Running head: Assignment 2

Assignment 2

FERNANDO LUZERNO AUGUSTO CARLOS LICHUCHA

Distance Learning Doctorate of Finance

Program
This assignment is submitted in partial fulfilment of the
requirements for 5524S1861 DF Project Finance R2

School of Management
Professor Dr. Igor Gvozdanovic

July 23, 2016

Assignment 2

Please answer the following questions in the form of a

short essay:
a. What is the essence of preliminary risk assessment in
project finance?
b. What are the typical project risks at start-up and how
can these risks be mitigated?
c. Why is it important to understand the financial and
political risks surrounding a project?
d. Is negative pledge adequate to protect a lenders
position? If not what else should be considered?

Assignment 2

Table of Contents
Abstract............................................................................................................................................4
What is the essence of preliminary risk assessment in project finance?.........................................5
Feasibility studies.........................................................................................................................5
Due diligence...............................................................................................................................6
What are the typical project risks at start-up and how can these risks be mitigated?......................8
Engineering and construction risks..............................................................................................9
Start-up risks..............................................................................................................................10
Operational risks........................................................................................................................11
Why is it important to understand the financial and political risks surrounding a project?..........11
Financial risks............................................................................................................................11
Political risks..............................................................................................................................12
Is negative pledge adequate to protect a lenders position? If not what else should be considered?
.......................................................................................................................................................15
Conclusion.....................................................................................................................................16
References......................................................................................................................................17

Assignment 2

Abstract
The assignment examines the essence of preliminary risk assessment in
project finance; identifies the typical project risk at start-up and strategies
for its mitigation, analysis financial and political risks surrounding a project
and explains if is negative pledge adequate to protect a lenders position? If
not what else should be considered?
The main purpose of conducting a preliminary risk assessment is to identify
and allocate risk among the players of project and describe the project
feasibility.

Assignment 2

What is the essence of preliminary risk assessment in

project finance?
In project finance risk is the possibility that unexpected event occurs which
have impacts on economic return; as resulting of risk, project finance has to
be structured within a risk confident envelope to secure and increase the
financial viability of a project (Chu 2007) as cited in (Merna, Chu, & Al-Thani,
2012). As project finance has extremely high debt levels, mean debt of 70%
and as high as nearly 100% (as compared to 30% of similar-sized
investments) (Banal-Estaol, n.d.) and it is a complex financing mechanism
that can requires significant lead times (McPherson, 2012) with no recourse
to the project sponsors assets for the debts or liabilities of the project (Fight,
2006) it has to

apply strong discipline to the contracting process and

operations through proper risk allocation and private sector participation

(McPherson, 2012).
In practical terms preliminary risk assessment comprehends feasibility
studies and due diligence (Fight, 2006).

Feasibility studies
Feasibility studies describes the project, the goals of the project sponsor,
sensitivities of the project to various construction, start-up and operating
risks, an analysis of financing alternatives and credit enhancement playing a
particular attention to capital needs, debt service capabilities, revenue
projections from output sales, operating costs, market projections, and
macroeconomics variables such as interest rates, currency exchange rates
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Assignment 2
and others. The feasibility study is useful in that it can be analysed by
various legal, financial and technical experts to establish the viability of the
project. (Fight, 2006).

Due diligence
Due

diligence

in

project

financing

encompasses

legal,

technical,

environmental and financial

matters, and is designed to detect events that might result in total or partial
project failure. So, it is an important process for risk identification and the
level of due diligence undertaken involves considerations of time available,
cost and the type of project (Fight, 2006).
According to (Yescombe, 2002) due-diligence process examines the risks
inherent in the project, inter-alia, the following:

Commercial viability: does the project make overall sense?

Completion risks: can the project be completed on time and on

budget?
Environmental risks: does the project face any environmental

constraints in construction or operation?

Operating risks: is the project capable of operating at the projected

performance level and cost?

Revenue risks: will operating revenues be as projected?
Input supply risks: can raw materials or other inputs be obtained at

the projected costs?

Force majeure risks: how can the project cope with force majeure

events?
Contract mismatch: do the Project Contracts fit together properly?

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Sponsor support: is there a need for more recourse to the Sponsors?

(cf.

Thus, preliminary risk assessment in project finance is essential given that

project financings are complex transactions involving many participants with
diverse interests. This results in conflicts of interest on risk allocation
amongst the participants and protracted negotiations and increased costs to
compensate third parties for accepting risks (Fight, 2006).

(Fight, 2006)

explains that the view of risk moreover is subjective and based not only on
economic factors but on characteristics relating to the financial condition of
the participant so that a particular risk, event or condition that is
unacceptable to one party may be considered manageable and routine by
another. (Fight, 2006) concludes by writing that the identification of risks
and knowledge of the participants is therefore essential if a project financing
is to be assembled successfully (p. 45) .

Assignment 2

What are the typical project risks at start-up and how

can these risks be mitigated?
This section starts by reviewing project risks classifications presented by
(Fight, 2006), (Gatti, 2008) and (Yescombe, 2002).
According to (Fight, 2006) there are three main risk phases in a project
financing, namely, (i) engineering and construction, (ii) start-up and (iii)
operational. In other hand, (Gatti, 2008) asserts that a project goes through
at least two phases in its economic life, (i) the construction, or pre
completion, phase and (ii) the operational, or post completion, phase and
distinguish three categories of risks, namely, (i) pre completion phase risks,
(ii) post completion phase risks, and (iii) risks common to both phases (Figure
1).

Figure 1 Classification of Risks and the Strategies for Their

Allocation (Hedging)
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Assignment 2

Source: (Gatti, 2008, p. 33)

While for (Yescombe, 2002) project finance risks are grouped into three main
categories:

Commercial risks (also known as project risks) are those inherent in

the project itself, or the market in which it operates.

Macro-economic risks (also known as financial risks) relate to
external economic effects not directly related to the project (i.e.,

inflation, interest rates, and currency exchange rates).

Political risks (also known as country risks) relate to the effects of
government action or political force majeure events such as war and
civil disturbance.

The assignment takes on the classification of (Fight, 2006) and exposes the
three main risk phases in a project financing, namely, (i) engineering and
construction, (ii) start-up and (iii) operational

with greater emphasis to

typical project risks at start-up.

Engineering and construction risks

In the engineering and construction phase, project finance risks are the
highest of all the three phases when the funds begin to flow from the
financiers to the project entity that cannot yet generate cash flow and pay
interest. In many financings the borrower is allowed to roll up interest or
draw down further funds to make interest payments. The length of this phase
can vary from several months (for example, the construction of a short toll
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Assignment 2
road) to several years (for example, the construction of the Channel Tunnel).
The lenders become more exposed as funds are drawn down but cash flows
have yet to be generated. Risks associated with the project during the
construction phase include; sponsor risk, pre-completion risk, siting and
permitting, completion risks, experience and resources of contractor,
building materials, facility site, construction of related facilities, cost
overruns, completion delays (Fight, 2006)

Start-up risks
According to (Gatti, 2008) a start-up phase refers to the point when the
testing phase begins, followed by operations once the plant construction is
complete.
In this phase commercial risks such as operating risks pop up
particularly when the banks need to be satisfied that the project will operate
at the costs and according to the specifications agreed at the outset given
that they are providing non-recourse funding (Fight, 2006). According to
(Gatti, 2008) operating risks can be mitigated by entering in to put or pay
agreements, O&M agreements and Offtake agreements (whenever possible).
There are concerns voiced over the construction risk namely the duration
of the start-up phase and the evaluation of the facilitys acceptance
testing and start-up procedures (Fight, 2006). (Gatti, 2008) states that
construction risk is rarely allotted to the SPV or its lenders. As a result, it is
the contractor or even the sponsors themselves who must assume this risk.

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Assignment 2
Another source of start-up risks emanates from a potential conflict of
interest in sense that risk arises from the need to start commercial
operations versus the need to get the project to pass its long term reliability
test (Fight, 2006). The start-up risk arising from potential conflict of
interest can be mitigated by requiring that the engineer who engineer
witnesses, verifies and signs off on all testing before releasing the contractor
be fully (Fight, 2006). They will also be financial pressures and bribery
pressure, which often occur near the end of the construction phase, to get
the job done

which may prompt the sponsor to accept a compromised

performance test in an effort to generate cash flow as soon as possible. This

is why lenders typically require that the engineer who engineer witnesses,
verifies and signs off on all testing before releasing the contractor be fully
independent (the engineer can, of course, be subjected to bribes or other
pressures) (Fight, 2006).

Operational risks
(United Nations Capital Development Fund, 2014) argues that operational
risks should address the issues like

What happens if technology breaks down?

Who is responsible for site maintenance?
Does the maintenance budget cover all costs?
Is O&M a reasonable amount compared to sales?
What happens if O&M is more expensive than budgeted for?

Operational risks can be mitigated by (i) confirming that a financially strong

O&M-contractor is appointed, (ii) insisting that insurance policies are put in
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place and (iii) requesting a Maintenance Reserve Account (MRA) (United
Nations Capital Development Fund, 2014).

Why is it important to understand the financial and

political risks surrounding a project?
Financial risks
(Yescombe, 2002) identifies macro-economic risks (also known as financial
risks) as the ones related to external economic effects not directly related to
the project (i.e., inflation, interest rates, and currency exchange rates).
(Fight, 2006) argues that project financial advisers should identify and
mitigate for any risks that may occur outside of the project and scope of the
project sponsors control because if all project inputs are not denominated on
one currency the project will most likely loose income because of foreign
exchange risk.

The project financial advisers should show the impact of

floating interest rate and fixed interest rate over debt service project
capacity. The project financial advisers should be able to produce resilient
cash flow projections in case of inputs price raise otherwise the income will
be eroded by inflation. The project should foresee an appropriate working
capital to avoid liquidity risk and ensure that sales will generate enough
funds for long term commitments. Therefore, with these risks in mind, the
project financial advisers should look at the possibility of using appropriate
hedging instruments such as a) futures contracts (interest rate futures can
be used to protect against funding costs and currency future to protect
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Assignment 2
against foreign exchange rate fluctuations) (Fight, 2006), b) Forward
contract on foreign exchange for hedging existing or anticipated currency
exposures (Fight, 2006), c) Options for protecting the price of the underlying
asset (Fight, 2006), and d) currency swaps,

interest rate swaps and

commodity swaps (Fight, 2006).

Political risks
(Fight, 2006, p. 58) defines country risk as the exposure to a loss in crossborder lending due to events more or less under the control of the
government and gives the following typical examples of political risk:

expropriation or nationalization of project assets;

failure of a government department to grant a necessary consent or

permit;
imposition of increased taxes and tariffs;
withdrawal of valuable tax holidays and/or concessions;
imposition of exchange controls, restricting the transfer of funds to

outside the host country;

changes in law adversely impacting project parties obligations with respect to the
project.
(Fight, 2006) emphasises that, in project financing, the political risks are
more acute because:

The project may rely on governmental concessions, licences or

permits.
Tariffs, quotas or prohibitions might be imposed on exports of the

projects production.
The host government might introduce controls to restrict the rate of
production or depletion of the projects reserves.
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Assignment 2

Additional taxes might be imposed on the projects production, such as

the surcharge taxes imposed by the United Kingdom on revenues from
North Sea oil production.
(Gatti, 2008, pp. 43-44) proposes two ways to cover against political risks.
The first is to draw up an agreement with the government of the host country
stating that the government will create a favourable (or at least nondiscriminatory) environment for the sponsors and the Special Purpose
Vehicle. This kind of contract, called a government support agreement, can
include provisions with the following intent:
1. To provide guarantees on key contracts (for example, the government
provides guarantees that a key counterparty will fulfil its obligations as off
taker or input supplier)
2. To create conditions that would serve to prevent possible currency crises
from adversely affecting the convertibility of the debt service and the
repatriation of dividends (for example, the host country could set up ad hoc
currency reserves through its central bank)
3. To facilitate the operational capacity of the SPV from a fiscal standpoint
through tax relief or exemptions
4. To create favourable institutional conditions (for example, importation
procedures

exempt

from

customs

duties,

streamlined

bureaucratic

processes, service provision for the SPV, concessions for the use of public
lands, or provisions for accepting international arbitration outside the host
country to resolve legal disputes)
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Assignment 2
The second way to cover against political risks is through the insurance
market. Insurance policies are available offering total or partial coverage
against political risks. These policies are offered by multilateral development
banks and export credit agencies as well as by private insurance companies
(Gatti, 2008)
(Fight, 2006) asserts that it is impossible to mitigate all risks pertaining to a
specific project. One way to avoid entering into potentially high risk lending
situations, reducing political risk, is to lend through, or in conjunction with,
multilateral agencies such as the World Bank, the

European Bank for

Reconstruction and Development (EDRD) and other regional development

banks such as the Asian Development Bank (ADB).
Thus, (Fight, 2006) suggests other ways of protecting against political risk
including:

Private market insurance.

Political insurance from national export agencies.
Obtaining
assurances
from
the
relevant

departments in the host country.

The central bank may guarantee the availability of hard

government

currency for export.

Thorough review of the legal and regulatory regime in the
country where the project is to be located is essential so as to ensure
that all laws and regulations are complied with and all procedures are
followed correctly.

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Assignment 2

Is negative pledge adequate to protect a lenders

position? If not what else should be considered?
A negative pledge is a contractual commitment on the part of the borrower
not to create encumbrances over its assets in favour of any third party
(Fight, 2006, p. 75).
(Bjerre, 1999) points out that this is common in unsecured loan agreements
because it addresses one of the most fundamental concerns of the
unsecured lender: that the borrower's assets will become unavailable to
repay the loan, because the borrower will have both granted a security
interest in those assets to a second lender and dissipated the proceeds of
the second loan. However, (Bjerre, 1999) argues that negative pledge
covenants' prohibition of such conduct may not be adequate to protect a
lenders position, because as a general matter they are enforceable only
against the borrower, and not against third parties who take security
interests in violation of the covenant. Hence, when a borrower breaches a
negative pledge covenant, the negative pledgee generally has only an effect
on the party whose assets are, by hypothesis, already encumbered.
Therefore, (Bjerre, 1999) proposes making negative pledge covenants
enforceable against subsequently perfecting secured parties, provided that
the negative pledgee satisfies certain third-party notice concerns in order to
adequately protect a lenders position.

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Assignment 2

Conclusion
The assignment found out that during preliminary risk assessment a) due
diligence in project financing is an important process for risk identification and
allocation, and b) feasibility study is a useful mechanism for setting forth a

description of the project, the goals of the project sponsor, sensitivities of the
project to various construction, start-up and operating risks, an analysis of
financing alternatives and credit enhancement (Fight, 2006).

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Assignment 2

References
Banal-Estaol, A. (n.d.). Project Finance. Retrieved June 30, 2016, from
http://albertbanalestanol.com/wp-content/uploads/cfmsc-chapter-8.pdf
Bjerre, C. S. (1999). Secured Transactions Inside Out: Negative Pledge Covenants Property and
Perfection. Cornell Law Review, 84(2), 305-393.
Fight, A. (2006). Introduction to Project Finance. Great Britain: Elsevier.
Gatti, S. (2008). Project Finance in Theory and Practice Designing, Structuring, and Financing
Private and Public Projects. London: Elsevier Inc.
McPherson, S. L. (2012). Advanced Project Finance Modeling. Africagrowth Institute.
Merna, A., Chu, Y., & Al-Thani, F. F. (2012). Project Finance in Construction A Structured
Guide to Assessment. New Delhi: Blackwell Publishing.
United Nations Capital Development Fund. (2014, October). PROJECT FINANCE. Retrieved
July 15, 2016, from UNCDF:
http://www.uncdf.org/sites/default/files/Documents/uncdf_lfi_project_workshop21.10.2014daressalaam.pdf
Yescombe, E. R. (2002). Principles of Project Finance. Amsterdam: Academic Press.

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