves the asset off the balance sheet, while maintaining ownership for tax
purposes through the following steps:
The energy company (the lessee) isolates the asset by having a special purpose
entity (SPE) buy the asset or enter into the appropriate equipment and
construction contracts on a build-tosuit basis, with the lessee acting as
construction agent.
To finance the asset purchase, the SPE raises debt and equity. The debt is
generally tranched and issued in the bank and debt capital markets. The
equity is a requirement to ensure the independence of the SPE and is privately
placed.
At the time of completion, the lessee can either purchase the asset from the
SPE or lease the asset from the SPE.
Under the typical structure, a synthetic lease is treated as an operating lease under
Generally Accepted Accounting Principles (GAAP), and a financing for tax purposes.
The legal ownership of the asset resides with the lessee, so the lessee retains all
rights and obligations of ownership, including legal liability, market risk, and
ownership in bankruptcy. In addition, the lessee will assume all maintenance
and insurance requirements associated with ownership as in a triple-net lease.
To qualify as an operating lease for GAAP purposes, the lease must be structured
to meet the following requirements for operating leases detailed in the Statement
of Financial Accounting Standards Number 13 (SFAS 13):
166
The Synthetic Lease Basic Scheme

Tax Ownership
Lessee
Residual Value
Guaranty
Synthetic
Lease
Plant
Accounting Ownership
SPE
85%
12%
3% Investment
A Senior
Notes
B
Subordinated
Notes
Certificates
SPE Special purpose entity.
No automatic transfer of the asset to the lessee at the end of the lease term.
No bargain purchase option at the end of the lease term.
The lease term cannot be 75%, or more, of the economic useful life of the
leased property.
The present value of the minimum lease payments cannot be 90%, or more,
of the fair market value of the property at the inception of the lease term.
It is important to note that a synthetic lease does not result in any transfer of
operating risk from the energy company to the SPE or the noteholders. In cases
where the underlying asset is a generating plant, the lessee continues to bear all
fuel supply risk, market off-take risk, and operating risk of the plant. Consequently,
when assessing the impact of a synthetic lease on the rating of the lessee, Fitch
will incorporate the energy companys risk management and hedging strategy on
a qualitative basis. When assigning a rating to the lease debt, Fitch will look to the
underlying credit quality of the lessee and its ability to satisfy the obligations
under the lease.
Treatment in Bankruptcy: While actual case law regarding synthetic leases in the
area of bankruptcy is limited, the parties to the transaction generally represent
and intend that the debt of the SPE would be treated as a secured financing of the
lessee in the case of the lessees Chapter 11 filing. However, investors should be
aware of the possibility that the bankruptcy court may take the opposite view
Synthetic Leasing
167
and treat the structure as a lease. In this case, the lessee would have the option of
affirming or rejecting the lease as part of its reorganization plan. If the
lessee concludes that the underlying asset(s) is integral to its ongoing operations
and decides to affirm the lease, it must continue to perform under the lease
through the timely payment of scheduled interest and principal. If the lease is
rejected, the lessee would effectively concede control of the asset, returning it to
the lessor. In addition, the lessee would become subject to liabilities for breaching
the lease, which would be an unsecured claim in a bankruptcy situation.
Financing Structure
Special Purpose Entity (SPE): The SPE can be a trust, a limited liability company,
or any other passthrough entity that is separate and distinct from the operations
of the lessee. It will have a very limited purpose, usually to construct, purchase,
and/or own the asset, to raise funds to finance the purchase or refinancing, and to
lease the asset back to the lessee. The SPE must be capitalized with a minimal
amount of equity to classify as a separate subsidiary of the lessee. The minimum
equity required under GAAP is currently 3% of the total project cost. Equity may
be invested by independent, third parties or by parties related to the debt holders;
however, affiliates of the lessee cannot supply the equity to the SPE. Equity holders
will generally have a first loss position in the waterfall and are fully exposed to the
residual value of the underlying asset. Equity raised by the SPE will be part of the
overall financing of the asset. The remainder will be raised through the issuance
of senior and subordinate notes.
Debt Portion: The vast majority of the financing for the asset purchase is achieved
through a combination of senior and subordinated notes issued by the SPE. In
most instances, the debt portion represents up to 97% of project cost and is
typically comprised of two tranchesthe senior note A tranche, equal to 85% of
project cost; and the junior note B tranche, equal to 12%. The A notes will
have a first claim on cash flows and on the residual value of the asset.
The subordinated B notes will have second claim on cash flows followed by
equity holders.
Synthetic leases are usually structured in a manner that exposes the A
noteholders solely to the underlying corporate credit risk of the lessee. In particular,
if the lessee elects to return the assets to the lessor at the end of the lease term, the
168
lessee is generally required to make a residual value payment equal to approximately

80%85% of the original cost (the residual value guarantee). This payment is applied
first to the A notes with any remaining proceeds to the B notes and certificates.
When providing ratings for synthetic lease transactions, Fitch will assess the
credit quality of the lessee as well as the value of the underlying asset. Given the
residual value guarantee, the A note portion is clearly recourse to the lessee and
therefore will be assigned the senior credit rating of the lessee in most cases. This
analysis assumes that the lease debt would be considered secured debt of the
lessee in bankruptcy. However, if the credit rating of the lessee were to decline,
Fitch may incorporate asset value into the analysis, on a secondary basis.
With respect to the B note, Fitch will rate this tranche one or more notches
below that of the A note to account for the return scenario risk (as described
below) and potential residual value shortfall. The level of notching will be assessed
on a case by case basis and could vary based on Fitchs assessment of the return
risk, including the strategic importance of the asset to the lessee, potential
fair market value, and replacement value.
Lease Term and Residual Value

To abide by GAAP requirements, the lease is structured with a periodic lease
payment and a residual. The lease payments will generally be sized to cover interest
payments on the debt and some minimal principal amortization. Although the
term of the lease cannot exceed 75% of the useful economic life of the asset, which
can range as high as 60 years for a generating facility, the initial term under a
synthetic lease is relatively short, with most ranging from five to seven years.
At the end of the initial lease term, the lessee will have three primary options to
choose frompurchase the asset (for book purposes, effectively buying out the lease);
renew the lease (extending the financing for tax purposes); or return the asset to the
lessor and arrange for its sale. The credit implications surrounding the first two
options are relatively straightforward. Under a purchase scenario, all debt and equity
holders are effectively made whole as the lessee must buy the assets at a price equal
to the entire outstanding lease balance. If a renewal is sought, the lessee can simply
extend the lease term after receiving approval of the extension from the lenders or
cash proceeds from refinancing in the case of a capital markets debt issuance.
Synthetic Leasing
169
Under a return scenario, the A notes are, in most instances, fully protected by
the residual value guarantee and are thus exposed only to the corporate credit risk
of the lessee. On the other hand, the B note and certificate holders are exposed
to a potential principal loss if the asset deteriorates significantly in value since
accounting rules state that the guaranteed residual value cannot exceed 90% of
the fair market value. However, Fitch believes that the return option is the least
likely to be pursued by an energy company given the strategic importance of the
underlying assets subject to the lease. In addition, lease terms often contain fairly
onerous return provisions, which can discourage a sale.
Credit Implications for Lessee

As with any type of interim financing, a synthetic lease poses refinancing risk to
the lessee at the end of the lease term. However, as described above, it also provides
some intrinsic refinancing options. Under the purchase option, the lessee would
be responsible for raising sufficient capital to repay the lease and purchasing the
asset for book purposes (it would already own the asset for legal and tax
purposes). Under the renewal option, the lessee would be responsible for arranging
the extension terms with the lease debt holders and the lessor. Under the
return option, the lessee would be responsible for the payment of the residual
value guarantee and for arranging the sale of the asset. It is important to note that,
as legal owner of the asset, the lessee had retained all risks of ownership (including
market value risk) throughout the term of the lease. If, during this term, the
market value of the asset had fallen, the lessee would suffer a loss if the residual
value guarantee exceeded the market value of the asset.
When assessing the impact of a synthetic lease on the credit of the lessee, Fitch
will analyze the relationship of the synthetic lease debt to the companys
existing corporate debt and loans. Some companies have very tight restrictions in
their existing indentures or bank agreements regarding the ability to enter into
secured financing such as synthetic leases. Other companies corporate debt
covenants may include broad carve outs that allow for the creation of a significant
or unlimited amount of secured debt to be incurred as synthetic leases or other
types of contracts. If a corporation creates a material amount of
additional obligations that have an equal or superior claim on cashflow to that of
unsecured senior creditors, it may reduce the rating of the companys senior
unsecured obligations.
170
Hypothetical Credit Impact of Synthetic Lease with 90%

Residual Value Guarantee
Scenario 1
Base Case
Scenario 2
with $300 Million
Synthetic Lease
Scenario 3
With $300 Million
Additional Debt.
Income Statement ($000)

EBITDA (GAAP Basis)
Gross Synthetic Lease Rent
195.00
0.00
170.50
24.50
195.00
0.00
Adjusted EBITDAR
195.00
195.00
195.00
70.00
0.00
70.00
70.00
21.20
91.20
91.20
0.00
91.20
707.00
0.00
0.00
707.00
900.00
0.00
1,607.00
707.00
270.00
21.00
998.00
900.00
9.00
1,907.00
1007.00
0.00
0.00
1,007.00
900.00
0.00
1,907.00
Unadjusted Ratios
EBITDA/Interest
Debt/EBITDA (x)
Debt/Capital (%)
2.79
3.63
44.00
2.44
4.15
44.00
2.14
5.16
52.80
Adjusted Ratios
EBITDAR/Lease Adjusted Interest
Lease Adjusted Debt/EBITDAR
Lease Adjusted Debt/Capital (%)
2.79
3.63
44.00
2.14
5.12
52.30
2.14
5.16
52.80
Reported Interest Expense

Interest Portion of Synthetic Lease
Total
Balance Sheet ($000)
Reported Debt
Synthetic Lease Residual Value Gurantee
Synthetic Lease Uncovered Debt
Total Adjusted Debt
Shareholders Equity
Plus: SPE Equity (3%)
Total Adjusted Capitalization
EBITDA Earnings before interest, taxes, depreciation, and amortization, GAAP Generally accepted accounting principles.
EBITDAR Earnings before interest, taxes, depreciation, amortization, and rent. SPE Special Purpose Entity.
Fitch will recalculate key interest coverage and balance sheet ratios, effectively
consolidating the SPE back onto the balance sheet. Specifically, the following
adjustments will be made:
Earnings before interest, taxes, depreciation, and amortization (EBITDA)

is adjusted by adding back the annual synthetic lease payment
(principal and interest) to calculate EBITDA earnings before interest, taxes,
depreciation, amortization, and lease rental expense (EBITDAR).
The interest component of the synthetic lease payment is stripped out and
included as additional interest expense. As previously stated, the
interest component represents the vast majority of the annual rental payment
under a synthetic lease.
Synthetic Leasing
171
Balance sheet debt is modified to treat a portion of the lease balance as

on-balance sheet debt. Specifically, Fitch will adjust reported debt levels to
include a portion of the original lease balance, equivalent to the residual
value guarantee as senior debt. This represents the maximum potential
principal payout for which the lessee would be responsible under a return/
sale scenario. The remaining B tranche would be treated as subordinated
debt. SPE equity will be given credit as equity (in effect, treating the SPE
equity as a minority).
The table above provides a hypothetical illustration of the credit impact of financing
an acquisition using a synthetic lease as opposed to senior debt. The first scenario
shows the base case, with no additional financing. Scenario two shows the same
balance sheet with an additional $300 million synthetic lease. The third scenario
shows the balance sheet with $300 million of additional debt. As mentioned
previously, Fitch will treat the SPE as though it were consolidated on the companys
balance sheet. Before adjustments, in scenario two, the company seems to carry
much lower leverage than in scenario three, and has a higher coverage ratio. After
adjustments, scenario two and scenario three have the same coverage ratios, while
scenario two has a slightly lower leverage ratio due to the treatment of the equity in
the SPE. Note that the EBITDA in scenario two is lower than in the base case
and in the debt case. This is due to the fact that under GAAP accounting rules,
the lease payments would be classified as an operating expense, a difference that
is eliminated by the use of ratios based on EBITDAR. For simplicity, the
table assumes that the implied interest rate on the synthetic lease is the same as
the actual interest rate on the debt.
(Fitch Ratings is a leading global rating agency committed to providing the world's
172
15
Peter Rigby and James Penrose, Esq.,
To address the challenge in analyzing project finance risk, Standard

& Poors uses a framework of analysis that extends well beyond
its traditional approach that grew out of rating US independent
power projects. The approach begins with the assumption that a
project is a collection of contracts and agreements among various
parties, including lenders, that collectively serves two primary
functions: The first is to create a company that will act on behalf
of its sponsors, to bring together several unique factors of
production to produce a single product or service. The second
function is to provide lenders with the security of payment of
interest and principal from a single operating entity. Standard &
Poors analytic framework then focuses primarily on determining
how competitive the project will be in its market segment, and
which risks might undermine its competitiveness and hence, the
assurance of repayment to lenders.
Source: http://www2.standardandpoors.com/spf/pdf/fixedincome/030502IFcriteria.pdf. November 2004 Standard

& Poors Global Project Finance Yearbook. Standard & Poors Rating Services, a division of The McGraw-Hill
Companies, Inc. Reprinted with permission.
173
s project finance has adjusted to the increasingly diverse needs of project

sponsors and their lenders, the analysis of risk has become more complicated.
The increasing variety of project finance applications and locations suggests that
perhaps project finance, despite weaker numbers recently, continues to be the
viable means of raising capital. Yet, projects have departed from their traditional
long-term revenue contract bases. Contract-based revenues are increasingly rare.
Fewer projects are able to secure the highly desirable fixed-price, turnkey, date-certain
construction contracts that protect lenders from construction and completion
risk. Commodity price and market risk now complicate the analysis of project
finance. Term B loan structures with minimal amortizations and risky bullet
maturities have made inroads in project finance. Transactions span such industries
as meatpacking, power generation, oil and gas, entertainment, transport and
military housing, to name a few. For lenders and other investors, identifying,
comparing, and contrasting project risk systematically can indeed be a
daunting task.
To address the challenge in analyzing project finance risk, Standard & Poors
uses a framework of analysis that extends well beyond its traditional approach
that grew out of rating US independent power projects. The approach begins
with the assumption that a project is a collection of contracts and agreements
among various parties, including lenders, that collectively serves two primary
functions. The first is to create a company that will act on behalf of its sponsors to
bring together several unique factors of production to produce a single product
or service.
The second function is to provide lenders with the security of payment of
interest and principal from a single operating entity. Standard & Poors analytic
framework then focuses primarily on determining how competitive the project
will be in its market segment and which risks might undermine its competitiveness
and hence, the assurance of repayment to lenders.
Project Finance Defined

Standard & Poors defines a project company as a group of agreements and contracts
between lenders, project sponsors, and other interested parties that creates a form
of business organization that will issue a finite amount of debt on inception; will
174
operate in a focused line of business; and will ask that lenders look only to a
specific asset to generate cash flow as the sole source of principal and interest
payments and collateral.
What the rating means: Standard & Poors project ratings address default
probability, or put differently, the level of certainty with which lenders can expect
to receive timely payment of principal and interest according to the terms of the
bond or note. Project ratings do not distinguish between the debt issue rating
and the issuer credit rating, as is the case with corporate credit ratings, for a
number of reasons. First, project documentation generally allows a project to
issue debt at its inception to operate with a single business focus and typically to
maintain a constant risk profile. Second, project debt does not become a permanent
part of the capital structure, but rather amortizes in most projects according to a
schedule based on the projects useful life. Finally, projects do not by design build
up equity, but instead, use up cash quickly, first as operating expenses, then as
debt service (often the most significant expense), and finally as dividends. (For a
more comprehensive discussion of project finance risk and for clarification of specific
topics, see Debt Rating Criteria for Energy, Industrial, and Infrastructure Project
Finance, March 19, 2001).
Framework for Project Finance Criteria

This article summarizes an analytic framework that can be used to systematically
assess cash flows based on project-level risks and then to analyze risks external to
the project. External risks, many of which are often country specific, include lack
of host country institutional development needed to support the project, force
majeure, and sovereign risk.
Five levels of analysis form Standard & Poors framework of project analysis: (Chart 1)
Project-level risks,
Sovereign risk,
Business and legal institutional development,
Force majeure risk, and
Credit enhancements.
175
Chart 1: Framework of Project Analysis

Credit Enhancement
Force Majeure Risk
Institutional Risk
Sovereign Risk
Project Level Risks
The analysis begins with identifying and assessing project-level risks. These
risks generally define most of the risks associated with the choice of business
because if a project cannot reasonably forecast commercially ongoing operations,
other concerns such as the viability of guarantees or credit enhancements will
count for little.
Project-level risk consists of the following categories:
Contractual foundation;
Technology, construction, and operations;
Competitive market exposure;
Legal structure;
Counterparty exposure; and
Financial strength.
A project debt rating involves a marshaling of the various heads of risk, analyzing
their respective magnitude and likelihood of occurrence, and assessing the effect
thereof on the project to operate and to pay debt service on the rated obligations.
Surprisingly, even though project finance is supposed to be non-recourse to the
176
sponsor, some lender credit assessments are often based on the sponsors reputation,
its creditworthiness, or boththe implication being that the sponsor will support
the project in difficult times. When the sponsor is rated higher than the project,
such an approach flies in the face of evidence that sponsors have walked away
when the projects became uneconomical. Sponsor reputation and experience are
certainly considered in the assessment of project completion and operations. But
in the absence of an independent determination that, despite its non-recourse
status, the project is strategically essential to the sponsor, the rating will reflect
primarily the projects standalone economic viability.
Project Level Risks

The analysis of project finance risk begins with identifying and assessing project-level
risks. Standard & Poors defines these risks as those intrinsic to the projects business
and the industry in which it operates (e.g., a merchant power plant selling power
to the UK electricity sector). The first objective of the analysis is to determine
how well a project can sustain ongoing commercial operations throughout the
term of the rated debt and, as a consequence, how well the project will be able to
service its obligations (financial and operational) on time and in full.
Assessing project-level risk takes six broad steps:
1. Evaluate project operational and financing contracts that, along with the
projects physical plant, serve as the basis of the enterprise;
2. Assess the technology, construction, and operations of the enterprise;
3. Analyze the competitive position of the project against the market in which
it will operate;
4. Determine the risk that counterparties, such as suppliers and customers,
present to the enterprise;
5. Appraise the projects legal structure; and
6. Evaluate the cash flow and financial risks that may affect forecasted results.
Contractual foundation. The primary objective of analyzing project contracts
is to determine the level of protection from market and operating conditions each
agreement provides. The secondary objective is to determine how well the various
177
contract obligations address the projects operating risk characteristics and mesh
with other project contracts.
The project structure should protect stakeholders interests through contracts
that encourage the parties to complete project construction satisfactorily and to
operate it competently. The projects structure should also give stakeholders a
right to a portion of the projects cash flow to service debt and, in appropriate
circumstances, to release free cash to the equity in the form of dividends. Moreover,
higher rated projects generally give lenders the assurance that project management
will align their interests with lenders interests; project management should have
limited discretion in changing the projects business or financing activities. Finally,
the stronger projects distinguish themselves by agreeing to give lenders a firstperfected security interest (or fixed charge, depending on the legal jurisdiction)
in all of the projects assets, contracts, permits, licenses, accounts, and other
collateral so the project can be disposed of in its entirety, should the need arise.
Table 1: Contractual Foundation Benchmark Scores
Score
1
Characteristics
Project has a credit lease, hell-or-high-water contract; even if the project is a technological/
operational failure, it receives full revenue payments sufficient to cover debt service.
Indenture creates a first-perfected security interest in all project assets, contracts, permits,
and accounts necessary to run the project.
Strict controls on cash flows and distributions.
Trustee (offshore for cross-border debt).
Project has a credit lease, hell-or-high-water contract; even if the project is a technological/
operational failure, it receives full revenue payments.
and accounts necessary to run the project. Strict controls on cash flow.
Project has excellent long-term concession or other offtake agreement, that provides
predictable revenues that cover fixed payments and variable costs.
Virtually no conditions that could reduce revenue payments.
Revenues are protected from foreign exchange, inflation, and market risks.
Solid supply contracts; minimal cost/revenue mismatch.
Contd...
178
Contd...
Business interruption and casualty insurance policies in place.

No regulatory outs or easy termination provisions.
Strict controls on cash flow.
5
Project has good long-term concession or offtake agreement, but does not fully protect
lenders from market, inflation, or foreign exchange risks.
Project could be a merchant project, but is secured by licenses, permits, sites, and
contractual access to markets.
Contract outs for offtaker or government.
Adequate supply contracts; potential for cost/revenue mismatch.
Business interruption and casualty insurance policies in place.
Strict controls on cash flow.
Project has fair long-term concession or offtake agreement, but exposes lenders to
market, inflation, or foreign exchange risks.
Contract outs or termination easily achieved.
No contractual requirements to perform while disputes are being resolved.
Contracts contain poorly defined provisions and ambiguous requirements.
No provisions for international arbitration.
Weak insurance program.
Indenture provides little security or collateral for lenders.
Few controls on cash flow. No trustee.
10
No contracts support revenue or supply.

No contractual requirements to perform while disputes are being resolved.
Contracts contain poorly defined provisions and ambiguous requirements.
No provisions for international arbitration.
Little or no insurance.
Indenture provides virtually no security for project.
Virtually no controls on cash flow.
No trustee.
179
Contract analysis focuses on the terms and conditions of each agreement. The
analysis also considers the adequacy and strength of each contract in the context
of a projects technology, counterparty credit risk, and the market, among other
project characteristics. Project contract analysis falls into two broad categories
commercial agreements and collateral arrangements. Examples of key commercial
project agreements and contracts include the following:
Power purchase agreements,
Gas and coal supply contracts,
Steam sales agreements,
Concession agreements, and
Airport landing-fee agreements.
Collateral agreements include an analysis of the following:
Project completion guarantees;
Assignments to lenders of project assets, accounts, and contracts;
Credit facilities or lending agreement;
Equity contribution agreement;
Indenture;
Mortgage, deed of trust, or similar instrument that grants lenders a firstmortgage lien on real estate and plant;
Security agreement or similar instrument that grants lenders a first mortgage
lien on various types of personal property;
Depositary agreements;
Collateral and intercreditor agreements; and
Liquidity support agreements, such as letters of credit (LOCs), surety bonds,
and targeted insurance policies.
Technology, construction, and operations. A projects rating rests, in part, on
the dependability of a projects design, construction, and operation; if a project
fails to achieve completion or to perform as designed, many contractual and other
legal remedies may fail to keep lenders economically whole.
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Table 2: Technology, Construction, and Operations Benchmark Scores

Score
Characteristics
Project is a credit lease, hell-or-high-water contract; even if the project is a technological/

Project has fixed-price, date-certain, turnkey contract; one-year-plus guarantees; superior

liquidated performance/delay damages; highly rated by Standard & Poors, EPC contractor,
credible sponsor, completion guarantee, or LOC-backed construction; installed costs at or
below market; contracts executed.
Independent engineer (IE) oversight through completion, including completion certificate.
Commercially proven technology used.
Rated O&M contract with performance damages.
Budget and schedule are credible, not aggressive.
Thorough and credible IE report.
Project has fixed-price, date-certain, turnkey contract; one-year guarantees for adequate
liquidated performance/delay damages; reputable EPC contractor or LOC-backed
construction; installed costs at market rate; mostly permitted and well-sited.
IE oversight through completion.
O&M contract with performance damages.
Budget and schedule are credible, possibly aggressive.
Thorough IE report, but missing key conclusions.
Project has fixed-price, date-certain, turnkey contract; less than one-year guarantees;
some liquidated performance/delay damages; known EPC contractor or surety bond-backed
construction; installed costs at premium rate; many permits and well-sited; possible local
political/regulatory problems.
Limited IE oversight.
O&M contract with performance damages.
Budget and schedule are credible, possibly aggressive.
Mostly complete IE report; conclusions are weak.
Project has partial fixed-price, date-certain, turnkey contract and cost-plus features; weak
guarantees, if any; minor liquidated performance/delay damages; questionable EPC contractor
or weak performance bond-backed construction; installed costs at premium rate or not
credible; permits lacking and siting issues; possible local political/regulatory problems.
No IE oversight.
Technology issues exist.
Aggressive budget and schedule.
IE report leaves many issues open.
Contd...
181
Contd...
10
Project has cost-plus contracts, no cap; weak guarantees, if any; minor liquidated
performance/delay damages; questionable EPC contractor.
Costly budget.
Permits lacking; siting issues exist.
Possible local political/regulatory problems.
No IE oversight.
No IE report.
Technology issues exist.
Aggressive budget and schedule.
The technical assessment of project risk falls into two categoriespreconstruction

and postconstruction.
Preconstruction risk consists of:
Engineering and design,
Site plans and permits,
Construction, and
Testing and commissioning.
Postconstruction risk is made up of:
Operations and maintenance (O&M), and
Historical operating record, if any.
Project lenders frequently rely on the reputation of the engineering,
procurement, and construction (EPC) contractor or the project sponsor as a proxy
for technical risk, particularly when lending to unrated transactions. The record
suggests that such confidence may be misplaced. Standard & Poors experience
with technology, construction, and operations risk on more than 300 project
finance ratings indicates that technical risk is pervasive during the pre- and
postconstruction phases, while the possibility of sponsors coming to the aid of a
troubled project is uncertain. Moreover, many lenders do not adequately evaluate
the risk when making investment decisions. Thus, Standard & Poors places
considerable importance on the technical evaluation of project-financed
transactions.
182
Standard & Poors relies on several assessments for its technical analysis,
including a review of the independent engineers (IE) project evaluation. This
review assesses whether the scope and depth of the engineers investigation support
the sponsors and EPC contractors conclusions. Standard & Poors supplements
its review of the independent experts report with meetings with the authors and
visits to the site to inspect the project and hold discussions with the projects
management and EPC contractor. Without an IE review, Standard & Poors will
most likely assign a speculative-grade debt rating, regardless of whether the project
is in the pre- or postconstruction phase.
Competitive market exposure. A projects competitive position within its peer
group is a principal credit determinant. Analysis of the competitive market position
focuses on the following factors:
Industry fundamentals,
Commodity price risk,
Supply and cost risk,
Outlook for demand,
Foreign exchange exposure,
The projects source of competitive advantage, and
Potential for new entrants or disruptive technologies.
Given that most projects produce a commodity, such as electricity, ore, oil or
gas, or some form of transport, low-cost production relative to the market characterizes
many investment-grade ratings (Table 3). High costs relative to an average market
price, in the absence of mitigating circumstances, will almost always place lenders
at risk. But competitive position is only one element of market risk. The demand for
a projects output can change over time, sometimes dramatically, resulting in low
clearing prices. The reasons for demand change are many and usually hard to predict.
Any of the following can make a project more or less competitive:
New products,
Changing customer priorities,
Cheaper substitutes, or
Technological change.
183
Experience has shown, however, that offtake contracts providing stable revenues
or that limit cost risk, or both, may not be enough to mitigate adverse market
situations. Hence, market risk can potentially take on greater importance than
the legal profile of, and security underlying, a project. Conversely, if a project
provides a strategic input that has few, if any, substitutes, economic incentives
will be stronger for the purchaser to maintain a viable relationship with the project.
Table 3: Competitive Market Risk Benchmark Scores
Score
Characteristics

Project sells a commodity sold widely on the world market.

Project is in first cost quartile of producers.
Solid competitive advantage in location, technology, and know-how.
Demand is excellent for product/service.
Long-term market outlook is excellent.
For non-commodity products/services, project is in first cost quartile of producers and
enjoys defensible price premium.
Revenue and supply contracts will likely keep project economical.
Project sells a commodity sold widely in regional markets.

Project is in first cost quartile of producers.
Solid competitive advantage in location, technology, and know-how.
Demand is excellent for product/service.
For non-commodity products/services, project is in second cost quartile of producers and
enjoys defensible price premium.
Revenue and supply contracts will likely keep project economical.
Project sells a commodity widely sold on the market.

Project is in the second cost quartile of producers.
Demand for product/service should be adequate through debt.
Competitive advantage in location, technology, and know-how, but may be hard to defend
long term.
For non-commodity products/services, project is in second cost quartile of producers;
does not have a premium product.
Pricing controlled/influenced by a regulator.
Project could be uneconomical to primary offtaker.
Contd...
184
Contd...
Project sells a commodity, but sold in limited markets.

Project is in the third cost quartile of producers Few competitive advantages.
For non-commodity projects/services, project is in third cost quartile of producers
producers; does not have a premium product.
Demand for product/service is limited and decreasing.
Project is out of market or soon will be.
Project is uneconomical to primary offtaker.
10
Project sells a commodity, but sold only in a few markets.

Project is one of the most expensive producers.
Virtually no competitive advantage in any aspect of its business.
For non-commodity projects, project is in fourth quartile of low-cost producers and does
not have a premium product.
Little demand for product/service.
Project is uneconomical to any/all parties associated with it.
Legal structure. Standard & Poors assesses whether the project is chartered
solely to engage in the business and activities being rated. It will also determine
that the insolvency of entities connected to the project (sponsors, affiliates thereof,
suppliers, etc.), which are unrated or are rated lower than the rating sought for
the project, should not affect project cash flow. Standard & Poors also analyzes
other structural features to assess their potential to manage cash flow and prevent
a change in the projects risk profile. These may include:
Choice of legal jurisdiction,
Documentation risk,
Trustee arrangements, or
Intercreditor arrangements.
Standard & Poors generally will not rate a project higher than the lowest rated
entity (i.e., the offtaker) that is crucial to project performance, unless the entity
may be easily replaced, notwithstanding its insolvency or failure to perform, or
unless it is a special purpose entity (SPE). Moreover, the transaction rating may
also be constrained by a project sponsors rating if the project is in a jurisdiction
where the sponsors insolvency may lead to the insolvency of the project, particularly
if the sponsor is the sole parent of the project. (Table 4)
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A project finance SPE, as defined by Standard & Poors, is a limited purpose

operating entity whose business purposes are limited to:
Owning the project assets,
Entering into the project documents (e.g., construction, operating, supply,
input and output contracts, etc.),
Entering into the financing documents (e.g., the bonds; indenture; deeds
of mortgage; and security, guarantee, intercreditor, common terms,
depositary, and collateral agreements, etc.), and
Operating the defined project business.
The thrust of this single-purpose restriction is that the rating on the bonds
represents, in part, an assessment of the creditworthiness of specific business
activities.
One requirement of a project finance SPE is that it is restricted from issuing any
subsequent debt rated lower than its existing debt, unless such debt is subordinated
in payment and security to the existing debt and does not constitute a claim on the
Table 4: Legal Risk Benchmarks
Score
Characteristics

operational failure, it receives full revenue payments sufficient to service fixed obligations.
Project is a bankruptcy-remote SPE.
Virtually no ability to issue additional debt.
New York or London financing jurisdiction.
Adequate legal opinions support project documentation, collateral, and relevant tax matters.
Documents provide for superior ongoing disclosure and monitoring.

Adequate legal opinions support project documentation, collateral, and relevant tax
matters.
Superior financing documentation.
Extremely limited ability to issue additional debt.
Collateral and security strongly enforceable.
Contd...
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Contd...

Adequate legal opinions support project documentation, collateral, and relevant tax
matters.
Excellent financing documentation.
Mostly limited ability to issue additional debt.
Collateral and security strongly enforceable.
Project is reasonably bankruptcy-remote and strong SPE.

Adequate legal opinions support project documentation, collateral, and relevant tax matters.
Adequate financing documentation.
Project can issue additional debt with some controls.
Collateral and security adequately enforceable.
Documentation provides for adequate ongoing disclosure and monitoring.
Project is neither bankruptcy-remote nor an SPE.

Financing jurisdiction is questionable.
Legal opinions weak or unavailable.
Marginal financing documentation.
Project can issue unlimited additional debt.
Collateral and security probably not enforceable.
Ongoing disclosure and monitoring will probably be difficult.
10
Project is neither bankruptcy-remote nor an SPE.

Financing jurisdiction is questionable.
Legal opinions unavailable.
Weak financing documentation.
Project can issue unlimited additional debt.
Questionable enforceability of collateral and security.
Documentation does not provide for ongoing disclosure or monitoring.
project. A second requirement is that the project should not be permitted to merge
or consolidate with any entity rated lower than the rating on the project debt.
A third requirement is that the project (as well as the issuer, if different) continue in
existence for as long as the rated debt remains outstanding. The final requirement is
that the SPE must have an antifiling mechanism in place to hinder an insolvent
parent from bringing the project into bankruptcy. In the US, this can be achieved
by the independent director mechanism whereby the SPE provides in its charter
187
documents that a voluntary bankruptcy filing by the SPE requires the consenting
vote of the designated independent member of the board of directors (the board
generally owing its fiduciary duty to the equity shareholder(s)). The independent
directors fiduciary duty, which is to the lenders, would be to vote against the filing.
In other jurisdictions, the same result is achieved by the golden share structure, in
which the project issues a special class of shares to some independent entity (such as
the bond trustee), whose vote is required for a voluntary filing.
The antifiling mechanism is not designed to allow an insolvent project to
continue operating when it should otherwise be seeking bankruptcy protection.
In certain jurisdictions, antifiling covenants have been held to be enforceable, in
which case such a covenant (and an enforceability opinion with no bankruptcy
qualification) would suffice. In the UK and Australia, where a first fixed and
floating charge may be granted to the collateral trustee as security for the bonds,
the collateral trustee can appoint a receiver to foreclose on and liquidate the collateral
without a stay or moratorium, notwithstanding the insolvency of the project debt
issuer. In such circumstances, the requirement for an independent director may
be waived.
The SPE criteria will apply to the project (and to the issuer if a bifurcated
structure is considered) and is designed to ensure that the project remains
nonrecourse in both directions: by accepting the bonds, investors agree that they
will not look to the credit of the sponsors, but only to project revenues and collateral
for reimbursement. Investors, on the other hand, should not be concerned about
the credit quality of other entities (whose risk profile was not factored into the
rating) affecting project cash flows.
Counterparty exposure. The strength of a project financing rests on the projects
ability to generate cash, as well as on its general contractual framework, but much
of the projects strength comes from contractual participation of outside parties in
the establishment and operation of the project structure. This participation raises
questions about the strength and reliability of such participants. The traditional
counterparties to projects have included raw material suppliers, principal offtake
purchasers, and EPC contractors. Even a sponsor becomes a source of counterparty
risk if it provides the equity during construction or after the project has exhausted
its debt funding. (Table 5)
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Important offtake counterparties to a project can include:

Providers of LOCs and surety bonds,
Parties to interest rate and currency swaps,
Buyers and sellers of hedging agreements and other derivative products,
Marketing agents,
Political risk guarantors, and
Government entities.
Because projects have taken on increasingly complex structures, a counterpartys
failure can put a projects viability at risk.
Financial strength. Projects must withstand numerous financial threats to their
ability to generate revenues sufficient to cover O&M expenses, nonrecurring items,
Table 5: Counterparty Benchmark Scores
Score
1
Characteristics
Rated offtake counterparty with exceptional credit rating.
Counterparty guarantees debt payment.

Rated offtake counterparty with excellent credit rating.
Counterparty guarantees revenue payments.
Supply and offtake contract counterparties have good credit ratings.

Sponsor counterparty obligations are backed by good ratings or LOCs.
Government counterparties, if any, have good credit ratings.
Financial counterparties have good credit ratings.
Supply and offtake contract counterparties have adequate credit ratings.

Sponsor counterparty obligations are backed by adequate ratings or LOCs.
Government counterparties, if any, have adequate credit ratings.
Financial counterparties have adequate credit ratings.
Contd...
189
Contd...
Supply and offtake contract counterparties have doubtful creditworthiness.

Sponsor counterparty obligations are uncertain.
Government counterparties, if any, have adequate credit ratings.
Financial counterparties have weak credit ratings.
Service counterparties have weak credit ratings.
10
Supply and offtake contract counterparties have poor creditworthiness.

Sponsor counterparty obligations are weak.
Government counterparties, if any, have poor credit ratings.
Financial counterparties have poor credit ratings.
Service counterparties have poor credit ratings.
capital replacement expenditures, taxes, and annual fixed charges of principal and
interest, among other expenses. Projects must contend with such risks as interest
rate and foreign currency volatility, inflation risk, liquidity risk, and funding risk.
Standard & Poors considers a projects capital structure a source of financial risk.
Too much debt places a project at risk of volatile currencies, interest rates, and
market liquidity. (Table 6)
Investment-grade project debt should be amortizing debt. Few projects,
particularly power projects, can adequately assume the refinancing risk of the
bullet maturities characteristic of corporate or public financings. Unlike a corporate
entity, a single-asset power generation facility is more likely to have a finite useful
life. Because of this depreciating characteristic, a fixed obligation payable by an
aging project near the end of the projects life is necessarily more risky and speculative,
than an obligation payable from cash sourced in diverse assets.
Standard & Poors relies on debt-service coverage ratios (DSCRs) as the primary
quantitative measure of a projects financial credit strength. The DSCR is the
ratio of cash from operations (CFO) to principal and interest obligations. CFO is
calculated strictly by taking cash revenues and subtracting expenses and taxes,
but excluding interest and principal, needed to maintain ongoing operations.
The ratio calculation also excludes any cash balances that a project could draw on
to service debt, such as the debt service reserve fund or maintenance reserve fund.
To the extent that a project has tax obligations, such as host country income tax,
withholding taxes on dividends and interest paid overseas, etc., Standard & Poors
190
treats these taxes as ongoing expenses needed to keep a project operating (see Tax
Effects on Debt Service Coverage Ratios, July 27, 2000).
Note that some projects have been using subordinated debt recently in their
capital structures to help mitigate commodity price risk. Although such structures
can be helpful, subordinated debt is just that-inferior to senior lenders rights to
cash flow or collateral until after the project has met senior lenders obligations.
Moreover, in calculating the DSCR, and ultimately the rating, on subordinated
debt, Standard & Poors divides total CFO by the sum of senior debt-service
obligations plus the subordinated obligations. Such a formula more accurately
Table 6: Financial Risk Benchmark Scores
Score Characteristics
1

Financial flexibility not needed.
Amortizing debt payments.
No subordinated debt allowed.
Financial model strongly reflects project documentation.

Minimum DSCR exceeds 4.0x.
Average DSCR exceeds 6.0x.
Project insensitive to interest, inflation, and foreign exchange risks.
Distress scenario analyses show less than 50 basis point coverage deterioration.
Excellent financial flexibility protection.
No subordinated debt allowed.
Financial model reflects project documentation.

Average DSCR exceeds 5.0x.
Project slightly sensitive to interest, inflation, and foreign exchange risks.
Good financial flexibility.
Subordinated debt allowed, but rights against senior debt are unenforceable.
Financial model adequately reflects project documentation.

Contd...
191
Contd...
Average DSCRs range from 2.0x to 3.0x.

Project sensitive to interest, inflation, and foreign exchange risks.
Good financial flexibility.
Mostly amortizing debt, but may have limited bullet payment(s).
Subordinated debt allowed, but rights against senior debt are limited.
7
10
Financial model conflicts with project documentation.

Average DSCR ranges from 1.5x to 2.5x.
Interest, inflation, and/or foreign exchange changes significantly affect DSCRs.
Limited financial flexibility.
Bullet maturities likely.
Subordinated debt allowed; distress may affect senior debt.
Financial model conflicts with project documentation.
Average DSCRs range from 1.1x to 1.5x.
Interest, inflation, and/or foreign exchange changes significantly affect DSCRs.
No financial flexibility.
Bullet maturities likely.
Subordinated debt likely to have enforceable rights.
measures the subordinated payment risk than using CFO after senior debt service
obligations and dividing it by subordinated obligations.
Sovereign Risk
As a general rule, the foreign currency rating of the country in which the project
is located will constrain the project debt rating. A sovereign foreign currency
rating indicates the sovereign governments willingness and ability to service its
foreign currency denominated debt on time and in full. The sovereign foreign
currency rating acts as a constraint because the projects ability to acquire the
hard currency needed to service its foreign currency debt may be affected by acts
or policies of the government. For example, in times of economic or political
stress, or both, the government may intervene in the settlement process by
impeding commercial conversion or transfer mechanisms, or by implementing
192
exchange controls. In some rare instances, a project rating may exceed the sovereign
foreign currency rating if the project has foreign ownership that is key to its
operations, if the project can earn hard currency by exporting a commodity with
minimal domestic demand, or if other risk-mitigating structures exist.
Institutional Risk
Even though a projects sponsors and its legal and financial advisors may have
structured a project to protect against readily foreseeable contingencies, risks from
certain country-specific factors may unavoidably place lenders at risk. Specifically,
these factors involve the business and legal institutions needed to enable the project
to operate as intended. Experience suggests that in some emerging markets, vital
business and legal institutions may not exist or may exist only in nascent form.
Standard & Poors sovereign foreign currency ratings do not necessarily measure
institutional risk. In some cases, institutional risk may prevent a projects rating
from reaching the host countrys foreign currency rating, notwithstanding other
strengths of the project. That many infrastructure projects do not directly generate
foreign currency earnings, and may not be individually important for the hosts
economy may further underscore the risk. (Table 7)
In certain emerging markets, the concepts of property rights and commercial
law may be at odds with investors experience. In particular, the notion of contractTable 7: Institution Risk Exposure Benchmark Scores
Score
Characteristics
1
Well-developed legal system; significant precedent exists.
Well-developed financial system.
Significant history of transparency in financial reporting.
3
Developed legal system; reasonable precedent exists.
Developed financial system; enforcement culture still developing.
Transparency in financial reporting may raise concerns.
5
Developed legal system; limited precedent exists.
Financial system beginning to develop.
Contract culture developing.
Transparency just taking hold.
10
No legal statutes for project finance.
Bankruptcy code not developed or not enforced.
Banking sector poorly monitored and/or poorly supervised.
Little contract culture.
193
supported debt is often a novel one. There may, for example, be little or no legal
basis for the effective assignment of power purchase agreements to lenders as
collateral, let alone the pledge of a physical plant. Overall, it is not unusual for
legal systems in developing countries to fail to provide the rights and remedies
that a project or its creditors typically require for the enforcement of their interests.
Force Majeure Risk

Project-financed transactions distinguish themselves from corporate or structured
finance assets by their vulnerability to potential force majeure risks. Force majeure
can excuse performance by parties when they are confronted by unanticipated
events outside their control. A careful analysis of force majeure events is critical in
project financing because such events, if not properly recompensed, can severely
disrupt the careful allocation of risk on which the financing depends. Floods and
earthquakes, civil disturbances, strikes, or changes of law can disrupt a projects
operations and devastate its cash flow. In addition, catastrophic mechanical failure,
due to human error or material failure, can be a form of force majeure that may
excuse a project from its contractual obligations. Despite excusing a project from
its supply obligations, the force majeure event may still lead to a default depending
on the severity of the mishap.
The risk of force majeure events, if unallocated away from the project, will
limit most projects to the BBB category or below. Occasionally, some types of
project, such as pipelines and toll roads, can achieve ratings that are less affected
by force majeure risk because of the improbability of such an event materially
disrupting operations. Thus, pipeline and road projects can more easily return to
operations, compared with a mechanically complex, site-concentrated project such
as a refinery or liquefied natural gas plant. In addition, some rating increase may
be possible to the extent that a project can mitigate force majeure risk with business
interruption and property casualty insurance. (Table 8)
Credit Enhancement
Some third parties offer various credit enhancement products designed to mitigate
project-level risks, sovereign risks, and currency risks, among others. Multilateral
agencies, such as the Multilateral Investment Guarantee Agency, the International
Finance Corp., and the Overseas Private Investment Corp., to name a few, offer various
194
Table 8: Force Majeure Risk Exposure Benchmark Scores

Score
Characteristics
Examples
Highly linear, simple operations.

Loose linkages.
Geographically spread out.
Toll roads,
Pipelines,
Hydro-electric power plants
Greater complexity in operations.

Specialized equipment used
(compressors, generators, heat exchange,
high pressure, high temperature).
Coal-fired power plants,

Natural gas-fired power plants,
Tighter linkages of sequential operations.
Mines
Highly complex operations.

Extremely tight linkages among
system operations.
Petrochemical plants,
Highly specialized equipment used.
Liquefied natural gas,
Operating accidents can be costly.
Nuclear power plants.
10
Refineries,
insurance programs to cover both political and commercial risks. Project sponsors can
themselves provide some type of support in mitigation of some risks-a commitment
that tends to convert a non-recourse financing into a limited recourse financing.
Unlike financial guarantees provided by monoline insurers, enhancement
packages provided by multilateral agencies and others are generally not
comprehensive for reasons of cost or because such providers are not chartered to
provide comprehensive coverage. These enhancement packages cover only specified
risks and may not pay a claim until after the project sustains a loss; they are not
guarantees of full and timely payment on the bonds or notes. Although these
packages may enhance ultimate postdefault recovery, they may not prevent a
default. On a project default, the delays and litigation intrinsic in the insurance
claims process may result in lenders waiting years before receiving an insurance
payment. Even if a project has a debt-service reserve fund of six to 12 months, the
effect of the reserve would be limited in preventing the default; the insurance
payment could come well after the reserve funds have been exhausted.
For Standard & Poors to give credit value to insurers, the insurer must have a
demonstrated history of paying claims on a timely basis. Standard & Poors financial
enhancement rating (FER) for insurers addresses this issue in the case of private
insurers (see Surety Policies as Mechanisms for Timely Credit Support in Project
195
Finance Transactions, published on RatingsDirect, June 28, 2000), but it should

be stressed that such policies or guarantees tend to be limited in scope and that as
a result, ratings enhancement may be limited.
Outlook for Project Finance

For single-asset-based transactions and as an asset class for investors, project finance
has seen a remarkable growth during the past 20 years This growth will likely
continue. Hundreds of billions of dollars of debt have financed thousands of projects
across many industries throughout the world. Currency crises tested many project
structures and ultimately the financial viability of many projects, especially in
Asia and Latin America. Some survived, while others folded. In the US and the
UK, the massive buildout in gas-fired generation followed by the collapse in
operating margins has underscored project vulnerability to commodity price risk
as projects failed. Despite the failure of some projects, project sponsors will
continue to use project finance to raise capital. It is a proven financing technique.
Yet, political and country risks will persist, as will market risks. And clearly, the
risk profile for project finance is as complex as it has ever been.
Standard & Poors expects that project sponsors and their advisors will continue
to develop new project structures and techniques to mitigate the growing list of
risks and financing challenges. As investors and sponsors return to emerging
markets, particularly as infrastructure investment needs increase, project debt
will remain a key source of long-term financings. Moreover, as the march toward
privatization and deregulation continues in all markets, nonrecourse debt will
likely continue to help fund these changes. Standard & Poors framework of project
risk analysis anticipates the problems of analyzing these new opportunities, in
both capital debt and bank loan markets. The framework draws on Standard &
Poors experience in developed and emerging markets and in many sectors of the
economy. Hence, the framework is broad enough to address the risks in most
sectors that expect to use project finance debt, and to provide investors with a
basis with which to compare and contrast project risk.
Project Risk Benchmarks-Appendix

The analysis of project finance relies on many subjective judgments, although
many quantitative techniques are available to assess comparative financial and
196
competitive project attributes, such as sales price or cost of production. To facilitate

comparing and contrasting key project risks across the spectrum of rated projects,
Standard & Poors uses a series of benchmark scoring criteria for project-level and
external risks (e.g., institutional, and force majeure).
Benchmark scores, expressed as integers, range from one to 10, with one being
the least risky. Higher numbers represent exponentially higher risk. The scores
and their criteria represent only guidelines; they are not prescriptive but are flexible,
given the specifics of a particular transaction.
The different benchmark scores are not additive, as they might be in a scoringdriven rating model. As project finance is a form of structured finance, a deficiency
in one small part of a transaction, such as the lack of a debt-service reserve fund, or
an unsecured lending structure that prevents lenders from taking control of the
project, could be cause for a speculative-grade rating. In such an example, a project
could conceivably have relatively high benchmark scores in all categories but one
and still achieve only a speculative-grade rating. Nonetheless, in general, scores of
one to five will typically point to investment grade characteristics.
(Standard & Poors is the worlds foremost provider of independent credit ratings,
indices, risk evaluation, investment research, data, and valuations.)
Pension Funds In Infrastructure Project Finance: Regulations...
197
16
Pension Funds In Infrastructure
Project Finance: Regulations and
Instrument Design
Antonio Vives
Private pension funds benefit from the opportunity to enhance the
risk-return combination offered to the affiliates, hopefully
enhancing the value of their savings and pensions. Private
investments in infrastructure benefit from the possibility of tapping
long-term resources in local currency and reducing financing
costs. In the process, there is the opportunity to promote the
development of the country in areas that can have a multiplier
effect in terms of competitiveness and quality of living. To achieve
this relationship, pension fund regulations must be restructured
so that the goal of safeguarding the value of pensions does not
hinder investments in viable and profitable infrastructure projects.
On the other hand, infrastructure needs to tailor the instruments
to satisfy the needs of pension funds. The discussion presented
shows how this can be achieved for the benefit of all parties. This
relationship is a positive sum game.
Source: http://www.iadb.org/sds/doc/IFM-110-E-Rev2002.pdf. May 1999. Inter-American Development Bank,

Washington, DC. Reprinted with permission.
198
Introduction
In the nineties, two major reforms were undertaken with intensity by Latin
American countries; namely, private participation in pension fund management
and in infrastructure investment. Many countries in other parts of the world have
undertaken one or another of these reforms, but not both at the same time
(with the exception of the United Kingdom, which closely resembles the case of
many countries in Latin America and pioneered private participation in
infrastructure). These dual reforms have created a sizable, mostly domestic source
of long-term funds, while at the same creating a sizable need for domestic
investment funds. Nevertheless, in spite of the potential benefits of a happy
marriage, a relationship has not yet been developed.
The liberalization of many emerging market economies and the attendant
realization of the many benefits of private participation in infrastructure, have
resulted in a considerable need for private capital. This liberalization, occurring
in the context of relatively underdeveloped financial markets, has meant reliance
on foreign capital to finance growing needs, with the concomitant risk for the
economies of unexpected devaluations and/or sudden reversals of those flows. Even
though foreign capital flows into infrastructure projects are more resilient than
portfolio investment, recent crises have reduced the willingness of investors to
provide capital for emerging markets. As a result, projects have been subjected to
severe foreign exchange risks.
This situation underscores the importance of developing domestic sources of
long-term capital. The major, and sometimes only sources of domestic long-term
capital are local pension fund resources, which, in addition, can contribute to the
development of local financial markets. It is imperative that these resources be
tapped by infrastructure projects. If they are to tap their resources successfully,
project developers and the international project finance industry must be aware
of the special needs of local pension funds. Even though the discussion is
concentrated on Latin America, it has implications for most countries with privately
managed pension funds and private infrastructure.
The purpose of this paper is to promote this symbiotic relationship, outlining
the conditions under which sources and uses of long-term resources can meet, and
focusing the attention of both parties to the benefits of a properly structured
199
relationship. There are benefits for both parties that can be exploited through a
better mutual understanding of the needs of the other party. We do not propose
that special subsidies, guarantees or tax benefits be granted to infrastructure works
to make them attractive to private pension fund managers. Nor do we propose
that public pension fund resources be directed or forced into infrastructure
investments on account of their positive externalities or social benefits. Private
infrastructure investment instruments must be structured so that they fit into the
investment strategies of private pension funds, while appropriate changes in the
pension fund regulatory framework should be encouraged. We propose a strictly
voluntary private-to-private relationship, albeit with the participation of the public
sector as grantor and regulator of private activities. The public sector has the
important role of facilitator; it controls most of the rules of the game and its
actions in either sector can make or break the relationship.
Before embarking on the purpose of this paper, the discussion of the structure
of infrastructure financial instruments needed to capture pension fund investments
and the consequent policy and regulatory reforms needed in most developing
countries, we briefly review the potential sources and needs for investment, the
characteristics of the funds and of the projects, the current limitations to the
relationship and the benefits for both parties. The article concludes with a
discussion of the implications this can have for developed countries, like the United
States and most of Europe, that lag in private participation in both areas, mandatory
pensions and infrastructure.
Private Pension Fund Investments in Latin America

Since the pioneering effort of Chile, which took place in 1981, many Latin American
countries have undertaken pension fund reform, including the introduction of
private management of mandatory pension savings along with or as a replacement
for the public pension system.
These pension funds have accumulated a significant amount of resources. 1
Table 1 shows that Chile has the largest pension funds relative to the size of its
economy. At the end of 1998, accumulated assets exceeded US$31 billion,
1
Even though Brazils public system has not been reformed, the assets under administration under corporate pensions are
so large that they are of considerable interest for financing infrastructure and as such are included in the discussion.
200
representing 40% of GDP. Other regulated systems (mandatory and voluntary)

are relatively recent, and more are added every year (the most recent one being
that of El Salvador, which was established in 1998; a private pension fund system
is slated to start in Venezuela in late 1999). While most systems are relatively
incipient, they are growing rapidly, both as a result of the profitability of
investments and the number of new entrants. Chile's private pension fund system
has been in operation for almost 20 years, and in that period resources have grown
at an annualized rate of 29.4% (in local currency). Most recent systems have
posted very high growth rates. For example, in Argentina, pensions increased at a
rate of 29% a year over three years; in Colombia the rate of increase was 39% over
two and a half years; in Mexico it reached 168% over two years; and in Peru, 22%
over three years. Nevertheless, they are still small when compared with their
potential and relative to the size of the respective economies. If the countries that
have started private pension funds were to reach the levels attained in Chile, Latin
America would have over US$560 billion. This is a significant amount that the
underdeveloped and thin capital markets would not be able to absorb, forcing
investments in government paper or bank instruments (Table 7 gives an indication
of capital market depth). There is a need to develop those markets and to introduce
new instruments, which the pension funds are in a position to support.
Investment Regulations2
In order to protect the interests of the affiliates, all the countries of Latin America
in which private pension funds operate, regulate the composition of portfolios. As
these portfolios are expected to provide or supplement the pensions that were previously
provided by the state, they tend to place strict limits on allowable investments and
the performance of the portfolio.
These regulations tend to favor stability and uniformity of investment portfolio
performance, which tends (however unwittingly) to exclude worthwhile, and
economically and socially desirable investments like the provision of new
infrastructure. A few regulations that further exacerbate this difficulty must be
overcome, if infrastructure investments are to be a part of pension fund portfolios.
2
This section benefits from the paper by Shah (1996), which criticizes the regulation for their effect on management
expenses and sub-optimal portfolio choice, and Vittas (1998), which moderates the criticisms, for lesser developed
countries, on account of under-developed financial markets and institutions.
201
The regulations cover the range of allowable investments, their liquidity,

valuation and risk characteristics and other regulations on the portfolios themselves,
such as minimum return. They also govern the management, allowing freedom to
switch administrators, the number of portfolios per affiliate, portfolios per
administrator and allowable managers. Still other regulations set limits on the
liquidity and valuation of investments and limit investments to rated instruments.
Some of these regulations make it almost impossible to invest in infrastructure
assets or at least tend to discourage such investments. Appendix II presents a
summary of the most relevant regulations in the countries listed in Table 1.
Table 1: Comparative Size of Private Pension Funds
Total Pension
Fund System (a)
(millions of US$)
Argentina
Brazil
Chile
Colombia
Mexico
Peru
Germany
Netherlands
Spain
UK
USA
(corporate)
(a)
GDP 1998
Population Pension/ Pension Assets
(millions of US$) Projected 1998 GDP (%)
per Capita
(millions)
(US$)
11,526
75,068
31,146
2,110
5,801
1,739
294,379
457,807
31,831
991,951
337,615
776,900
77,417
87,474
379,126
60,480
2,142,100
378,300
569,000
1,362,300
36.1
165.5
14.8
37.7
95.8
24.8
82.0
15.6
39.3
58.3
3.4
9.4
42.7
2.4
1.5
2.9
13.7
121.0
5.6
72.8
319
454
2,101
56
61
70
3,591
29,259
810
17,027
4,400,000
8,508,900
269.8
51.7
16,310
Pension Fund Data at Dec. 1998, Except Germany, Netherlands and UK at Dec. 1997
Sources: GDP data: IMF (1999). Latin America Pension data: FIAP, Boletin #5; Europe Pension data:
Mercer W./Inverco. USA Pension data: Pensions and Investments (1999)
Regulations That Hinder

Ratings: In order to account for the risk of the allowable assets and the rules set by
regulators, pension fund administrators tend to require that non-government paper
be rated by an independent agency and have a local investment grade. Those
pension schemes that allow investments in foreign assets require an investment
grade for such assets, rated by internationally recognized credit rating companies.
Even equity investments are sometimes limited to rated firms.
202
Liquidity: To minimize problems with the valuation of security assets, most

regulations prohibit, or in the best of cases, limit the holding of assets that are not
traded or do not have a high degree of liquidity in major organized exchanges. For
the purpose of identifying the level of liquidity, some regulations use liquidity
indexes.
Valuation Rules: Most regulations require mark-to market valuation, which
by itself tends to favor investments whose prices are frequently quoted. This,
again, would make investments in new infrastructure less likely to occur, because
the instruments backing those assets would tend to be traded infrequently.
Regulations That Discourage

Allowable Investments: As of 1999, the most restrictive private pension fund
regulation is that of Mexico, where the only allowable instruments are debt securities
issued or guaranteed by the federal government or the central bank. The only
exception is the investment of up to 35% of the assets of the fund, in debt securities
issued or guaranteed by private companies and financial institutions with high
credit rankings. Also, at least 65% of the portfolio should be invested in paper
with maturities and/or review of interest rates not higher than 183 days, some of
which must be invested in securities issued by the government or central bank
with maturities of less than 90 days. At the end of 1998, the portfolio composition
of all pension fund administrators in Mexico included 97% government or central
bank paper. In addition to being conservative, these rules, which are expected to
be temporary, aim to ensure financing for the government liability created by the
transition from the old pays-you-go (PAYG) public pension system to the private
system. The most liberal and oldest of the pension fund regulations are those of
Chile, which allow investments in stocks, foreign securities, real estate, infrastructure
and most negotiable instruments with an investment grade rating. These regulations
have been progressively liberalized, as capital markets became more developed
and confidence in the operation of the system increased.
These investment regulations discourage investment managers from investing
in infrastructure assets, as most (with the exception of Chiles) make the rules of
liquidity, valuation and ratings applicable to all investments. This, in effect, limits
direct investment in projects and, only in some cases, allows indirect investments
203
through the purchase of stocks of well established infrastructure corporations or

mutual funds. Furthermore, investments in non-recourse or limited recourse
greenfield projects (i.e., investments that depend on the cash flows of newly
constructed or under-construction projects) are even more restricted. These projects
do not have an established track record, are rather risky, illiquid, and in most
cases lack a rating (let alone an investment grade rating).
Performance Regulations: In order to protect the value of the affiliate's pensions
against overaggressive behavior by the administrators and to minimize the need
for supplementary public pensions, most countries regulate the performance of
portfolios. In many cases, they are required to earn minimum returns, measured
in either absolute (nominal or real) terms or relative to the performance of other
pension funds. In the case of Chile, administrators are required to earn a minimum,
which is the lesser of 200 basis points below the average system return or half the
average return. Those that do not meet this criteria are required to compensate
the portfolio with resources from a fluctuation reserve, established with prior
earnings exceeding the minimum, and/or the administrator's own capital. In the
case of Argentina, minimum returns are measured as 30% below the system average.
In order to avoid under-performance at a given point in time, pension fund
managers tend to avoid volatility (inherent in infrastructure) and to invest in
similar portfolios, reducing incentives for taking greater risks, while diversifying
the portfolio within the limits allowed by local financial markets thereby precluding
larger returns. Quantitative evidence from the Chilean system presented by Shah
(1997), show that there are minimal variations in portfolio composition.
This herding behavior is not exclusive of regulated funds. It can also be found
in the management of private corporate pension funds, where managers often
compare their performance with the industry average or with a standard benchmark
and, in an attempt not to report under-performance relative to the average, tend
to imitate each others portfolio. This tendency is obviously not as prevalent as
that forced by regulation.
Switching: Most regulations allow affiliates to switch accounts, between pension
fund administrators, once or more in a given year. In addition to the obvious
impact on marketing expenses, when combined with restrictions on portfolio
204
composition and minimum performance requirements, this option tends to

reinforce herding behavior since administrators do not want to lose customers on
account of reporting volatility, arising out of infrastructure investments.
One Portfolio Per Affiliate: All Latin American countries require that all pension
assets of the affiliate be invested in the same portfolio, although several are
considering a change. This precludes the existence of portfolios with different
risk-return characteristics, that could adapt to the risk tolerance of the affiliate
and his/her life-cycle. Again, this restriction conspires against the incorporation
of illiquid assets. The model of the individual retirement accounts sponsored by
private US corporations is a good one. In this case, the affiliate can opt to divide
investments among several portfolios offered by the fund manager in order to
tailor the combined portfolio based on age, risk tolerance or to take account of
other investments he/she may have. Obviously in this case, there is no bailout of
pensioners by the government, as is the case in some Latin American countries,
which guarantee a minimum pension. Moreover, the level of development of the
capital markets and the investment sophistication of the affiliates in Latin America,
make it more difficult to allow this freedom.
A better solution would be to allow flexibility in the choice of portfolio within
a given pension administrator, after the pensioner has a part of his/her savings in
one that guarantees a minimum pension.
One Portfolio Per Administrator: Pension fund managers can only offer one
portfolio to their clients. Combined with the restrictions described above, this
one also reinforces the convergence to the mean portfolio and precludes the
incorporation of riskier assets. In the case of Mexico, for example, the law establishes
that pension fund administrators could manage several pension fund companies
with different portfolio composition and risk levels, although the current, very
strict investment and minimum return rules restrict the viability of this option.
Monopoly of Pension Asset Management: Almost all Latin American countries
currently restrict the management of pension assets to institutions exclusively
devoted to this end, often regulated by a special regulator (in the case of Colombia,
the Bank Superintendency regulates pension fund administrators). Competition
from banks, insurers and other financial institutions is not permitted. While this
205
allows for easier oversight of the industry, it also precludes the offer of alternative
investment vehicles, which in general have had better returns than pension fund
portfolios, albeit with greater risk. This choice, which should become available as
the system matures, would allow for greater competition, portfolios which are
more along the risk-return frontier, and a stronger interest in infrastructure assets,
particularly as financial institutions gain experience in infrastructure finance. This
is not to suggest that oversight be eliminated. As investment and pension
management services become specialized, the industry will continue to need
regulation to protect the interests of affiliates. But, as the system and financial
markets mature, it will become more obvious that there are significant similarities
between the pension fund and the banking and insurance industries, and that all
can operate in the same markets with common regulations.
Portfolio Composition
Given the foregoing, the portfolio composition of pension funds tends to be rather
conservative. The least conservative system is that of Chile because that country's
system is more mature. (Table 2)
Table 2: Portfolio Composition by Sector (End of 1998)
Bonds
Stocks
Real
Estate
Foreign
Other
Total
Argentina
70.9%
25.0%
0.3%
0.3%
3.5%
100.0%
Brazil
47.0%
36.5%
14.5%
0.0%
2.0%
100.0%
Chile
76.4%
16.1%
1.7%
5.7%
0.1%
100.0%
Colombia
84.0%
3.2%
2.5%
0.0%
10.3%
100.0%
100.0%
0.0%
0.0%
0.0%
0.0%
100.0%
Peru
65.8%
33.5%
0.0%
0.0%
0.7%
100.0%
Germany
71.0%
6.0%
13.0%
7.0%
3.0%
100.0%
Netherlands
47.0%
15.0%
7.0%
29.0%
2.0%
100.0%
Spain
62.4%
13.7%
0.0%
16.7%
7.2%
100.0%
Mexico
UK
USA (a)
(a)
8.0%
54.0%
2.0%
29.0%
7.0%
100.0%
28.9%
51.9%
3.0%
10.5%
5.7%
100.0%
Top 1,000 Funds aggregate asset mix.
Source: Latin America: FIAP (1999); USA: Pensions and Investments (1999); Europe: Mercer.
206
The case of Chile, with its longer history, is illustrative of the possible evolution
as funds mature and tend toward riskier portfolios, even within the very conservative
limits set by regulations. At the beginning, most assets were invested in essentially
riskfree securities, as is the current case in Mexico (although in this case, pension
assets are also used to finance the deficit of the transition form the old to the new
system). As time went by and capital markets developed, funds started to invest
in mortgage bonds and corporate securities, to the point that in 1994 these
represented a proportion similar to public securities. This changed in 1998, when
the stock market was hit by uncertainties associated with the Asian crisis and
funds moved into bank deposits and international diversification.
Moreover, in 1990, pension funds were authorized to invest in foreign securities
subject to a very low and slowly increasing limit (currently set at 12%). Foreign
investments started in 1993, increasing by 38% in 1998, reaching US$1,785 million.
Investments in venture capital and infrastructure funds were permitted in 1993; in
1995 the limit on equity holdings was raised to 37% (Vittas, 1996). (Table 3)
Given their relatively large size, Chiles pension funds have also contributed to the
development of the market. They have been instrumental in developing credit rating
agencies (clasificadoras de riesgo), giving depth to the markets, stabilizing prices (because
they are long-term investors), developing new products to attract them and the
possibility of investing in infrastructure funds as we are exploring in this paper.
Table 3: Evolution of Chiles Pension Fund Investments
Type of asset
(percentage of total assets) 1981
1985
1990
1994
1998
Government Securities
28
43
44
40
41
Bank Deposits
62
21
17
14
Mortgage Bonds
35
16
14
17
Corporate Bonds
11
Corporate Equities
11
32
15
Other
Foreign Securities
Total
100
100
100
100
100
Source: Vittas (1996), data for 1998 form Boletin #5, FIAP (1999).
207
As can be seen, when private pension funds mature and capital markets develop,
the range of investments tends to widen and move away from concentration in
government securities. The current, very restrictive regulations can be expected to
be liberalized as the systems gain the confidence of regulators and self-regulation
is developed. Eventually those systems will adopt the prudent man rule (i.e., no
restrictions, just common sense), that governs the pension programs of private
corporations or the most advanced systems in Europe, like the Netherlands and
the United Kingdom. This trend needs to develop for the inclusion of infrastructure
as an allowable investment.
Infrastructure Investments
The only Latin American countries that now explicitly allow investments in
infrastructure (even greenfield projects) are Argentina, Colombia and Chile. Pension
fund managers in those countries are able to participate in infrastructure
development programs and public services only indirectly by purchasing paper
issued by specialized infrastructure investment funds or (titulos securitization),
which spread the risks involved. Obviously, those systems that allow investments
in private securities allow, indirectly, investments in infrastructure assets, through
the purchase of mutual funds or stocks and/or bonds of the corporations owning
those assets. Nevertheless, some of these assets may not have the required rating
and/or liquidity necessary to comply with other regulations, and, as such, may
have to be exempted if project finance investments are desired. Furthermore, most
managers would have to acquire the capabilities to perform due diligence on these
investments.
The case of investment in established corporations that have a significant portion
of their assets in infrastructure, falls within the categories of investments in stocks
or bonds of traded corporations and is rather straightforward. As a result, we will
not address it here. We are more concerned with investments in new infrastructure
projects (project finance). Although no precise figures exist, in the case of Chile
the private pension system has invested in several road and airport concessions by
investing in the concession partners. In all cases, it was investment in already
existing assets, not greenfield projects. In the case of Argentina as of the end of
1998, approximately 0.6% and 5.8% of total pension assets were invested in
bonds and shares respectively, of infrastructure related projects or companies.
208
The newly created pension funds should hope to emulate U.S. corporate pension
funds, which operate in a very well-developed financial market. As of the end of
1998, the defined benefit corporate pension funds, in the top 1000 funds in the
United States, have an average of 5.1% of their assets in private equity and real
estate (these assets are the most similar to infrastructure projects) and 11.8% in
international equity.3
Investment Needs of Private Pension Funds

The regulations described above determine, in most cases rather narrowly, the
potential investments of pension funds. If these regulations were relaxed, pension
funds would probably invest in other instruments. In particular, they are likely to
be interested in instruments that:
Provide higher returns.
Provide opportunities to reduce risk through diversification.
Provide inflation protection.
Do not enhance volatility of reported returns.
Do not add undiversifiable risks (like foreign exchange exposure).
Have liquidity.
Provide short-term and mid-term cash flows.
Unfortunately, most financial markets in the developing countries do not have
the instruments needed, even if the regulations were relaxed. Therefore, instruments
will have to be created, as financial markets develop. If properly structured,
infrastructure financial instruments can meet some of those needs and, as a result,
should be attractive to those pension funds. Nevertheless, infrastructure investment
is an activity which is inherently risky, both because of its strategic inflexibility
(it cannot be moved or used for other purposes) and the fact that it provides basic
public services subject to political interference (which could be reduced as a
consequence of private pension fund participation). In this regard, it is important
to distinguish between investments in well-established firms that provide
3
Even though private pension funds in Latin America are defined contribution, the management of the portfolios is in
the hands of independent managers with a single portfolio and as such, the resulting portfolio is more comparable to the
US-defined benefit case.
209
infrastructure services (which should be treated as regular investments) and

investments in new projects, which require special consideration in terms of the
regulatory environment and financial instrument design.
In terms of the latter, we propose that private pension funds invest between
1% and 5% in infrastructure project finance assets. Needless to say, this
recommendation is not based on a comprehensive analysis of the risk return
characteristics of infrastructure investments or the efficiency frontier of the allowable
assets of pension fund portfolios. Nor does it incorporate the risk preferences of
affiliates (the research required goes beyond the scope of this paper). This is merely
a rule of thumb, based on the preceding analysis, in particular by looking at the
evolution of the Chilean case and the practices of pension funds administered
under the prudent man rule.
Potential Private Pension Fund Investment in Infrastructure

Based on the expected rates of growth in pension fund assets4 and assuming that 3%
of those assets are invested in infrastructure, Table 4 gives an indication of the availability
of resources in selected countries. The third column gives the stock of potential assets
in the portfolio if the full 3% were invested. The fourth column gives the availability
of resources for new investments during the year, assuming that investment of 3% of
the new assets flow into the pension funds portfolio (growth).
Table 4: Availability of Resources for Infrastructure in the Year 2000
Country
Pension Fund
Assets year end
(billion US$)
Potential investments in
infrastructure projects
(portfolio) (million US$)
Potential new yearly

investments in
infrastructure
projects (million US$)
20
600
120
Brazil
117
3,900
780
Chile
49
1,470
180
90
30
20
600
180
90
30
Argentina
Colombia
Mexico
Peru
4
Assumes the following rates of growth: Argentina and Brazil, 20%; Chile, 12%; Colombia, Mexico and Peru, 30%.
These rates are not critical for the point we want to show and are merely indicative.
210
The investment of pension funds assets in infrastructure provides important

benefits to those projects in which:
Foreign exchange risk exposure is reduced, as most projects generate local
currency revenues, but have traditionally depended on foreign exchange
financing to cover long-term needs.
Financing (refinance) risk is reduced because pension funds are able to provide
longer tenors than those currently available in the local financial markets.
The cost of capital is potentially reduced because these resources tend to be
less expensive on a risk-adjusted basis than most of the alternatives (imported
capital or short-term local finance).
There would be less interference in decision-making because pension funds
tend to be less involved in day-to-day management than the alternative
sources (this must be compensated with proper governance system to ensure
that pension funds are not taken for a ride).
Political risk is reduced because the participation of resources representing
the pensions of local workers should induce closer adherence and fairness
in the application of infrastructure regulatory principles. Pension funds
can be honest brokers, as affiliates are affected both by the returns of the
projects and the rates charged by the services provided.
These benefits are important enough for infrastructure projects to be very interested
in pension fund resources and to take the necessary measures to capture them.
Private Participation In Infrastructure

The current decade has seen a significant transformation in the modalities of
provision of infrastructure services concurrent with pension reform. There has
been a major increase in private sector participation in the provision of infrastructure
services. This is particularly the case in the countries that undertook pension
reform, that also liberalized their economies, but it is not limited to them. In the
case of Latin America, the main reasons for the increase in private participation
has been the need to modernize and expand the services which the state can no
longer finance and to redirect resources used to finance the deficits of public
utilities to more pressing social needs. This has led most countries to privatize
211
public utilities and to concession in transportation services, leaving the financing

of the rehabilitation and expansion in the hands of the private sector. These
investment needs, as will be seen below, are rather large and are well beyond the
current capacities of domestic financial and capital markets, both in terms of
volume and in terms of tenor. This forces the private sector to resort to international
sources to finance investments that generate revenues mostly in domestic currencies.
Financing Needs
It has been estimated that for each 1% in GDP, investment in the traditional
infrastructure sectors (telecommunications, energy, transportation and water and
sewage) would need to increase by 1% of GDP (World Development Report,
1995). A reasonable goal for governments would be to make sure that infrastructure
can support a long-term annual growth rate of 5%. Given the size of the Latin
American economy, this would require investments of US$70 billion (in year
2000 dollars) per year. It is estimated that the telecommunications sector would
require roughly $25 billion a year; energy, $28 billion; transportation, $10 billion;
and water, $7 billion. Telecommunications can be considered a relatively safe and
developed sector that should be part of the regular portfolio of investments of
pension fund assets in publicly traded stocks and bonds. It should hence be
excluded from the special project finance allocation we are suggesting. Also, a
portion of the energy sector that includes well established utilities in countries
Table 5: Investment in Infrastructure Projects with Private Participation,
1990-1997 Latin America and the Caribbean (million US$)
Year
Electricity
Water
Gas
Telecom
Transport
Total
1990
645.70
4,443.30
5,311.00
10,400.00
1991
75.00
9,213.80
395.50
9,684.30
1992
2,130.06
2,930.00
11,112.00
2667.50
18,839.56
1993
2,925.74
4,153.00
142.80
5,804.40
835.80
13,861.74
1994
3,019.57
434.00
1,342.90
9,109.90
1,517.10
15,423.47
1995
5,380.48
1,178.80
796.50
6,910.30
1,600.70
15,866.78
1996
9,012.51
153.90
915.80
9,710.40
2,785.40
22,578.01
1997
20,514.80
1,625.20
2,490.88
11,273.40
3,658.50
39,562.78
43,628.86
7,619.90
8,618.88
67,577.5
Source: World Bank (1999).
18,771.80 146,216.94
212
with mature reforms could also be seen in this light. Nevertheless, as this is still a
small segment of the overall Latin American market (although it represents a large
part in Chile and Argentina), we will assume that the energy sector is in need of
risk capital and include the estimates in our proposal. As a result, total annual
needs that could potentially be covered by the risky portion of pension funds
assets could amount to almost $50 billion in the year 2000. These large needs
continue to be met mostly by the public sector and it is estimated that private
sources only cover 15% (World Bank, 1997a).
Table 6 shows the percentage of private investment covered assuming that the
private sector finances around 15% of the infrastructure needs of those countries
(15% of 5% of GDP).5 Obviously every country would be different, and the
numbers shown only attempt to provide orders of magnitude to assess the overall
feasibility of pension fund financing. They are more valid in the aggregate than
on an individual country basis.
Even though the potential contribution by pension funds appear to be small
compared with the needs, they do represent an important contribution to the
financing, particularly in terms of the very scarce local currency finance. When
considered in the context of the financing package of any project, these figures, even
excluding the special case of Chile, represent a large contribution from a single
source of financing and surely would be the largest of the local financing sources.
Table 6: Coverage of Infrastructure Needs in the Year 2000
Country
Argentina
1,900
New investments in
infrastructure projects
per year (million US$).
Exhibit 7.
120
Brazil
4,200
780
18.6
Chile
435
180
41.4
Colombia
525
30
5.7
2,700
180
6.7
435
30
6.9
Mexico
Peru
5
Private financing
of needs (15%)
Percent of yearly
needs satisfied
6.3
If the telecommunications sector is excluded from these estimates, under the assumption that they represent traditional
investments, then the figures could, as a rough estimate, be multiplied by 1.5, as telecommunications account for about
30% of the estimated financing needs.
213
What Do Infrastructure Investments Offer

Based on the discussion above, it should be clear that private infrastructure could
and should tap into pension fund assets. Yet, this can only happen if those
investments bring something which is of value to the pension funds. Indeed,
infrastructure investments do have some valuable features:
They tend to provide a higher return than the one obtained by pension
fund portfolios.
Although infrastructure projects are riskier, they provide diversification
benefits given that their returns are less than perfectly correlated with existing
pension fund portfolios. For risk averse investors, investments in
infrastructure may move the overall return to a more desirable risk return
combination.
These investments could increase the volatility of returns, but given that
the proportion would be very small, the impact should be negligible.
These investments contribute to overall economic growth, including the
creation of new jobs, thereby generating even more resources for the pension
funds and benefiting their stakeholders.
Nevertheless, these investments also have some undesirable features that must
be overcome before pension funds undertake them:
Higher expected returns are achieved over the long run. Even though pension
funds can afford to wait for returns because their liabilities are long-term,
current regulations lead them to prefer short-term, steady returns.
These investments may not comply with some of the regulations described
above, in particular with respect to ratings, valuation and liquidity.
Given that these investments carry a higher (although mostly diversifiable)
risk, they bring the nondiversifiable risk of having to report a failure in an
investment, with the potential for increased switching by affiliates to another
pension fund administrator. This is an agency problem, because even though
the investment may benefit the affiliate in the long run, it poses a shortterm risk to the administrator.
214
Compatibility Between Infrastructure Investments and Pension

Fund Portfolios
At the end of the previous two sections, we analyzed the investment needs of the
private pension fund portfolios. Based on the previous discussion, it is apparent
that the incompatibilities outweigh the synergies. Nevertheless, it is important to
emphasize that these incompatibilities are more the consequence of the lack of
appropriate instruments and regulations, than of the fundamentals. We further
discuss the ideal regulatory environment to foster the investments and make some
policy recommendations. We also discuss the design of financial instruments needed
to take advantage of that pool of resources.
Changes In The Regulatory Environment

Based on the discussion on pension fund regulation and the characteristics of
infrastructure investment, it is no wonder that there has been so little participation.
The regulations on ratings, liquidity, switching, minimum return, one portfolio
per affiliate, one portfolio per administrator, monopoly by pension fund
administrators, and valuation rules make these investments almost impossible.
The ideal regulatory framework will use the prudent person rule, whereby decisions
on investments are left to the administrators exercising their fiduciary responsibility,
as is the case of corporate pension funds in the United States and pension funds in
the Netherlands and the United Kingdom. However, the government continues
to have a financial interest because, in many cases, it guarantees the minimum
pension. Furthermore, in the case of developing countries, this relaxation must be
accompanied by the corresponding enhancement of the capabilities of the
supervisory agencies. Thus, regulations should allow affiliates to have several
portfoliosa properly regulated one for the minimum pension, and several for
supplementary pensions that are basically deregulated and operate under the
prudent person rule. Minimum pension portfolios would be regulated under
current rules, and gradually relaxed as the system matures.
This ideal regulatory framework cannot be achieved in the short run, but
should be the benchmark to be achieved as pension funds and financial markets
mature. In the meantime, the regulations could be progressively relaxed and, move
from regulating investment to measures that regulate overall portfolio risk. The
performance of supplementary pension portfolios would be assessed based on
215
measures of risk-adjusted returns. Each administrator should be allowed to manage

several portfolios with different risk-return characteristics (with the number being
compatible with the development of the local capital markets). Each portfolio
would advertise the risk tolerance and net-of-expenses performance benchmark
and under-performance (say 20% below benchmark return) would be covered
through reserves or the administrators capital. Switching would still be allowed,
but it would be less of an issue, because comparison is relative to net-of expenses
benchmark and not to other competing portfolios (not comparable, unless they
are of the same risk and same expenses). Ideally, all financial institutions would be
able to manage pension funds and, would fall under a consolidated regulatory
body, with specialized units (banking, securities, insurance, pensions).
Regulations on ratings, liquidity and valuation should be handled through
the proper design of infrastructure financial instruments. Nevertheless, it would
help if these regulations were relaxed, not eliminated, for a small percentage of
assets, say 5%. For instance, valuation and rating rules could be substituted by
periodic independent assessments of the investment value.
The Ideal Regulatory Framework:
Prudent person rule for supplementary pensions
Progressive liberalization for minimum
Design of Financial Instruments

Based on the discussion above, it is clear that if these instruments are to be
attractive to pension funds, without been forced, they need to be, to the extent
possible:
More liquid
Less risky (lower probability of failure)
Less volatile.
The instruments can have either direct or indirect claims on the cash flows. In
the case of direct claims, the instruments can be securities (the need to be marketable
is a sine qua non condition) like general project bonds, securitization of specific
cash flows or shares of the special purpose vehicles. In any case, to comply with
216
these conditions, the securities would have to have claims on special cash flows.
For instance, they should have a senior claim on revenues, be based on projects
with track records (operation stage) or have some form of enhancement through
the participation of the government, multilateral agencies and/or political or credit
insurance. The above-mentioned conditions can be further enhanced if the securities
are based on indirect claims on the cash flows through some form of investment
pools. This would allow investment in the securities of several projects, over several
sectors and even over several countries. The resulting securities would already
constitute a well-diversified portfolio and, as such, would be more liquid, less
risky and less volatile, and may even be rated. In all cases, the underlying projects
must be well structured and backed by solid sponsors. Even though this is the
ideal, barely achievable in practice, it is the benchmark that those seeking pension
fund financing should strive for.
In the United States and other developed capital markets, there are endless options
for the private pension fund administrator to invest the portfolio assets, and to
configure the desired risk-return profile. In the case of countries with lesser developed
markets the options are rather limited, sometimes limited to government paper and
the negotiable certificates of deposit or liquid deposits of financial institutions. The
case of most countries of Latin America is paradoxical. The private pension fund
industry generates long-term, domestic, investable resources, and it needs to enhance
profitability and minimize risk. Unfortunately, it does not have a well-developed
capital market capable of providing the necessary instruments, either because it is
underdeveloped, or as the case of Chile, its size is rather small when compared with
the size of the funds. On the other hand, there are large unsatisfied needs of legitimate
long-term domestic investments waiting to tap into the pool of those resources.
There is a real gap between the potential of the funds, the needs of infrastructure
and the development of the capital markets that must be closed through the
development of the proper instruments, regulations, and institutions.
Pension Fund Investments in Infrastructure Assets

As discussed above, changes in the pension fund regulations are needed, but these
alone will not be enough. Changes in the design of infrastructure finance instruments
are also needed. These regulatory changes, if any, will occur over prolonged periods
of time. In the meantime, for pension funds to invest in project finance infrastructure
217
assets, the instruments will have to adapt to the existing regulations and the proposal
indicated in the box below requires minimal changes in regulations, and in some
countries none at all. The ideal instrument proposed is the most conservative that
can be designed, short of one guaranteed by AAA-rated institutions or governments.
It should have ample liquidity, very low risk (obviously with a correspondingly
lower return) and would be properly valued. Even though it would capture funds
for infrastructure, pension funds could do better in the risk-return tradeoff with
more direct investments. As regulations are relaxed, the instruments will not have to
be as complex as implied by the recommendation and some funds may be able to
acquire simpler instruments, including direct investments or the purchase of
negotiable debt instruments of specific projects.
The application of the prudent man rule most likely would not imply a dramatic
change in the portfolios of pension funds, evidenced by the portfolio composition
of countries that use this rule. Administrators would probably still insist on liquidity,
ratings and valuation rules, but most likely, they would be willing to exempt a
portion of the portfolio from these self-imposed rules and allow investment in illiquid,
non-rated and subjectively valued assets. This would favor direct investment in the
relatively riskier (diversifiable), but return-enhancing infrastructure assets.
The ideal financial instrument: Securities of a fund, invested in many carefully selected projects, with
some form of credit enhancement (e.g. multilateral participation, credit guarantees, political risk
insurance), over several sectors (heavy on energy, light on water, with a mix of transportation subsectors),
covering several countries, mostly in operational stage, with shares quoted in some exchange.
Table 7: Indicators of Capital Depth

1996 Market
Capitalization
Domestic
Credit (a)
1996
Turnover
1998
Fund Size
Argentina
18
26
50
3.4
Brazil
32
37
86
9.4
Chile
93
60
10
42.7
Colombia
25
46
10
2.4
Peru
27
12
26
1.5
USA
105
138
93
51.7
Percent of GDP, except turnover.

Sources: IMF, Financial Statistics, March 1999; Word Bank, World Development Indicators, 1998; (a)
Provided by banking sector in 1996.
218
Implications for Other Countries and Other Investments

Even though we have been mainly discussing Latin America, the conclusions have
implications for all countries, taking into account the differences in financial markets
development. This is particularly the case because pension fund reforms in many
developing countries are following the Chilean model (with the needed variations).
Also, many developed countries (particularly in Europe) are under pressure to reduce
their fiscal deficits and, to do so, are considering the private provision of infrastructure
services. Given that these countries already have corporate or private pension funds
in place, the implications of our discussion are also valid for them. Obviously, as the
discussion refers to a private-private relation, it is valid if both infrastructure and
pension funds are in private hands. The discussion can also be applied in the case of
other private investments, different from infrastructure, that share some of the
problems of inflexibility and size, as would be the case of housing.
In the United States, there was a proposal in the early nineties to utilize the
vast resources of private corporate funds to finance public infrastructure (see US
Department of Transportation, 1993). In this case, the proposal was to use resources
under private management to finance public sector works. The proposal involved
the creation of a public financial institution that would issue securities, insured
by a separate insurance company and with the implicit guarantee of the US
government and tax benefits for purchasers. These securities were to be purchased
by institutional investors, including private pension funds, and the proceeds would
be used to finance public infrastructure, leveraging the capital paid in the
corporation by the federal government. Even though the idea was very well
structured, the private sector was not enthusiastic about it, as it appeared to be a
form of forced investment. The problem was that even though the corporation
may have been managed along private criteria, the activities financed were public
works without an underlying cash flow and the tax exempt pension funds were
more interested in taxable securities (for a comprehensive analysis of the proposal,
see US General Accounting Office, 1995). Given that corporate pension funds in
the United States have very few investment restrictions, the problem of insufficient
infrastructure finance could be solved by privatizing some of the infrastructure
and issuing securities along the lines proposed in this paper.
219
Concluding Remarks
If regulations of private pension funds were to be relaxed to allow investments in
private infrastructure projects and, in turn, these projects adapted their financial
instruments to the needs of those pension funds, both parties would be able to
reap significant tangible and intangible benefits. Private pension funds benefit
from the opportunity to enhance the risk-return combination offered to the
affiliates, hopefully enhancing the value of their savings and pensions. Private
investments in infrastructure benefit from the possibility of tapping long-term
resources in local currency and reducing financing costs. In the process, there is
the opportunity to promote the development of the country in areas that can
have a multiplier effect in terms of competitiveness and quality of living.
To achieve this relationship, pension fund regulations must be restructured so
that the goal of safeguarding the value of pensions does not hinder investments in
viable and profitable infrastructure projects. On the other hand, infrastructure
needs to tailor the instruments to satisfy the needs of pension funds. The discussion
presented shows how this can be achieved for the benefit of all parties. This
relationship is a positive sum game.
(Antonio Vives is Deputy Manager, Infrastructure, Financial Markets and Private
Enterprise, of the Sustainable Development Department and Vice-Chairman of the
Pension Fund Investment Committee at the Inter-American Development Bank in
Washington, DC.)
References
1
Bustamante J Quince aos despus: Una mirada la sistema privado de pensiones, Santiago,
Chile, 1997.
Federacin Internacional de Administradoras de Fondos de Pensiones. Semi-annual Bulletins

for the years 1996,1997, and 1998, Santiago de Chile.
Financial Times. Pension Fund Investment, Financial Times Survey, Financial Times,
May 14, 1998.
International Monetary Fund. International Financial Statistics, International Monetary

Fund, Washington DC, March 1999.
Kilby P The Rising Tide of Local Capital Markets, Latin Finance, Number 92, October 1997.
Latin Trade Growing Older: Latin Americas Pension Funds Come of Age, Latin Trade,
December 1998.
220
Mercer European Pension Fund Managers Guide, Investment and Pensions Europe, March
1998, W.H. Mercer Companies, Inc., 1998.
Ministerio de Obras Publicas, Ministerio de Hacienda. Bonos de Infraestructura, Santiago,

Chile, 1997.
Pension and Investments: The International Newspaper of Money Management. January 25,1999.
Crain Communications Inc.
10 Queisser M The Second-Generation Pension Reform in Latin America, Organization for

Economic Cooperation and Development, Paris, 1998.
11 Riesen H Liberalising Foreign Investments by Pension Funds: Positive and Normative
Aspects. Technical Paper No.120, Organization for Economic Cooperation and Development,
Paris, January 1997.
12 Shah H Toward Better Regulation of Private Pension Funds, Policy Research Working
Paper No. 1791, World Bank, Washington DC, March 1998.
13 US Department of Transportation. Financing the Future, Report of the Commission to
Promote Investment in Infrastructure, US Department of Transportation , Washington DC,
February 1993.
14 US General Accounting Office. Private Pension Plans: Efforts to Encourage Infrastructure
Investment, US General Accounting Office, Washington DC, September 1995.
15 Vittas D Pension Funds and Capital Markets, Public Policy for the Private Sector, Note
No. 71, World Bank, Washington DC, February 1996
16 Vittas D Regulatory Controversies of Pension Funds, Policy Research Working Paper
No. 1893, World Bank, Washington DC, March 1998.
17 World Bank, Infrastructure for Development, World Development Report 1994, World Bank,
Washington DC, 1994.
18 World Bank Facilitating Private Involvement in Infrastructure: An Action Program, World
Bank, Washington DC, 1997.
19 World Bank Mobilizing Domestic Capital Markets for Infrastructure Financing, World
Bank Discussion Paper No. 377, World Bank, Washington DC, 1997.
20 World Bank. World Development Indicators, World Bank, Washington DC, 1998.
21 World Bank. Private Sector Development Department, Private Participation in Infrastructure
Database, World Bank, Washington DC, April 1999.
APPENDIX 1
Characteristics of Latin American Private Pension Funds
Peru
Colombia
Argentina
Mexico
Bolivia
Brazil
1981
closed
1993
remains
1994
remains
1994
remains
1997
closed
1997
closed
1977
remains
mandatory
AFP
voluntary
AFP
voluntary
AFP
voluntary
AFJP
mandatory
AFORES
mandatory
AFP
corporate
EFPP
10
8 (d)
10
7.5
6.5+subsidy
10
variable
2.94
3.72
decentralized decentralized
RB
RB
private
private
specialized
specialized
2 x p.a.
2 x p.a.
relative
unregulated
yes
no
3.49
decentralized
RB
private
integrated
2 x p.a.
relative
yes
3.45
4.42
3.00
variable
centralized decentralized decentralized corporate
CP
life-time switch
CP
N/A
private
public
private
N/A
specialized
specialized
integrated integrated
2 x p.a.
1 x p.a.
1 x p.a.
N/A
relative
no
no (e)
N/A
yes
yes
no
N/A
Notes: (a) AFP = Administradoras de Fondos be Pensioners; AFJP = Administradoras de Fondos de Jubilacioness Pensiones;
AFORE = Administradoras de Fondos de Ahorro para el Retiro; EFPP = Entidades Fechadas de Previdencia Privada.
(b) RB = Recognition Bond; CP = Compensatory Pension;
(c) Due to administrative delays, transfer may be more limited.
(d) Contribution rate will be increased gradually to 10%.
(e) Guarantees are required from the fund management companies.
221
Source: Queisser (1998) and own data.
Start of operations
Public PAYGO system
Privately-funded system
Affiliation of new workers
Fund management companies (a)
Contribution rate for savings
(% of wage)
Commissions + insurance
(% of wage)
Contribution collection
Past contributions (b)
Disability/survivors insurance
Supervision
Account transfers (c)
Minimum rate of return
Minimum pension
Chile
Comparison of Investment Regulations (Percentages are of the Total Assets of the Pension Fund)
Brazil
Chile
Colombia
Mexico
Peru
Germany
Netherlands
Spain
United Kingdom
Source: Websites of Associations of Pension Fund Administrators, law and regulations.
Argentina
Securities issued
Debt Securities
Stocks
Mutual Funds
Foreign Investments
Others
guranteed by Government
(non Government)
and/or Central Banks
Max. 65%
Max. 100%
Max. 35%
Max. 14%
Max. 17%
Max. 2%
In any case no more than 7% in securities issued or guaranteed by the same entity
Max. 1% of the fund in a mutual fund and/or 10% of the capital of the mutual fund. If mutual fund ivests in the real estate sector,
max. 5% of capital of the fund per real estate mutual fund or 20% of the issue.
Max. 100%
Max. 80%
Max. 50%
Max. 15%
Max. 35%
Max. 5%of the fund in the capital of a company or max. 20% of its capital
Max. 10% of the fund in a company and/or group and max. 20% of the fund in a financial institution and/or group
Max. 20% of the capital of a real state mutual fund
Max. 50%
Max. 100%
Max. 37%
Max. 15%
Max. 16%
Max. 10%
Max. 7% of the fund in one entity or max. 15% of the fund in a group
Max. 5% per diversification factor on mutual funds that invest in real state, development of enterprises and securitization;
and/or 20% of its capital
Max. 3% in debt of new companies (could include public infrastructure by private companies); and/or 20% of the issue
Max. 5% in real estate companies (could include investments in public concession projects); and/or 20% of the capital of the company
Max. 1% of the fund per foreign investment fund
Max. 50%
Max. 100%
Max.30%
Max. 10%
Max. 5% of the fund per issuer, including group. If the issue is supervised by the bank superintendency, the limit is 10%
Max. 10% of the capital of a company and max. 20% of an issue, including securitization, except government or central bank paper.
Max. 100%
Max. 35%
Max. 10% issued or guaranteed by an entity, and max. 15% for a group
Max. 15% for a serie or same issue
Max. 40%
Max. 100%
Max. 35%
Max. 15%
Max. 10%Max. 10%
In any case no more than 15% in one company or 25% in an economic group
Max 30%
Max. 20%
Max. 25%; Real Estate
Equities: EU, equities, including Germany: max 30%; Non EU equities: max. 6%
Prudent person rule
Self Investment: max. 5%
Min. 90% invested in listed assets, real estate and bank deposits; Bank Deposits: max. 15%.
Max. 5% (max. 10%) in securities issued or guaranteed by one entity (group). This limit doesnt apply to foreign estates/
international organization
Prudent person rule
222
APPENDIX 2
Private Power Financing From Project Finance to Corporate Finance
Section V
Applications and Cases
223
224
225
17
Private Power Financing From Project
Finance to Corporate Finance
Karl G Jechoutek and Ranjit Lamech
To achieve substantive progress in IPP financing, limited recourse
project financing will have to evolve toward structures with greater
balance sheet support. The IPP experience in the United States
offers useful insights, and indicates new evidence that variants of
corporate financing are being used for financing electric utilities.
Developers are pooling projects into entities, that are then able to
raise capital on the strength of a combined balance sheet comprising
the pooled assets of the different projects. Providers of equity
and debt then finance the business of building and operating private
generation facilities rather than an individual power plant. Pooling
spreads project risk. Industry consolidation has become a steady
trend in the IPP business. It has been argued that the increasing
size and scope of projects is the main factor driving this change.
Although these mergers and acquisitions could be driven by a
number of strategic objectives, increased balance sheet support in
project development is clearly one of them.
Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/056lamech.pdf. October 1995 World Bank Publication. Reprinted with permission
226
imited recourse project financing of power generation projects has been widely
promoted, as a solution to the intractable problem of getting private credit to
a sector dominated by non-creditworthy borrowers and public agenciesfrom
the point of view of both those supplying capital and those needing it. When the
lights are going out, incumbent power enterprises are financially unviable, and
the public purse is nearly empty, project financing of independent power producers
(IPPs) may seem the only way to get new capacity fast. In the developing world,
however, the public-private partnership in project-financed IPP ventures has been
disappointingly slow to produce results.
This Note argues that, to achieve substantive progress in IPP financing, limited
recourse project financing will have to evolve toward structures with greater balance
sheet support. The need for corporate balance sheet support for private power sector
investments is gradually being recognized, and the benefits of this shift in financing
structure are worth reflecting upon. First, balance sheet support by the mainpartners
in an IPP financing offers greater security to lenders and provides easier (and perhaps
cheaper) access to long-term debtcritical to sustainable power sector financing given
that IPPs typically depend on debt for 60 to 75 percent of their financing requirements.
Second, while equity in limited recourse project finance is almost exclusively private,
balance sheet support by IPP sponsors can open access to public equity markets,
which are deeper and generally cheaper. Third, increased corporate balance sheet support
is a corollary to the restructuring in the worlds power sectors. As sector unbundling
and self-generation expand choice for wholesale and (potentially) retail consumers,
and thus increase demand uncertainty, balance sheet support by IPPs will play an
important role in sharing demand risk among key participants.
Project Finance is More Expensive for an IPP

Project finance implies that the lenders to a project have recourse (or claim) only
to the projects cash flows and assets. In effect, then, the project is financed off
the balance sheet of the project sponsors. Such project finance is termed nonrecourse
and is at one extreme of the project financecorporate finance continuum of
financing possibilities. In practice, project finance in developing countries is backed
by sponsor or government guarantees provided to give lenders extra comfort. This
is limited recourse project financing, involving at least a small degree of corporate or
balance sheet support.
227
In traditional corporate financing, at the other extreme of the financing

continuum, lenders rely on the overall creditworthiness of the enterprise financing
a new project to provide them security. If the enterprise is publicly held,
information on its performance and viability is usually available through stock
markets, rating agencies, and other market-making institutions. This combination
of security, liquidity, and information availability allows debt to be issued at a
lower cost than through project finance. Further, because the enterprises overall
risk is diversified over all the activities that it is engaged in, the cost of equity is
also usually lower. The financing advantage for both debt and equity makes the
overall cost of capital lower for corporate finance.
Systematic empirical evidence specific to the power sector in the developing
world is lacking, but anecdotal evidence suggests that corporate finance is indeed
cheaper than project finance. Corporate financing also has significant transaction
cost advantages because it avoids the high cost of negotiating the web of carefully
structured legal contracts with purchasers and commercial lenders necessary under
project financing.1
The IPP experience in the United States offers useful insights, and indicates
that the projectfinanced independent generation model may not necessarily be
the most efficient mode for capital formation in generation. Nor is it the dominant
mode in other countries. The United States pioneered generation by independent
operators on a merchant basis, and it is where the now ubiquitous term independent
power producer, or IPP, originated. Project-financed independent generators have
thrived in the United States, contributing more than half the additions to
generation capacity in recent years. It has been shown that the cost of capital for
a purchasing US utility may be higher if it chooses to build its own generation
capacity rather than purchase power from an IPP.2 But much of the advantage is
due to the adversarial regulatory environment in the United States, which favors
IPPs. Purchasing utilities weigh the risk that state regulators will disallow investment
costs against the perceived lower risk (and lower profits) of purchasing electricity
from an IPP, an arrangement in which all costs can be passed through or expensed.
The preference for purchasing power from IPPs is easily rationalized when one
1
See Anthony A Churchill, Beyond Project Finance, Electricity Journal 8(5): 3644, 1995.
For the only systematic presentation of information on this issue, see Edward Kahn, Steven Stoft, and Timothy Belden,
Impact of Power Purchased from Non-Utilities on the Utility Cost of Capital, Utilities Policy 5(1): 311, 1995.
228
notes how many utilities and their bondholders were hurt in the 1970s and
1980s, when regulators disallowed cost recovery for large investments in capacity.
Increasing Balance Sheet Support for IPPsThe Evidence

Project developers operate in a fiercely competitive market for international projects.
Assuming competitive bidding, the primary source of competitive advantage lies
in the ability to find financing at the lowest cost, as differences in technical and
operating abilities become virtually indistinguishable among the frontrunners.
(Other attributes may, however, predominate in negotiated, noncompetitive IPP
deals.) In the competitive international IPP market, several trends indicate that
balance sheet support is the preferred means for achieving this cost-of-capital
advantage.
Raising Capital Using a Parents Balance Sheet

Project developers are putting their own balance sheets at riskor those of their
parent companiesto raise cheaper debt for projects and to finance their equity
contribution. Projects in which sponsors have used their own balance sheets to
raise finance include the Puerto Quetzal project in Guatemala (Enron), the Puerto
Plata project in the Dominican Republic (Enron), and the Upper Mahaiao and
Mahanagdong projects in the Philippines (California Energy). Chinese IPP
developers, such as Huaneng Power and Xinli (Sunburst Energy), an affiliate of
CITIC, have also used this strategy. California Energy pioneered the largest
corporate financing in the independent power business, raising US$530 million
through ten year securitized bonds in March 1994.
Creating Consolidated Balance Sheets

Developers are pooling projects into entities that are then able to raise capital on
the strength of a combined balance sheet comprising the pooled assets of the
different projects. Providers of equity and debt then finance the business of building
and operating private generation facilities rather than an individual power plant.
Pooling spreads project risk. For a multinational developer, it also reduces countryspecific risk. And for a developer with a few projects already under commercial
operation, pooling offers the advantage of an immediate revenue stream for repaying
debt and paying dividends.
229
Pooling has two other benefits. First, it enables project developers to tap public
equity marketsmost private project developers finance the equity component of
a project privately. Second, it enables developers to raise cheaper debt on a corporate
finance basis. IPP sponsors that have used this approach include Consolidated
Electric Power Asia (CEPA), the San Franciscobased Bicoastal Energy Investors
Fund (EIF), and Huaneng Power International (HPI) of China. CEPA raised debt
and equity in the capital markets on the basis of its corporate strategy of building
multiple power plants in Asia. EIF securitized its equity interests in sixteen
independent power projects in the United States, creating a synthetic balance
sheet and issuing US$125 million of seventeen-year bonds. And HPI, which owns
2,900 megawatts of capacity under commercial operation and has another 5,900
megawatts under construction, raised US$332 million by listing its IPP business
on the New York Stock Exchange in October 1994.3
Pursuing Mergers and Acquisitions
Industry consolidation has become a steady trend in the IPP business. Notable
transactions among international players include the purchase of CMS Generation
by HYDRA-CO Enterprises, the purchase of Magma Energy by California Energy
Inc. (creating an enterprise with annual revenues exceeding US$400 million),
and the acquisition of J Makowski Co. Ltd. by PG&E Enterprises and Bechtel
Enterprises to form International Generating Co. Ltd. It has been argued that the
increasing size and scope of projects is the main factor driving this change. Smaller
companies are at an important disadvantage in international capital markets
compared with larger players, with their greater experience, capitalization, and
track records. Although these mergers and acquisitions could be driven by a number
of strategic objectives, increased balance sheet support in project development is
clearly one of them.
The IPP Financing Challenge
Private financing needs to be tailored to the changing structural relationships in
the sector. Core generation, transmission, and distribution functions are being
separated, competition is being introduced in wholesale and retail markets, and
technological progress is rapidly increasing the number of cost-effective options
3
The proclaimed success of this transaction is controversial, as the share price of Huaneng dropped from US$14.25 at
listing (October 1994) to about US$9 in mid-1995.
230
for decentralized self-generation or cooperative generation. This restructuring will

require a redefinition of the underlying assumptions in power sector financing.
The financial challenge will be to find ways to provide lenders with adequate
long-term revenue security when the new industry structure might not allow
utilities to guarantee demand risk and price risk for the maturities required.
Traditional project finance is based on allocating demand risk to the purchaser,
whether an integrated utility, a central generator and purchaser, a distribution
utility, or a large consumer. This risk allocation works well because purchasers
have a monopoly franchise area, which they are obliged to serve. But as direct
access to consumers is encouragedwhether or not the sector is broken up
purchasing utilities will face increased demand risk as the loss of retail customers
becomes a greater possibility.
The key to any debt-based financing is the ability to provide adequate security
through a contract or other credible evidence of future revenue streams. Innovative
sharing of demand risk between market playersthe power seller, the power
purchaser, and the financierwill become necessary. An IPP developers ability
to bear any of the demand risk will depend in part on its willingness to provide
corporate assets and revenues as a backstop for lenders.
The view that well-capitalized corporate entities will be the ones able to meet
financial markets requirements in a competitive environment seems to be confirmed
by market responses. Most recent additions to generation capacity in the United
Kingdomthe model of sector unbundlinghave been corporatefinanced IPPs.
And witness the efforts by industry players in the United States to create highly
capitalized enterprises as competition for final consumers looms on the horizon.
The recently announced US$1.26 billion merger of Public Service Co. of Colorado
and Southwestern Public Service Co. is a reaction to the perceived increase in
demand risk stemming from plans for wider retail competitionthe utilities are
noncontiguous and plan to build a connecting transmission line to share generating
resources.
Conclusion
Greater corporate finance support will make it possible to raise private capital for
independent power financing from wider, deeper, and cheaper sources. But
231
innovative strategies will be required from governments, lenders, investors, and

power sector enterprises alike. The following strategies are worth considering:
Encourage the formation of large, well capitalized independent generation
companies. Purely private and quasi-private variants of the Huaneng
merchant generation model in China might be workable in large power
systems. Healthy competition should be engendered through prudent
regulatory reviews of the market power of the IPP in a particular system.
Encourage divestiture of commercially operating (and perhaps
underperforming) generation plants by incumbent utilities to IPP
developers. These sales should be conditional on the purchasers commitment
to making specified investments. By making positive revenue streams
available to IPP developers immediately, such transactions would give them
the financial base to invest in multiple plants.
In IPP prequalification under competitive bidding, give greater weighting
to IPP developers with businesses listed on a stock exchange and to those
with well-capitalized balance sheets. The strategic goals of publicly held
entities are likely to be more transparent and longer term because of these
entities obligations to public shareholders.
Encourage project sponsors to use balance sheet support for subordinated
debt and quasi-equity portions of the project financing plan in order to
increase corporate financing. This strategy would ease the overall financing
costs of projects and could be a transitional strategy for meeting the huge
financing needs for IPPs in developing countries.
(Karl G Jechoutek, Division Chief, Power Development, Efficiency, and Household
Fuels Division (email: kjechoutek@worldbank.org), and Ranjit Lamech, Restructuring
Specialist (email: rlamech@worldbank.org), Industry and Energy Department.)
(For comments contact Suzanne Smith, editor, Room G8105, The World Bank,
1818 H Street, NW, Washington, DC 20433, or E-Mail: ssmith7@worldbank.org)
232
18
Pooling Water Projects to Move
Beyond Project Finance
Many commercial banks have had little interest in water and
sanitation projects not only because of non-commercial political and
regulatory risks, but also the small size, weak local government
credit, and high transactions costs (legal, consulting, and financial
costs of structuring). Most projects have been financed on a limited
recourse basis, that is, with project cash flows and assets as the
main security for lenders. The move from project to corporate
(balance sheet) financing is occurring in stages. Financing project
debt from the sponsor companys balance sheet exposes that company
to significant risk and thus requires a strong and large balance sheet.
Designed in part to shield a companys balance sheet and improve a
projects credit strength, innovative structures and financial
instruments are emerging. Ultimately, the goal is for water utilities
to raise debt and equity from capital markets on the basis of their
own balance sheets, strengthened by a diversified and stable ratepaying customer base. This Note reviews the new trends.
Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/152haarm.pdf. September 1998 World Bank
Publication. Reprinted with permission. The Note is based on a longer paper by the auLthors Tappinig the Prisate
Sector: Approaches to Maniaging Risk in Vater and Sanitation (RINC Discussion Paper 122, World Bank. Resource
Mobilization and Cofinancing Vice Presidency, Washington, DC, 1998).
Pooling Water Projects to Move Beyond Project Finance
233
n the transition from government to private financing, projects in the water

and sanitation sector require a heavy focus on risk allocation and mitigation,
which has often implied drawn-out negotiations before and sometimes after financial
closure. To address non-commercial risk, many projects have required some form
of ongoing government or third-party support (see Viewpoint151). To transform
themselves into economically viable enterprises, projects must mitigate commercial
risks and gain credit strength (significant cash for investments and the ability to
raise funds from capital markets). Risk pooling structures and in water and asset
aggregating instruments may be one way to achieve the funding objectives:
Financing of project debt on the basis of the sponsors balance sheet, or
corporate finance (pooling risks with the corporations other activities).
Equity funds to leverage sponsors equity and attract a larger group of
investors.
Bundling of water and sanitation projects to form economically viable
entities that can be integrative to lenders.
Integration of water and sanitation utilities with other utilities (such as
natural gas distribution or power generation and distribution entities) to
form holding companies with stronger balance sheets.
Corporate Finance and Capital Markets

Corporate finance can simplify the transition to capital market financing, because
the risk of a projects debt is absorbed in part by other corporate activities. As in
other sectors, projects in water and sanitation have been financed with some
(limited) recourse to a sponsors balance sheet. This mechanism focuses project
performance incentives but is generally costly in terms of time and resources.
Increasing balance sheet financing may require significant industry restructuring,
such as consolidating the ownership and operation of water utilities in a region or
encouraging the integration of different utility sectors (Box 1). Such restructuring
is already happening. Malaysia has bundled its entire sewerage system under one
concession, a case of project pooling. While this project has forgone the benefits
of comparative competition achieved when systems operate side by side, it creates
the potential for securing revenue streams to finance a large number of small
investments that would not be commercially viable on their own.
234
In the long term, however, achieving financial and operational sustainability

will require a utility to finance investments from internal cash and long-term
bond issues. As the English and Welsh water companies demonstrate, water projects
have the potential to do this. Once established, they can produce stable revenues
that not only permit internal financing but also allow access to a much broader
class of investors through bond issues. Among developing country projects, only
Aguas Argentinas has moved significantly in this directioninternal cash
generation accounted for nine percent of financing in the first three years and was
expected to rise to 30 percent in the next three.
The use of bond financing by privately financed water projects and utilities is
relatively new. Leading the way, the English and Welsh utilities have used bond
financing based on their balance sheets. In most developing countries, however,
the development both of bond markets and of economically viable water utilities
is at an incipient stage. The United States has the most mature bond market for
municipal infrastructure; its development has been aided by tax exceptions and
credit enhancements (see the discussion below on state revolving funds). Although
the funds are used primarily by utilities owned by local governments, this
municipal bond market taps private financing.
Box 1: Project Fragmentation
New investments in the water and wastewater sector tend to be much smaller than those in other
infrastructure sectors because of the markets fragmentation. Municipalities are in charge of
water and sanitation, so investments facilities reflect demand only within their jurisdictions. The
Mexican wastewater program, for example, will build many small wastewater plants, with an
average cost of about US$25 million to US$30 million. Even where large investments are expected,
they are spread over time, keeping pace with growth in demand. The massive Buenos Aires
concession is expected to make investments worth a few billion dollars over its lifetime but the
initial financing was for less than US$200 million. Similarly, the Manila concessions are expected
to invest about US$5 billion over thirty years, but the initial round of financing probably will not
exceed US$350 million. This pattern of small, incremental investments contrasts with that of
power and transportation projects, which typically require large investments over a short period
and gain the attention, and often the support, of national governments.
Equity Funds
Over the past few years infrastructure equity funds have provided a means by
which developers can raise financing for infrastructure projects and investors can
participate in this emerging market. Such funds can be attractive to infrastructure
235
developers because they allow them to leverage their contributions with those of
other investors and thus to spread their capital. For investors, equity funds mitigate
project and country risk by creating a portfolio of projects under one company.
The French water and sanitation company Lvonnaise des Eaux for example,
introduced an infrastructure equity fund in Asia in 1995, a US$ 300 million water
fund. Besides Lyonnaise, contributors to the fund include Allstate Insurance Company,
the Employees Provident Fund Board of Malaysia, and the Lend Lease Corporation
of Australia. Investors are expected to benefit from the water companys significant
market position and deal flow in the region. The fund refinances the equity of the
original sponsors. Thus, it conserves sponsor equity for the riskier development
phase; sponsors apply their expertise in the early phase to get projects started and
can then move on to other projects. Investors in the fund expect to receive steady,
utility-like returns and potentially stand to gain significantly if the fund or a
portion of it is publicly listed.
Houston-based Enron Corporation used a similar strategy, though the fund
took the form of a publicly listed company. In 1994, Enron packaged its emerging
market power plants and natural gas pipelines in a new company that it floated
on the New York Stock Exchange. Capitalized at about US$165 million, Global
Power and Pipelines (GPP) included the assets of two power plants in the
Philippines, a power plant in Guatemala, and a natural gas pipeline system in
Argentina. Enron retained a 50 percent share of the company and sold the rest to
investors. GPP has the right to buy into projects developed by Eriron at favorable
prices, providing Enron an ensured exit mechanism to free up capital for
high-risk, high-return development opportunities.
EBRDs Private Multiproject Financing Facility

To mobilize private investment in Eastern Europe, the European Bank for
Reconstruction and Development (EBRD) has developed a multiproject financing
facility (MPF) that provides a framework for financing a series of projects that
may be too small to be considered individually. The MPF is made available to a
private company, which uses the facility to make equity investments in, and loans
to private water and sanitation projects. Under this arrangement the company
largely takes on the task of due diligence, which helps to reduce the transactions
costs for each project financed.
236
EBRD signed its first MPF in July, 1995a US$90 million equity and loan
facility with Lyonnaise des Eaux. The company was recently awarded a project
that could be the first to access the facility, a US$ 41 million, twenty-five-year
BOT (build-operate-transfer) wastewater treatment project in Maribor, Slovenia
(population 150,000). In 1996 the second MPF was signed, with three Austrian
companies. The agreement involves a $700 million (approximately US$140 million)
equity and loan facility to support an investment program of $2 billion. The
Austrian companies will also receive financial support in the form of a guarantee
from the East-West Fund of the Austrian Finanzierungsgarantie GmbH.
State Revolving Funds

In the United States the federal government has supported state and local
governments in financing the construction of wastewater treatment plants since
the 1950s. In 1987, in an effort to delegate more responsibility to state and local
governments, the US Congress replaced the existing grant funding with a program
to capitalize state revolving funds (SRFs). States are required to contribute an
amount equal to at least 20 percent of the federal capitalization funding. The
program is aimed at leveraging federal resources and creating a renewable and
perpetual source of financial assistance for wastewater infrastructure. Unlike with
grant funding, the need to repay SRF loans introduces an important element of
accountability, as well as a basis for new loans.
The structure of each states revolving fund program depends primarily on the
states needs and circumstances (such as its borrowing limit and ability to repay
loans). Some states use program funds to provide direct loans to local governments
of up to 100 percent of a projects cost at below-market rates. Others provide
excess reserves or excess debt payment coverage that helps secure bonds backed by
the revenues of a wastewater facility. Program funds may be used as collateral to
borrow new resources; because several jurisdictions borrow on the basis of the
same collateral, spreading the risks, the overall costs of borrowing are lowered.
The large, diversified pools of municipal borrowers created under SRF programs
are attractive to lenders because they spread the risks of debt payment interruption
or default. Pooling projects for financing on a statewide basis also makes it more
economical for credit rating agencies to evaluate credit risks. While a single project
might not be large enough to justify a credit assessment, a large group of projects
237
will be attractive. Credit rating agencies provide important information to

prospective lenders about the creditworthiness of SRF programs by, for example,
assessing and monitoring reserve fund and debt coverage levels and evaluating the
size and composition of the borrower pool. Size and diversity matter. Rating
agencies have found that smaller pools (20-100 borrowers) generally face more
stringent credit requirements from lenders than larger pools because the behavior
of individual borrowers has an amplified effect. For pools with fewer than twenty
borrowers the weakest borrower tends to determine the credit rating.
The revolving nature of the funds has had a insignificant effect on purchasing
power. According to the US Environmental Protection Agency, funds invested in
the SRFs provide about four times the purchasing power over twenty years than
funds used to make grants. Even so, the funds represent only a fraction of the
investment needed to upgrade municipal plants. In 1997, states were expected to
make SRF loans of US$ 3 billion, compared with US$ 11 billion in total capital
investment in wastewater infrastructure from all sources (federal, state, and local).
Multi Utilities
Deregulation and increasing competition in industrial countries are creating
pressures for different utility sectors to combine. By combining, utilities hope to
achieve not only economies of scope but also larger balance sheets and increased
credit strength (through diversity) to attract long- term private financing. The
trend has been most pronounced in the United Kingdom but is growing elsewhere.
United Utilities and Scottish Power, two of the three UK provide utility services
that run the gamutprincipally electricity generation and distribution and water
and sanitatiion, but also gas distribution and telecommunications services.
Multiutilities in developing countries may soon play a growing role. Argentina
and Slovenia have combined gas and water utilities. In Cote dIvoire the project
company developing the water supply concession went on to develop the electricity
distribution system and a power generation project. This multiutility approach is
being adopted in the concessions recently awarded in Casablanca and Gabon and
is being considered for water and power projects in the Republic of Congo. However,
the implications for the concentration of monopoly power are a concern. Chile
recently passed a law prohibiting owners of water utilities from simultaneously
owning power distribution or telephone service in the same area.
238
Conclusion
As a utility matures, and its revenues become increasingly predictable and secure,
its financing structure can be expected to shift to corporate finance or greater
balance sheet support. Internally generated revenues are an important source of
funding for water projects that have achieved a stable and diversified customer
base. And strong balance sheets permit utilities to obtain external financing by
issuing long-term debt to a broader class of investors. However, as a result of high
political risk and shallow or nonexistent capital markets, in developing countries,
the work of building stronger balance sheets and tapping capital markets generally
takes time.
New financing techniques in other sectors and their early applications in water
and sanitation, suggest that pooling projects may be a way to move beyond project
finance, particularly for the many small projects that need financing. Multiutilities
entities that deliver multiple infrastructure services such as water and electricity,
offer another approach to attracting private capital. These multiutilities can gain
credit strength through a diversified revenue base that enhances the prospects for
corporate finance.
(David Haarmeyer (david.haarmeyer@ stoneweb.com), Stone & Webster Consultants.
Boston, and Ashoka Mody (amody@worldbank.org), Project Finance and Guarantees
Department.
For comments contact Suzanne Smith, editor, Room F6p-188, The World Bank,1818
H Street, NW, Washington, DC. 20433, or E-Mail: ssmith7@worldbank.org).
Financing Water and Sanitation Projects - The Unique Risks
239
19
Financing Water and Sanitation
Projects The Unique Risks
A project finance structure allows water projects with attractive
cash flows and risk profiles to secure long-term private capital.
This structure provides a direct link between a projects cash flow
and its funding to give project sponsors, investors, and lenders
strong incentives to ensure that projects are structured and
operated to generate stable revenue streams. But even in industrial
countries, the credit strength of offtaking municipal governments
and the sectors traditional monopoly structure expose lenders to
potentially significant credit, regulatory, and political risks. These
risks, combined with the sunk, highly specific, and non-redeployable
nature of water investments, mean that lenders and investors are
vulnerable to government opportunism and expropriation. Reviewing
some recent innovative projects, this Note shows that private
participation on a limited recourse or no recourse basis has required
support from multilaterals and federal government agencies to
absorb non-commercial risks.
Source: http://rru.worldbank.org/Documents/PublicPolicyJournal/151haarm.pdf. September 1998. World Bank

Publication. Reprinted with permission.
240
rivate sector participation in water and sanitation has often taken the form of
special purpose build-operate-transfer (BOT) projects following the project
finance or limited recourse model. These are self-contained projects that address
the need for more water and sanitation. Although these bulk suppliers can alleviate
immediate shortages, they have virtually no effect on systemwide revenue problems
(for example, leakage and tax collection) or labor cost problems. These long-term
problems are sometimes tackled incrementally through leases and management
contracts. An increasing number of countries have gone further by awarding
operating concessions for entire systems, which require investment commitments
from the concessionaire. Beyond such concessions lies full privatization of assets,
which facilitates financing by creating collateral.
The promise of steady, if not growing, long-term future cash flows is the basis
of the private sectors interest in financing these ventures. As one of the last
monopoly utility sectors, water and sanitation can be especially attractive to longterm private investors. But financing water and sanitation projects has been a
special challenge because of their unique risks:
Expensive to transport but cheap to store, water is essentially a local service
and subject to control by local government, which can be more politicized
and have weaker credit than state or federal government.
With most of the assets underground, their condition is hard to assess.
That makes investment planning difficult, posing risks for contract
renegotiations.
Inadequate provision is associated with health and environmental risks, so
government has a strong interest in extending access to service, regardless
of ability to pay.
Significant currency risk arises because customers pay in domestic currency
that does not match the currency of international debt and equity financing.
There has so far been little scope to introduce direct competition in
treatment, transmission, and distribution.
The risk profile of a project is also influenced by its type and by its stage of
development. Greenfield projects with a build-operate-transfer or build-own-
241
operate (BOO) structure, because they involve a period of construction before

revenues are generated, generally expose lenders to greater credit, political, and
regulatory risks than concessions for infrastructure services that are up and running.
Similarly, older and more efficiently run systems with longer operating histories
tend to have more secure and predictable cash flows and mature investment profiles,
and thus expose lenders and investors to fewer risks.
The water and sanitation sectors exposure to risks that are often difficult and
costly to cover has two important ramifications:
Fewer projects have been successfully financed with private capital than in
other infrastructure sectors, such as power and telecommunications.
Projects financed with private capital have tended to involve direct financial
or credit support from government or third parties such as bilateral,
multilateral, and export credit agencies.
Case Studies in Finance

The experience of six water and sanitation projects and one set of utilities in
accessing and structuring private finance illustrates the level of government or
third-party support (Table 1). All the projects follow the standard project finance
structure except for the more mature English and Welsh water companies, which
rely on corporate finance.
Only the BOT project in Johor, Malaysia, was financed on a non-recourse basis
with no sponsor or third-party support to cover risk of nonpayment. All other
projects were financed on a limited recourse basis. The recourse was generally
provided by payment guarantees to the parties offtaking the service (buying bulk
water or wastewater services), such as a local government entity in a BOT or BOO
project. For the BOT in Chihuahua, Mexico, for example, Banobras, the domestic
development bank, provided credit support to the local government entity. In
Izmit, the Turkish government stands behind the local governments water purchase
agreement. In Sydney, the state government guarantees the payment of the city
water utility (Sydney Water Corp.) to the private project company, even though
the utilitys debt is rated AAA by Standard & Poors. In Buenos Aires, the Argentine
governments guarantee to pay compensation if the concession is terminated early
provides the chief form of security for lenders.
Project Cost
Debt/Equity
Countryrating
Source and Maturity of Debt
Malaysia
Concession (1993)
US$2.4 billion
(about US$500 million
in first 2 years)
75/25
A+
Government soft loans due to

severe tariff collection problems
Buenos Aires, Argentina

Concession (1993)
US$4 billion
(US$300 million
in first 2 years)
60/40
BB
10-year IFC A-loan,12-year IFC B-loan

(recourse to Argentine government in
event ofearly termination)
Izmit, Turkey
US$800 million
85/15
13-year export credit agency loans,

7-year MITIa loan,
7-year commercial bank loan
(recourse to Turkish government)
BOT (1995)
Chihuahua, Mexico
BOT (1994)
US$17 million
53/15/32b
BB
8.5-year commercial bank loan

with limited recourse to Banobras
Johor, Malaysia
BOT (1992)
US$284 million
50/50
A+
10-year project finance loan

from Public Bank Bhd(non-recourse)
Sydney, Australia
BOO (1993)
A$230 million
80/20
AAA
15-year commercial loans

(State government stands behind
Sydney Water Corp. payment)
England and Wales

Full privatization (1989)
US$5.24 billion
25/75
AAA
Capital markets, corporate finance,

European Investment Bank, andother
sources
a. Ministry of International Trade and Industry of Japan.

b. Debt/equity/grant.
Source: Haarmeyer and Mody 1998.
Project Site, Type, and Date
242
Table 1: Funding for Selected Water and Sanitation Projects
243
Sources of Debt
In countries with weak sovereign credit ratings, financing has been provided by
multilateral and export credit agencies. These agencies are generally in the best
position to shoulder political and regulatory risk, and thus provide long-term
finance at reasonable rates. The US$9 million Chase Manhattan Bank loan to the
Chihuahua BOT project, which received no multilateral or bilateral funding but
did receive grant and credit support from Banobras, is a rare case of commercial
bank participation. In a similar BOT project in Puerto Vallarta, Mexico, the
International Finance Corporation provided debt finance backed by a revolving
and irrevocable letter of credit from Banobras.
In countries with high sovereign credit ratings, projects have been financed by
domestic commercial bank loans. The BOT project in Johor, Malaysia, and the
BOO project in Sydney, Australia, were financed by commercial debt. As a result
of the project structure (existing cash flows) and Malaysias highly developed capital
market and relatively low interest rates, the Johor project was financed entirely
with local debt. The Sydney project had both local and offshore financing.
The limited capital market financing of water and sanitation indicates that
individual investors are not in a position to accurately evaluate and mitigate the
risks. But as the experience of the English and Welsh water companies shows,
projects can be expected to access capital markets as their cash flows to support
debt service become more stable and certain and independent regulatory agencies
are established.
The English and Welsh companies have drawn on a variety of financing sources,
including the bond markets. Anglian Water, one of the ten privatized water
companies, reflects the low risk profile of more mature water utilities. In 1990 the
company floated a twenty-four-year bond issue priced at just fifty-three basis points
over UK Treasury gilts due November 2006. Standard & Poors based its AA rating
of the 150 million Eurobond on Anglians robust financial profile and stable
operating environment, which should provide the company with a fair degree of
insulation from the impact of key regulatory and political risks going forward.
The English and Welsh companies have also taken advantage of low-cost loans from
the quasi-governmental European Investment Bank.
244
Equity Financing
Although debt is generally cheaper than equity, a long-term equity stake by the
sponsor (which is sometimes also the operator) ensures that management has a
long-term interest in the project and that cash flow growth leads to capital
appreciation. Equity also reduces the debt service burden on the cash flow, which
can be especially important in a projects early development phase.
Equity has been provided largely by sponsors. For large projects especially,
equity, like debt, is often sourced from multiple consortium members, both
international developers and local investors. The Buenos Aires concession, for
example, has four international shareholders and four local shareholders (including
the utilitys employees).
Lenders like to see sponsors achieve a reasonable return on their investment, to
ensure that sponsors have adequate incentive to maintain support for the project,
at least through the life of the loans. Equity holders partially shield lenders, because
the lower priority of their claims on a projects revenues means that they will
absorb unexpected shortfalls in revenue. In full concessions and privately owned
utility companies internal cash generation can provide an important source of
equity for financing investment.
Although information on the return on equity for project sponsors is not widely
available, the return can be expected to vary with project risk and cash flow profiles.
In two of the cases discussed here, returns to investors are regulated:
The Malaysian government has guaranteed returns of 14 to 18 percent on
investment in the national sewerage project; actual returns are currently at
12 percent because the concessionaire failed to achieve a 90 percent tariff
collection rate.
For the English and Welsh water companies, the returns on regulatory
capital (the assets of the core business) were 11.5 percent in 1995-96 and
12 percent in 1994-95. According to Ofwat, the UK water company
regulator, these returns are expected to fall as the water companies become
more established and capital expenditures decline.
To compensate for the greater country and political risks, required returns in
most developing country projects are likely to be significantly higher and closer
245
to those in other infrastructure sectors. For a sample of power projects in Asia and
Latin America, Baughman and Buresch (1994) estimated the equity return
at between 18 and 25 percent. And for privately financed toll roads, Fishbein and
Babbar (1996) found that investors expect annual returns to range between
15 and 30 percent.
Conclusion
The challenge for the future is in mitigating the non-commercial risks that
characterize the sector and moving beyond the limited capacity of third parties.
Part of the solution lies in generating better information about these risks so that
they are more transparent and their costs are more fully recognized by parties that
can mitigate them. Two tracks to achieve this end are independent regulatory
agencies and competitionfor the market and for rights to supply individual
customers, as in England and Wales.
(David Haarmeyer (david.haarmeyer@ stoneweb.com), Stone & Webster Consultants,
Boston, and Ashoka Mody (amody@worldbank. org), Project Finance and Guarantees
Department.)
(For comments contact Suzanne Smith, editor, Room F6p-188, The World Bank,
1818 H Street, NW, Washington, D.C. 20433, or E-Mail: ssmith7@worldbank.org)
References
1
Baughman David, and Matthew Buresch. (1994). Mobilizing Private Capital for the
Power Sector: Experience in Asia and Latin America. US Agency for International
Development and World Bank, Washington, DC.
Fishbein Gregory, and Suman Babbar. (1996). Private Financing of Toll Roads. RMC
Discussion Paper 117. World Bank, Resource Mobilization and Cofinancing Vice Presidency,
Washington, DC.
Haarmeyer David, and Ashoka Mody. (1998). Tapping the Private Sector: Approaches to
Managing Risk in Water and Sanitation. RMC Discussion Paper 122. World Bank, Resource
Mobilization and Cofinancing Vice Presidency, Washington, DC.
246
20
Successful Project Financing HUB
Power Project
World Bank Project Finance Group
Hub Power Company (HubCo), was established by private
developers in Pakistan to own and operate the power station. The
sponsors, which led the development and negotiation process, were
Xenel Industries of Saudi Arabia and National Power of the UK.
HubCo will build, own and operate the conventional, oil-fired steam
plant. The transmission interconnection between the plant and the
national power grid is being handled by the Water and Power
Development Authority (WAPDA), partially financed by a Bank
loan. Hub is important to Pakistan for several reasons. In addition
to being the largest private sector project in the country, it
demonstrates investor confidence in the expansion of the private
sectors role in infrastructure development. The project also played
a significant role in the formulation of the Governments
long-tem strategy to attract private investment to the power sector
and the development of model independent power contracts. As a
result, several follow-on projects are expected to be completed
relatively quickly. Finally, the project will expand Pakistans
generating capacity by approximately 20% and ease power
shortages that currently constrain economic growth.
Source: http://siteresources.worldbank.org/INTGUARANTEES/Resources/HubPower_PFG_Note.pdf. Originally
published as World Bank Guarantee Sparks Private Power Investment in Pakistan: The Hub Power Project, June
1995. World Bank Publication. Reprinted with permission.
247
The Hub Power Project

The Hub Power Project marks the first use of a World Bank guarantee for a private
sector project, and is a major step forward in the Banks effort to increase private
sector investment in infrastructure. In addition, the project sets several milestones
for the Bank:
First use of a partial risk guarantee;
Largest private sector infrastructure project supported by the Bank to date;
First Bank-financed infrastructure fund to support private sector projects;and
First co-guarantee with another financial institution, the Japan Export-Import
Bank.
Financial closure occurred in January 1995, putting into place nearly US$1.8
billion in equity and long-term debt financing, required to refinance construction
bridge loans and complete the project. Construction of the 1,292 megawatt power
plant began in early 1993, and is expected to be completed by 1997. The project
is located about 40 kms outside Karachi.
The Banks guarantee, which protects commercial lenders against sovereign risks
associated with the project, establishes a new method of supporting build, own,
operate (BOO) projects which are normally financed on a project finance or limitedrecourse basis. Prior to Hub, Bank guarantees were utilized as cofinancing
instruments, designed to help mobilize commercial funding for Bank-supported
public sector projects. It is expected that the Bank guarantee for the Hub project
will serve as a model for future guarantees in support of other BOO projects.
What is Project Finance?
Project finance, sometimes referred to as limited-recourse finance, refers to financing structures
under which lenders look to project cash flows for debt repayment and to project assets for
collateral. In deciding whether or not to lend to a project, a lender bases its decision on an
evaluation of a project's-not the sponsors-creditworthiness. In the event of default, the liability of
project sponsors is limited to their investment in a project.
Project Overview
Bank involvement in the project dates back to the late 1980s, when Pakistan initiated
an energy sector adjustment program with Bank assistance. A key element of the
248
program was the opening of the power sector to private investment To this end, the
Bank, along with several bilateral donors, established the Private Sector Energy
Development Fund (PSEDF). PSEDF, a Government-owned facility, provides debt
financing of up to 30% of the financing needs of private sector energy projects.
Project sponsors are expected to mobilize 20-25% equity and raise the remaining
45-50% of the funding in domestic and international financial markets.
A special-purpose project company, Hub Power Company (HubCo), was
established by private developers in Pakistan to own and operate the power station.
The sponsors, which led the development and negotiation process, were Xenel
Industries of Saudi Arabia and National Power of the UK. HubCo will build, own
and operate the conventional, oil-fired steam plant. The transmission
interconnection between the plant and the national power grid is being handled
by the Water and Power Development Authority (WAPDA), partially financed
by a Bank loan.
Hub is important to Pakistan for several reasons. In addition to being the
largest private sector project in the country, it demonstrates investor confidence
in the expansion of the private sectors role in infrastructure development. The
project also played a significant role in the formulation of the Government's longtem strategy to attract private investment to the power sector and the development
of model independent power contracts. As a result, several follow-on projects are
expected to be completed relatively quickly. Finally, the project will expand
Pakistan's generating capacity by approximately 20% and ease power shortages
that currently constrain economic growth.
Financing Structure
The total financing of US$1.8 billion includes US$1.7 billion equivalent in foreign
exchange and about US$100 million equivalent in local costs. The capital structure
is 20% equity and 80% debtthe debt is mobilized on a project finance basis.
Included in the financing plan are costs associated with the turnkey construction
contract, development costs, interest during construction and other finance related
costs, as well as a reserve contingency fund.
The Sponsors contributed a significant portion of the projects total equity.
Other equity sources include Commonwealth Development Corporation (CDC)
249
of the UK, Entergy, Xenergy and other offshore and local investors. An innovative
feature of the projects financial structure is the US$ 102 million global depositary
receipt (GDR) issue underwritten by Morgan Grenfell, UK, the first GDR issue
for an independent power project.
The amount of debt financing required for the project (US$ 1.4 billion)
necessitated that it be raised from a variety of sources, including PSEDF, foreign
commercial banks supported by partial risk guarantees from the World Bank and
J-Exim, and political risk insurance from export credit agencies of France, Italy
and Japan, local commercial banks, and CDC. Other large private sector
infrastructure projects will likewise be obliged to obtain debt financing from many
different sources, given the exposure limitations of lenders, insurers and guarantors.
Funding Structure
Export Credit
Agency Insurance
World Bank/
J-Exim Guarantee
$335
$360
Commercial
Banks
$695
PSEDF*
Subordinated Loan
$602
Hub Power
Company
(Project Cost:
US$1.8bn)
$372
Equity
Investors
$163
Other Local
and
Offshore Lenders
* World Bank, J-Exim,
France, Italy, Others.
Contractual Framework
A key element of project finance is the apportioning and allocation of risks, a
difficult and complex process even in developed countries. In a developing country
such as Pakistan, the process is substantially more difficult. There is often a lack of
precedents to build on, and the process is further hampered by an undeveloped
legal regulatory environment.
250
Under Hubs commercial arrangements, project-specific risks (completion,

performance operation and underwriting risks) are assumed by equity investors
and lenders, while sovereign-or political-risks are assumed by the Government
(GOP) and its agencies. These risks are identified and allocated via the projects
contractual framework, which comprises the following main agreements:
Implementation Agreement (IA)
Overall project implementation is being undertaken within the provisions
of this 30- year agreement between HubCo and GOP. The IA grants HubCo
the sole right to develop the project and defines each partys responsibilities
during the construction and operation phases of the project.
Power Purchase Agreement (PPA)
The PPA, which secures the projects revenue streams, is the most important
commercial agreement. The 30-year agreement also defines the interface
between HubCo and WAPDA.
Fuel Supply Agreement (FSA)
Fuel supply is secured through this 30-year agreement between the
Government owned fuel supplier, Pakistan State Oil Company, and HubCo.
Operation & Maintenance Agreement (OMA)
The OMA between HubCo and National Power International (a subsidiary of
National Power, UK) has an initial term of 12 years and provides for operation
and maintenance of the plant according to agreed terms and technical criteria.
Construction Contract
A fixed-price, date-certain turnkey construction contract between HubCo
and a consortium led by Mitsui 7 Company of Japan was signed in 1991.
In addition to Mitsui, the consortium includes Ishikawajima-Harima Heavy
Industries Co., Ltd. of Japan, Ansaldo GIE, S.R.I. of Italy and Campenon
Bernard SGE-SNC of France.
Other Agreements
Several other agreements/provisions are integral components of the
contractual arrangements of the project. These include: (i) escrow agreements
for local and offshore escrow accounts; (ii) foreign exchange risk insurance
251
provided by the State Bank of Pakistan for a fee included in the project
cost; and (iii) a shareholders agreement and related corporate documentation
Bank Guarantee
To match project revenues with debt service, long-term financing is critical to the
viability of power (and other infrastructure) projects. However, due to its poor
credit standing, such long-term financing was inaccessible to Pakistan. Commercial
lenders needed a creditworthy third party to back commitments made to the
project by the Government of Pakistan to enable them to make long-term loans
hence the need for the World Bank Guarantee.
The Bank is providing a partial risk guarantee to a syndicate of international
commercial banks. The guarantee covers, on an accelerable basis, principal
repayments for up to US$240 million in loans. It would be triggered if GOP
noncompliance with one ormore of its obligations, as outlined in project contracts,
resulted in a default in the repayment of the loans. Specifically, these obligations
are delineated in the project agreements (IA, PPA, FSAsee above). The US$120
million J-Exim co-guarantee is of an identical structure. The 12 year maturity of
the projects commercial loan financing is a major achievement, considering that
prior to Hub, Pakistans access to international credit markets was limited to shortterm trade credit and medium-term aircraft financing.
Accelerability and Guarantees
If a loan is accelerable, lenders can demand payment of the unpaid balance if specified events of
default occur. Under an accelerable guarantee, the unpaid balance of guaranteed exposure (which
could be different than the unpaid balance) would be payable by the Bank upon call of the
guarantee. Prior to call of the guarantee, however, all remedies specified in project agreements
must exhausted. In contrast, under a nonaccelerable guarantee, each individual payment is, in
effect, guaranteed, and the guarantee would be called each time a payment default occurs.
There are three main categories of risk covered by the Bank and J-Exim guarantees:
(i) GOP guarantees of obligations (payment and supply) of state-owned
entities, including WAPDA and PSO; (ii) GOP payment obligations specified in
the Implementation Agreement, including payments resulting from occurrence of
certain force majeure events ( force majeure events can be political events, such as
war of civil strife, or natural events, such as lightning outside plant boundaries);
and (iii) provision and transfer of foreign exchange through the Foreign Exchange
Risk Insurance Scheme provided by the State Bank of Pakistan.
252
Risks guaranteed by the Bank were translated in GOP payment obligations so

that the exact cause of a debt service default can be determined, and hence, what
constitutes a legitimate call of the guarantee, is well-defined. The Bank entered
into Guarantee Agreement with the commercial banks, which outlines the coverage
and mechanics of the Banks guarantee. In parallel, the Bank entered into
an Indemnity Agreement with GOP which counterguarantees the Bank for any
disbursement made under the terms of the Guarantee Agreement. (A counterguarantee is a requirement of the Banks Articles of Agreement; it takes the form
of an indemnity agreement.) The Banks US$240 million commitment under the
guarantee was counted at 100% in the lending program, i.e., as if the Bank had
made a loan, because the Bank is providing coverage on the whole loan
amount (against certain risks).
The commercial banks, despite the breadth of the Banks guarantee, are
assuming substantial risks, including those associated with construction and
completion of the project and on time and efficient plant operation. Construction
cost overruns and delays, depending on their severity, would first erode returns to
equity and could also jeopardize debt service. Although the debt-equity ratio grants
debt providers a cushion of 20% (standby facilities are also available), lenders are
still at risk in the event of a shortfall in project revenue. Cost overruns and/or
inefficient management of the project during operation also could lead to debt
service default.
Security Structure
World Bank
Pakistan State
Oil Company
Counterguarantee
Guarantee
Agreement
Government
of Pakistan
State Bank
of Pakistan
FX &
Transfer
Implementation
Agreement
Offshore Escrow
Account
O&M
Agreement
Hub Power
Project
Power Purchase
Agreement
WAPDA
Cash Flows
Commercial
Lenders
National
Power Plc
Fuel Supply
Agreement
Domestic Escrow
Account
Construction
Contract
Construction
Consortium
253
Bank Guarantees and Private Sector Projects

In order to streamline its appraisal of private sector projects involving Bank
guarantees and shorten project development time, the Bank intends to capitalize
on project reviews by other project participants. To this end, the Bank
can incorporate third-party project assessments into its own appraisal. For instance,
since commercial lenders will assume construction and performance risks of a
project, they will closely scrutinize the projects technical and financial
characteristics. If it finds them satisfactory, the Bank could incorporate the results
of the analysis into its own appraisal.
The Banks partial guarantee covers debt service default caused by nonfulfillment
of government contractual obligation to a project. Therefore, risks covered by a
Bank guarantee need to be clearly defined in the commercial contracts which set
out the risk sharing allocation for a build, own, operate project. To allow the
Banks guarantee to voucher these risks, they must be translated into government
payment obligations. In the case of government guarantees of payment obligations
of state-owned entities, this is relatively easy to quantify since payments are related
to the provision of a service at a specified price. For other government obligations
which could jeopardize project cash flows, such as the granting of permits,
or political force majeure, this quantification becomes more difficult, This may
be handled, as in Hub, by linking government defaults related to these events to
the payment of fixed amount (defined in the Power Purchase Agreement as the
capacity purchase price) which covers fixed costs, including debt service.
In summary, the Banks guarantee can act as an important catalyst for
mobilizing private sector financing for private sector infrastructure projects. As
exemplified by the Hub Power Project, not only does the Bank guarantee provide
coverage for a part of the debt financing, but the presence of the Bank in the
project enhances the projects attractiveness to other providers of capital, both debt
and equity.
(For more information on the Hub Power Project and the Banks partial
risk guarantee, please contact Suman Babbar, CFSPF (ext. 32029) or Per Ljung, SA1EF
(ext. 81933)
254
21
Insurance Funds to Flow into Road
Projects-LIC Finalising Loan Pact
with NHDP
P Manoj
Insurance funds are set to be ploughed into the highways sector for
the first time, with the National Highways Authority of India (NHAI)
and Life Insurance Corporation (LIC) finalising the terms for a
long-term loan agreement of Rs.6,000 crore, to part-fund the
Rs.58,000-crore National Highways Development Project (NHDP).
ccording to the terms of the loan agreement to be signed in June, LIC would
provide a maximum of Rs.6,000 crore or a minimum of Rs.4,000 crore to
NHAI to be availed of in eight quarters as per a schedule to be drawn up.
The 25-year loan with a moratorium of ten years will be repaid in 30 equal
semi-annual instalments beginning from the second half of the tenth year to the
terminal year of the loan.
The LIC loan will carry an interest rate on par with Government of India
Securities (G-Sec) plus 100 basis points. Besides, NHAI will pay a commitment
Source: http://www.blonnet.com/2003/05/25/stories/2003052501630100.htm. May 2003. @ Businessline, Reprinted
with permission.
Insurance Funds to Flow into Road Projects-lic Finalising...
255
fee of 0.10 percent per annum of the funds to be disbursed in a particular financial
year, a penalty fee of 0.25 percent per quarter of the amount undrawn out of the
minimum agreed disbursement, for any quarter and expenses relating to listing.
The debt will be drawn by issuance of bonds, which will be listed in the
wholesale debt segment of the National Stock Exchange. Each bond carries a face
value of Rs.1 crore and will be issued in demat form.
The debt servicing obligations of the NHAI will be backed by a contingent
Government of India guarantee, on an unconditional and irrevocable basis for
which the highway authority will pay a guarantee fee of 0.25 percent every year
to the Finance Ministry.
All these elements will translate into a cost of less than 8 percent. Considering
that such long-term loans are not available in the market, at this maturity, the
cost is very competitive, a senior NHAI official said.
LIC will have pari passu first charge on the funds assigned to NHAI from the
Central Road Fund made up of the cess on petrol and diesel. The cess funds
would be utilised to service the debt obligations of NHAI through an escrow
mechanism operated by a suitable trustee, the official said.
The loan agreement also contains a provision to review the G-Sec rates after
seven years.
Apart from ensuring a steady stream of funds to finance the NHDP, the LIC
loan also fulfils a Government strategy to channelise insurance money to built
highways, port and railway projects.
257
Index
Index
A
Active Traders, 151
Callable Debt, 123
Adjusted Present Value, 85
Capital Markets, 20, 31, 32, 34, 44, 47, 51,

98, 129, 165, 168, 200, 202, 204, 206,
207, 211, 215, 216, 219, 220, 229, 232,
233, 238, 242, 243
Africa, 95, 143, 145, 154, 155

Agency Costs, 10, 11
Agency Fee, 147, 148
Casablanca, 237
Antifiling Mechanism, 186, 187
Cash Deficiency Agreement, 64
Argentina, 15, 39, 125, 143, 200, 201,

203, 205, 207, 209, 212, 217, 221, 222,
234, 235, 237, 242
Cash-Sweep, 114, 117, 118, 120, 123
Arrangers, 145, 148, 154, 156

Asia, 16, 19, 95, 143, 150
Asia-Pacific Region, 153, 154
Cash-Trap, 121
Chile, 30, 32, 37, 38, 110, 123, 199-203,
205-207, 209, 212, 216, 217, 219-222,
237
Asymmetric Information, 12, 68
Collateral, 6, 7, 11, 23, 38, 41, 44, 45, 108,

110, 149, 151, 174, 177-179, 185-187,
190, 193, 236, 240, 247
Austria, 155
Collateralized Debt Obligations, 153
Asset-Backed Securities, 9
Completion Risk, 3, 5, 35, 62, 173
Bond Financing, 142, 234
Concession Agreements, 18, 40, 55, 65, 97,

98, 179
Bond Market, 32, 55, 144, 154, 234, 243
Concessionaire, 41, 43, 240, 244
Brady Plan, 143
Consolidation Risk, 28, 31, 35, 40, 108
Brazil, 30, 33, 34, 129, 143, 199, 201,

205, 209, 212, 217, 221, 222
Contingent Liabilities, 43, 131, 133-137
Build-Operate-Transfer (BOT), 65, 240
Contract Enforcement, 25, 29, 30
Build-Own-Operate (BOO), 65
Contract Finance, 60
Build-Transfer-Operate (BTO), 65
Cost-of-Service Agreement, 64
Bullet or Balloon Repayments, 116
Counterparty Exposure, 175, 187
Contingent, 29, 43, 131-137, 255
258
Covenants, 10, 21, 23, 34, 36, 40, 63, 104,

107, 112, 114, 120-122, 144, 149, 151,
161, 169, 187
Credit Default Swap, 144
Credit Derivatives, 100, 151
Credit Enhancements, 25, 28, 33, 46, 174,
175, 234
Credit Lease, 177, 180, 183, 185, 188, 190
Credit Ratings, 174, 188, 189, 196, 243
Credit Risk, 23, 25, 27, 28, 42, 44, 45, 47,
60, 62, 63, 93-95, 99, 101, 105, 110,
123, 133, 142, 144, 145, 147, 149, 162,
167, 169, 179, 236
Cross-Border Debt, 177, 178
Electric Utilities, 12, 225

Emerging-Market, 32, 33, 47
Entertainment, 58, 173
Equator Principles, 158-162
Escrow, 62, 67, 250, 252, 255
Europe, 95, 96, 114, 115, 144, 145, 150,
152, 153, 155, 199, 201, 205, 207, 218,
220, 235
European Bank for Reconstruction and
Development, 235
European Investment Bank, 242, 243
Exchange Rate Risk, 124-130
Expropriation, 22, 40, 97, 100, 239
Currency Risk, 16, 137, 193, 240
Currency Swaps, 188
Financial Distress, 3, 5, 11, 68, 100
Financial Risk, 3, 5, 66, 82, 133, 176, 189,

190
Financial Sector Reforms, 32
Debt Market, 25-29, 32, 37, 38, 44, 46,

107, 109, 123, 150
Debt Service, 8, 10, 11, 29, 30, 34, 36, 39,
41, 42, 44, 45, 47, 62-65, 67, 94, 129,
174, 175, 177, 189, 191, 243, 244,
251-253
Debt-Service Coverage Ratios (DSCRs), 189
Force Majeure, 62, 64, 174, 175, 193, 194,

196, 251, 253
Foreign Direct Investment (FDI), 52
Foreign Exchange Reserves, 54
Debt-Service Reserve Fund, 45, 47, 194,

196
Foreign Exchange Risk, 130, 178, 190,

191, 198, 210, 250, 251
France, 93, 155, 249, 250
Debt-Service Reserve Account (DSRA), 114
Free Cash Flow, 10, 11, 62, 78, 79, 97, 99
Design-Build-Operate, 33
Funding Gap, 26, 27, 44
Dispute Resolution, 30
Domestic Resource Cost (DRC), 75
Dominican Republic, 228
Gabon, 237
Due Diligence, 40, 45, 207, 235
Generally Accepted Accounting Principles

(GAAP), 165
Global Depositary Receipt, 249
Economic Rate of Return (ERR), 70-72, 76
Golden Quadrilateral (GQ), 53

Governance, 16, 99, 210
Economic Value, 35, 73, 74, 111
Index
259
Government Guarantee, 23, 29, 42, 226,

241, 253
International Finance Corporation (IFC), 72,

160
Grant Funding, 236
Involuntary Bankruptcy, 35, 36, 40, 41
Greenfield Projects, 15, 24, 130, 203, 207,

240
IPP, 225-231
Italy, 155, 249, 250
Guaranteed Investment Contracts (GICs),

45
Guatemala, 228, 235
Japan, 144, 145, 155, 242, 247, 249, 250
Hedging, 55, 126, 127, 166, 188
Korea, 30-32, 38
Hell-or-High-Water Contract, 177, 180,

183, 185, 188, 190
Hong Kong, 153
Hungary, 15
L
Latin America, 34, 95, 130, 131, 143, 145,
155, 157, 195, 198-201, 204, 205, 207,
208, 210-212, 216, 218-221, 245
Lead Managers, 145
Indenture, 41, 115, 123, 169, 177-179,

185
Lease Rental Expense, 170
India, 3, 4, 13, 25, 47, 51-56, 58, 65, 68,

75, 81, 89, 93, 103, 159, 254, 255
Lender Rights, 31
Infrastructure, 3-5, 13-15, 18, 19, 25-30,

32-38, 42, 44, 46-48, 51, 52, 54-58,
60, 61, 65, 67, 68, 70, 71, 78, 80-82,
84, 86, 88, 93, 94, 96, 98, 101, 108,
110, 116, 117, 119, 124, 125, 128-131,
133, 134, 137, 159, 174, 192, 195, 197222, 234-238, 241, 245-249, 251, 253
Insolvency, 30, 184, 187
Institutional Bond Investor, 25, 26
Legal Framework, 25, 29-31, 38, 98

Leverage Ratios, 12, 59, 99, 101
Life Insurance Corporation (LIC), 254
Limited Liability Corporation, 37
Little Mirrlees Approach (LM), 73
Loan Portfolio, 44, 45, 119, 151, 153
M
Maintenance Reserve Account (MRA), 114
Institutional Risk, 175, 192
Malaysia, 233, 235, 241-243

Mandated Arrangers, 145
Inter- American Development Bank, 150,

197, 219
Market Risk, 18, 61, 63, 97, 99, 133, 165,

173, 177, 182, 183, 195
Interest Rate Risk, 118
Market-Makers, 151
Inter-Institutional Group (IIG), 54

International Arbitration, 178
McKinsey, 52
International Development Banks, 26
Mexico, 30-34, 36-38, 142, 143, 200-202,

204-206, 209, 212, 221, 222, 241-243
260
Military Housing, 173

Modified Internal Rate of Return, 84
Petrochemicals, 97, 100

Philippines, 20, 103, 143, 228, 235
Multilateral Agencies, 46, 61, 150, 193,

194, 216
Political Risk Guarantees, 94, 100, 102, 104,

105
Political Risk, 3, 5, 31, 32, 34, 35, 42-44,
94, 97, 100-106, 133, 188, 210, 217,
238, 239, 243, 244, 249, 250
Pooled Financings, 28
Multilateral Investment Guarantee Agency,

193
Multiproject Financing Facility (MPF), 235
Municipal Infrastructure, 234
Portfolio Performance, 55, 200

Power Purchase Agreement (PPA), 250
National Highways Authority of India

(NHAI), 254
National Stock Exchange, 255
Power Sector, 95, 110, 116, 226, 227, 230,

231, 245, 246, 248
Prepayment Fee, 147, 148
Natural Gas Pipelines, 235
Private Pension Funds, 197, 199-201,

207-209, 218-221
Network Effect, 78, 79

New Zealand, 117, 121
Non-recourse, 5, 7-9, 12, 14, 17, 55, 58,
59, 61, 68, 94, 95, 98-101, 109,175,
176, 187, 195, 203, 226, 241, 242
O
Offtake Agreement, 23, 97, 98, 108, 177,
178
Oil and Gas, 18, 97, 108, 110, 159, 173
Open-Ended Funds, 100
Operating Agreement, 38, 39
Private Sector Risk, 35

Privatizations, 9, 16, 26, 30, 31, 34, 130
Project Debt Rating, 175, 191
Project Finance Market, 3, 12, 13, 21, 95,
121
Project Financing Structures, 10, 11, 13,
55, 57, 58, 97, 100
Project Risks, 10, 22, 68, 97, 196
Project Sponsors, 5, 18, 20, 24, 61, 64, 66,
67, 82, 126, 173, 194, 195, 226, 231,
239, 244, 247, 248
Operating Risk, 23, 99, 166, 177
Public Utility Regulatory Policy Act

(PURPA), 7, 16
Organization for Economic Cooperation and

Development (OECD), 26
Public-Private Partnerships, 25, 27, 29, 99
Overseas Private Investment Corporation,

129
P
Pari Passu, 42, 112, 255
Pension Asset Management, 204
Pension Funds, 61, 129, 144, 197-201,
203, 205-221
R
Ratings, 25, 27, 45, 48, 96, 104, 105, 112,
118, 121-123, 144, 164, 165, 168, 171,
174, 181, 182, 188, 189, 192, 193, 195,
196, 201, 202, 213-215, 217, 243
Raw Material Supply Contracts, 64, 100
Real Estate, 6, 100, 164, 165, 179, 202,
208, 222
Index
261
Refinancing Risk, 107-123, 169, 189
Syndicated Loans, 24, 94, 141-145, 147,

150, 151, 156, 157
Refineries, 58, 100, 194
Synthetic Lease, 164-171
Republic of Congo, 237
Residual Value Guarantee, 168-171
Take or Pay Contract, 63, 65
Revolving Loan, 129
Take-if-Offered Contract, 63
Risk Contamination, 68, 99
Technical Risk, 181
Risk Identification, 133
Telecom, 9, 12, 58, 81, 88, 93, 95, 96,

211, 212, 237, 241
Real Options, 80, 87, 88, 100
Risk Management, 12, 13, 20, 23, 55, 68,

131-133, 137, 144, 162, 166
Risk-Return Trade-Off, 55
S
Secondary Market, 105, 141, 144, 148,
150-154, 156
Securitization, 9, 28, 31, 38-40, 100, 207,
215, 222
Shadow Prices, 73, 74, 76
Slovenia, 236, 237
Sovereign Risk, 174, 175, 191, 193, 247
Spain, 116, 155, 201, 205, 222
Special Purpose Entity (SPE), 165, 167, 184
Special Purpose Vehicles (SPVs), 59, 95
Throughput Agreement, 64, 67

Toll Road, 4, 34, 40, 96, 109, 110, 116,
119, 122, 123, 193, 194, 245
Tolling Agreement, 64
Transport, 12, 51-53, 58, 68, 75, 81, 88,
108, 117, 119, 121, 145, 173, 182, 211,
217, 218, 220, 234, 240
Trust Estate, 37
Trustee, 28, 37-43, 67, 177, 178, 184, 187,
255
U
US Agency for International Developments
USAID, 25, 47, 245,
Speculative Development, 66
Underwriting, 45, 142, 147, 148, 156,

157, 250
Stakeholder Analysis, 70, 76
UNIDO Approach, 73, 74
State Revolving Funds (SRFs), 45, 236
United Kingdom (UK), 93, 103, 114, 117,

130, 145, 154, 155, 176, 187, 195, 198,
201, 205, 207, 214, 222, 230, 237, 243,
244, 246, 248-250
Step-up Provisions, 64
Structured Finance, 38-40, 58, 107, 108,
119, 122, 193, 196
Subordinated Debt, 8, 21, 67, 112-114,
171, 190, 191, 231
Supplemental Credit Arrangements, 63, 66
Supply or Pay Contract, 64
Surety Bonds, 179, 188
United States (US), 6, 7, 16, 25, 26, 32, 37,

39, 45, 47, 64, 66, 85, 89, 95, 96, 103,
106, 110-112, 116, 118, 119, 123, 129,
134, 142-147, 150-157, 160, 161, 172,
173, 186, 195, 199-201, 204, 206, 208,
209, 211, 212, 214, 216, 218, 220, 225,
262
227-230, 234-237, 242-245, 247-249,

251, 252
User Fees, 27, 34, 39, 41, 42, 45, 47
Utilisation Fee, 147, 148
V
Venezuela, 143, 200
Venture Capital, 206
Voluntary Bankruptcy, 35, 40, 187
W
Water and Sanitation Pooled Fund, 25, 47
World Bank, 4, 55, 61, 76, 102, 124, 130,
131, 137, 158, 161, 162, 211, 212, 220,
225, 231, 232, 238, 239, 245-247, 249,
251, 252
Wraparound Addition, 66

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Padmalatha Suresh holds a post-graduate diploma in Management from the Indian

Institute of Management, Ahmedabad, as well as a degree in Law. She is a Certified

The ICFAI University Press

Project Finance Concept and Applications

The ICFAI University Press

The Project Finance Market An Overview

Project Finance: The Need to Treat Large

Project Finance in Developing Countries

Public-Private Partnerships: The Next

How Project Structures Create Value

Budget: Overcoming Roadblocks to Growth

Structure Matters in Project Finance

Assessing the Economic Impact of

Complexities in Valuing Large Projects

Managing Project Risks

The Nature of Credit Risk in Project Finance

Refinancing Risk Permutations of

Exchange Rate Risk

Philip Gray and Timothy Irwin

Contingent Liabilities for Infrastructure

Christopher M Lewis and Ashoka Mody

The Syndicated Loan Market: Structure,

Equator Principles Why Indian Banks

Project Finance: Debt Rating Criteria

Peter Rigby and James Penrose, Esq.,

Pension Funds In Infrastructure Project

Applications and Cases

Private Power Financing From Project

Karl G Jechoutek and Ranjit Lamech

Pooling Water Projects to Move

David Haarmeyer and Ashoka Mody

Financing Water and Sanitation

David Haarmeyer and Ashoka Mody

Successful Project Financing HUB Power Project

World Bank Project Finance Group

Insurance Funds to Flow into Road

features, every project is unique and requires tailoring of the financial

International Finance Corporation (IFC), features the growing

implementation of a debt structure that finances a project that is changing

program and come up with better-designed contracts and fewer and

article in this section, analysts from Fitch Ratings have described

to achieve such a union. Fortunately, there has been an almost

balance sheet and improve a project's credit strength, innovative

deregulation and economic development. As markets integrate and

Project Finance: The Need to Treat Large Projects Differently

The Project Finance Market:

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Project Finance: The Need to Treat Large Projects Differently

PROJECT FINANCE CONCEPTS AND APPLICATIONS

Rationale for Project Finance

Project Finance: The Need to Treat Large Projects Differently

Defining Project Finance

PROJECT FINANCE CONCEPTS AND APPLICATIONS

3. Financing of a particular economic unit in which the lender is satisfied to look

Evolution Of Project Finance

Project Finance: The Need to Treat Large Projects Differently

Figure 2: Non-Recourse Project Finance Structure

PROJECT FINANCE CONCEPTS AND APPLICATIONS

The use of Municipal bonds by the government and municipalities in many

Features of Project Finance

Project Finance: The Need to Treat Large Projects Differently

Structuring a project finance deal entails substantial transaction costs in

Comparison of Project Finance With Other Financing Vehicles

PROJECT FINANCE CONCEPTS AND APPLICATIONS