Eurotunnel project finance case study

Contents Cover

Series Page

Title Page

Copyright

Dedication

Preface

Acknowledgments

Chapter 1: What Is Project Financing? What is Project Financing? A Historical Perspective Requirements for Project Financing Appropriateness of Project Financing An Example Conclusion

Chapter 2: The Rationale for Project Financing Prior Studies' Explanations The Need for Contracts The Advantages of Separate Incorporation Countering the Underinvestment Problem Reallocating Free Cash Flow Reducing Asymmetric Information and Signaling Costs More Efficient Structuring of Debt Contracts More Effective Corporate Organization and Management

Compensation Project Financing versus Direct Financing Advantages of Project Financing Disadvantages of Project Financing Conclusion

Chapter 3: What Is Special about Large Projects? How Large Are “Large” Projects? Length of Project Contracts Initial Project Capital Structure Why Studying Project Finance Is Useful Why Study How Large Projects Are Financed? Conclusion

Chapter 4: Who Finances Large Projects? Sources of Funds for Large Projects Project Bonds' Default Risk Lead Arrangers, Managing Underwriters, and Advisors Conclusion

Chapter 5: Analyzing Project Viability Technical Feasibility Economic Viability Creditworthiness Conclusion as to Viability Assessing Project Risks Completion Risk Technological Risk Raw Material Supply Risk Economic Risk Operating Risk

Financial Risk Currency Risk Political Risk Environmental Risk Force Majeure Risk Implications for Project Financing The Cogeneration Project Conclusion

Chapter 6: Analysis and Financing of Renewable Energy Projects What Is Special About Renewable Energy Projects? International Standards for Promoting Environmentally and Socially Responsible Investing Evaluating the Viability of a Renewable Energy Project Example: The La Confluencia Hydroelectric Power Project The La Confluencia Hydroelectric Power Project and Responsible Investing Operating Risk Conclusion

Chapter 7: Designing Security Arrangements Purpose of Security Arrangements Direct Security Interest in Project Facilities Security Arrangements Covering Completion Security Arrangements Covering Debt Service Types of Purchase and Sale Contracts Raw Material Supply Agreements Supplemental Credit Support Insurance The Cogeneration Project Conclusion

Chapter 8: Structuring the Project Undivided Joint Interest Corporation Partnership Limited Liability Company The Cogeneration Project Conclusion

Chapter 9: Preparing the Project Financing Plan General Considerations Construction Financing Long-Term Financing Withholding Tax Considerations Estimating the Borrowing Capacity of a Project Loan Repayment Parameters Borrowing Capacity, Assuming Full Drawdown Immediately Prior to Project Completion Borrowing Capacity, Assuming Periodic Loan Drawdowns Application to a Hypothetical High-Speed Rail Project Annual Coverage Tests Conclusion

Chapter 10: Discounted Cash Flow Analysis Incremental After-Tax Cash Flows The Hurdle Rate Estimating the Cost of Capital for a Project Net Present Value Analysis Internal Rate of Return Analysis Comparing IRR and NPV Analyses Conclusion

Chapter 11: Financial Modeling and Project Evaluation Preparing Cash Flow Projections Preparing Projected Financial Statements Evaluating a Project's Debt Capacity Measuring Expected Rates of Return Sensitivity Analysis Conclusion

Chapter 12: Using Real-Options Analysis to Evaluate a Project Description of the Oil Field Project Project's Real Options Evaluating the Project Traditional DCF Analysis Sensitivity of Option Value to Oil Price Volatility and to Reserve Dispersion Conclusion

Chapter 13: Sources of Project Funds Equity Long-Term Debt Market Commercial Bank Loans Fixed-Rate Debt Market International Capital Market Supplier Credits Governmental Assistance World Bank Loans Inter-American Development Bank Local Sources of Capital Conclusion

Chapter 14: Managing Project Risks

Interest-Rate Swaps Credit Default Swaps Options Forwards and Futures Hedging Hedging with Options Hedging Foreign Exchange Risk Conclusion

Chapter 15: Sharia-Compliant Project Financing What Is Islamic Finance? Islamic Financial Instruments Islamic Derivatives Example: The Saudi Chevron Petrochemical Project The Future of Islamic Project Finance Conclusion

Chapter 16: Issues for the Host Government Contribution to the Host Jurisdiction's Economic Development Host Jurisdiction's Expected Economic Return Impact on the Availability of Hard Currency Exposure of the Host Government to the Project's Obligation to Repay Project Debt Avoiding Undesirable Precedents Hibernia Oil Field Project Public–Private Infrastructure Partnerships Public–Private Financing Structures Legislative Provisions that Can Affect Public–Private Partnerships Conclusion

Chapter 17: Case Study: The Indiantown Cogeneration Project

Project Description The Partnership and the Sponsors of the Project Principal Project Contracts Projected Operating Results Project Financing Conclusion

Chapter 18: Case Study: The Tribasa Toll Road Project The Mexican Government's Toll Road Program Infrastructure Financing Alternatives Risk Considerations in Foreign Infrastructure Projects Tribasa Toll Road Trust 1 Financing Credit Analysis Risk Minimization Features Conclusion

Chapter 19: Case Study: The Euro Disneyland Project Introduction Project Description Disney Project Ownership Structure Master Agreement with the French Government Project Financing Interests of the Participants in the Project Financial Projections Valuation Corporate Governance Issues Operating Results Subsequent Developments Conclusion

Chapter 20: Case Study: The Eurotunnel Project

Historical Background The Eurotunnel System Project Ownership Structure Construction Project Financing Economic Risk Projected Financial Results Project Debt Financing Project Equity Financing Sensitivity Analysis Subsequent Developments Conclusion

Chapter 21: Conclusion Reaping the Benefits of Project Financing Recognizing When Project Financing Can Be Beneficial Potential Future Applications of Project Financing Organizational (Re)Form Financial Engineering

Appendix A: Comparative Terms of Selected Projects

Appendix B: Other Examples of Project Financings

Appendix C: Legal Investment Requirements Governing New York Life Insurance Companies

Notes

Bibliography

Websites

Index

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Finnerty, John D. Project financing : asset-based financial engineering / John D. Finnerty, PHD. – Third edition.

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To my wife, Louise Hoppe Finnerty,

and my son, William Patrick Taylor Finnerty,

for their understanding and encouragement.

Preface

Project finance has intrigued me ever since I was introduced to it as an associate at Morgan Stanley & Co. My experience in project finance, both as an investment banker and as a professor of finance at Fordham University, has firmly convinced me of its usefulness, especially in enabling the emerging economies to unlock the value of their natural resources and build the infrastructure they need to move forward. Project financing is a well-established technique for large capital intensive projects. Its origins can

be traced to the thirteenth century when the English Crown negotiated a loan from the Frescobaldi, one of the leading merchant bankers of the period, to develop the Devon silver mines. They crafted a loan arrangement much like what we would call a production payment loan today. A great variety of investments have since been project financed, including pipelines, refineries,

electric power generating facilities, hydroelectric projects, dock facilities, mines, mineral processing facilities, toll roads, and many others. Indeed project finance experienced a resurgence in the 1980s when it was used frequently to finance cogeneration and other forms of power production. It grew in the 1990s as a means of financing projects designed to help meet the enormous infrastructure needs that exist in the developed countries and especially in the emerging markets. I wrote the first edition of this book with both practitioners and students of finance in mind. For

practitioners, project financing can provide a cost-effective means of raising funds. Sponsors should carefully consider using it whenever a project is capable of standing on its own as a separate economic entity. In this book, I describe the types of capital investments for which project financing is suitable and explain how to engineer the financing arrangements that support it. Because of project financing's enormous practical value, students of finance would be wise to learn about it so they can include it in their financing skill set. The audience for this book includes: Financial managers who are responsible for arranging financing for their companies' projects. Government officials who are wondering how to finance their wish lists of infrastructure projects. Investment bankers and commercial bankers who assist companies in raising funds for large capital intensive projects. Accountants, consultants, lawyers, and other professionals who work in the corporate finance area and wish to keep up-to-date. Investors who are considering committing funds to limited-purpose companies or to mutual funds that have been set up to invest in infrastructure projects in the emerging markets. MBA students and executive MBA students studying corporate finance. Students of finance who wish to be fully knowledgeable concerning the techniques modern financiers are using to finance large-scale projects. The first two chapters describe project financing and the circumstances in which it is most likely to

be advantageous. Project financing involves financing projects on a stand-alone basis, so particular attention must be paid to who bears the risks and who reaps the rewards. Chapter 3 discusses what is special about large projects, and Chapter 4 describes the role that financial institutions play in getting large projects financed. Chapter 5 explains how to identify the various risks associated with a project.

Chapter 6, which is new in this edition, discusses socially responsible project financing, and in particular, its application to renewable energy projects. Chapter 7 describes how to craft contractual arrangements to allocate project risks and the project's economic rewards among the interested parties. Chapter 8 discusses the legal, tax, and other issues that must be considered when selecting the legal structure for a project. Chapters 9 through 12 deal with financial issues: preparing a financing plan, performing discounted

cash flow analysis, using the techniques of discounted cash flow analysis to evaluate a project's profitability, and using real-options analysis to evaluate large projects. Chapter 12 provides analytical tools that are increasingly useful in capital budgeting. Chapter 13 describes the sources of the funds to invest in a project. Chapter 14 explains how to manage project risks and describes a variety of derivative instruments that are useful for managing interest rate, commodity price, exchange rate, and credit risks. Chapter 15, which is new in this edition, discusses Sharia-compliant project financing, which is an increasingly important application that holds great promise. The chapter explains how to design the project financing arrangements to comply with Islamic law. Chapter 16 reviews the issues a host government faces when private entities will finance the project. This material is particularly relevant to infrastructure projects in emerging markets because the capital requirements are often well beyond the capacity of the local government to meet them on its own. Chapters 17 through 20 contain case studies that illustrate how the concepts discussed in the earlier

chapters have been put into practice in four prominent projects. These examples richly illustrate the application of the concepts developed in the previous chapters. Finally, Chapter 21 provides some concluding thoughts on the direction in which project financing seems to be headed. The two new chapters in this edition, Chapters 6 and 15, bear special mention. Renewable energy

generates about 19 percent of the world's electricity. Its importance is increasing as world concern grows over the potentially high environmental cost of mining fossil fuels. As a result of the potential harm that can result from the misuse of project financing and also in recognition of the value of project finance as a mechanism for promoting responsible international economic development, the international project lending community has developed standards designed to ensure that projects are carried out in an environmentally and socially responsible manner. Chapter 6 describes the IFC Performance Standards and the Equator Principles, which are designed to promote only those projects that commit to follow acceptable environmental and social risk management practices. The chapter illustrates their application to a renewable energy project in Chile. Muslims, or followers of Islam, comprise more than one quarter of the world's population, and

Muslim countries produce more than 10 percent of the world's gross domestic product. Moreover, Islamic finance is especially well-suited to project financing because it is structured around physical assets. Chapter 15 explains how the basic Sharia principles affect Islamic financing transactions and financial instruments, describes the main Sharia-compliant debt and equity transaction structures, and discusses the application of Sharia-compliant Islamic financing to project finance. The chapter explains how Sharia-compliant financing can be tailored to finance large projects in Islamic regions of the world where this form of financing must conform to strict religious principles. Project finance engineers need to be aware of the special conventions and restrictions that apply in Islamic finance in order to be in a position to tap this source of funding for their projects because Islamic project finance will play an increasingly important role in furthering the economic development of these countries.

John D. Finnerty

New York, New York March 2013

Acknowledgments I would like to express my gratitude to those who helped me with the preparation of this book. Thanks to my former colleagues at Morgan Stanley & Co., Lazard Frères & Co., and Houlihan Lokey Howard & Zukin for many informative discussions concerning project finance and about “what really makes it work.” I am also grateful for the insights I have gained through numerous discussions with Zoltan Merszei, former President of Thyssen Henschel America and former Chairman, President, and CEO of Dow Chemical Company, concerning the application of project financing to infrastructure investment, such as high-speed rail projects. Special thanks go to Myles C. Thompson and Jacque Urinyi at John Wiley & Sons for their work on

the first edition; Bill Falloon and Laura Walsh for their terrific assistance on the second edition; Tiffany Charbonier for her expert guidance and support on third edition; and Mary Daniello for guiding the third edition through the production process. I am very grateful to Lawrence A. Darby, III, Esq., Sean J. Griffith, Esq., Stephen B. Land, Esq., Hal

Moore, Esq., and Omar T. Mohammedi, Esq., for insightful discussions regarding project finance and the legal and tax considerations involved. Larry is an experienced hand at project finance and provided many helpful suggestions, Sean and Hal are valued colleagues at Fordham University, Steve made sure I got the tax discussion right in the first edition, and Omar furnished helpful guidance concerning Sharia-compliant project financing, which I put to good use in writing Chapter 15. Albert Gavalis of Graf Repetti & Co., and Paul Bocitner of Fordham University reviewed the tax discussion in Chapter 8 of the second edition and provided helpful suggestions. Jim Arata of RSM McGladrey made several useful suggestions regarding the tax discussion in the third edition. Martin Kehoe and Chad Soares furnished several helpful suggestions for improving the accounting discussion in Chapter 8. Art Simonson, Diane Vazza, and Kate Medernach of Standard & Poor's were very helpful in providing a wealth of project credit and financing data. Matthew Rutter and Stephen Chung of Thomson Financial provided access to PFI's superb project data base. Special thanks to Matthew Wicker, my colleague at Finnerty Economic Consulting, LLC, who provided critically important research assistance throughout the revision process. I would like to thank Jennie R. Tricomi and Roman Asudulayez for research assistance. Jennie

wrote a paper entitled, “Project Finance and International Regulations: Assuring the Environmentally Friendly Development of Foreign Infrastructure” for my Spring 2011 Global Capital Markets class at Fordham Law School, which I drew on in writing Chapter 6 for this edition. Roman wrote a paper entitled, “Insuring Political Risk: On the Occasions, Uses, and Future of Political Risk Insurance, as Provided by Both the Public and Private Institutions” for my Spring 2012 Global Capital Markets class at Fordham Law School, which I drew on in revising Chapter 13 for this edition. Finally, thanks to my wife, Louise, and my son, Will, for their patience and understanding while I

took time away from our family to write. I hope that they are pleased with the book.

J. D. F.

Chapter 1

What is Project Financing?

Project financing can be arranged when a particular facility or a related set of assets is capable of functioning profitably as an independent economic unit. The sponsor(s) of such a unit may find it advantageous to form a new legal entity to construct, own, and operate the project. If sufficient profit is predicted, the project company can finance construction of the project on a project basis, which involves the issuance of equity securities (generally to the sponsors of the project) and of debt securities that are designed to be self-liquidating from the revenues derived from project operations. Although project financings have certain common features, financing on a project basis necessarily

involves tailoring the financing package to the circumstances of a particular project. Expert financial engineering is often just as critical to the success of a large project as are the traditional forms of engineering. Project financing is a well-established financing technique. Thomson Financial's Project Finance

International database lists 4,360 projects that have been undertaken since 2002. About 10 percent of these are large projects costing $1 billion or more. Looking forward, the United States and many other countries face enormous infrastructure financing requirements. Project financing is a technique that could be applied to many of these projects.

What is Project Financing? Project financing may be defined as the raising of funds on a limited-recourse or nonrecourse basis to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.1 The terms of the debt and equity securities are tailored to the cash flow characteristics of the project. For their security, the project debt securities depend mainly on the profitability of the project and on the collateral value of the project's assets. Assets that have been financed on a project basis include pipelines, refineries, electric generating facilities, hydroelectric projects, dock facilities, mines, toll roads, and mineral processing facilities. Project financings typically include the following basic features: 1. An agreement by financially responsible parties to complete the project and, toward that end, to make available to the project the funds necessary to achieve completion. 2. An agreement by financially responsible parties (typically taking the form of a contract for the purchase of project output) that, when project completion occurs and operations commence, the project will generate sufficient cash flow to enable it to meet all its operating expenses and debt service requirements under all reasonably foreseeable circumstances. 3. Assurances by financially responsible parties that, in the event a disruption in operation occurs and funds are required to restore the project to operating condition, the necessary funds will be made available through insurance recoveries, advances against future deliveries, or some other means. Project financing should be distinguished from conventional direct financing, or what may be

termed financing on a firm's general credit. In connection with a conventional direct financing, lenders to the firm look to the firm's entire asset portfolio to generate the cash flow to service their loans. The assets and their financing are integrated into the firm's asset and liability portfolios. Often, such loans are not secured by any pledge of collateral. The critical distinguishing feature of a project financing is that the project is a distinct legal entity; project assets, project-related contracts, and project cash flow are segregated to a substantial degree from the sponsoring entity. The financing structure is designed to allocate financial returns and risks more efficiently than a conventional financing structure. In a project financing, the sponsors provide, at most, limited recourse to cash flows from their other assets that are not part of the project. Also, they typically pledge the project assets, but none of their other assets, to secure the project loans. The term project financing is widely misused and perhaps even more widely misunderstood. To

clarify the definition, it is important to appreciate what the term does not mean. Project financing is not a means of raising funds to finance a project that is so weak economically that it may not be able to service its debt or provide an acceptable rate of return to equity investors. In other words, it is not a means of financing a project that cannot be financed on a conventional basis. A project financing requires careful financial engineering to allocate the risks and rewards among the involved parties in a manner that is mutually acceptable. Figure 1.1 illustrates the basic elements in a capital investment that is financed on a project basis.

Figure 1.1 The Basic Elements of a Project Financing

At the center is a discrete asset, a separate facility, or a related set of assets that has a specific purpose. Often, this purpose is related to raw materials acquisition, production, processing, or delivery. More recently, this asset is a power-generating station, toll road, or some other item of infrastructure. Many projects involve the modernization or upgrade of an existing facility, or a brownfield project, rather than the construction of a brand new facility, or greenfield project. As already noted, this facility or group of assets must be capable of standing alone as an

independent economic unit. The operations, supported by a variety of contractual arrangements, must be organized so that the project has the unquestioned ability to generate sufficient cash flow to repay its debts. A project must include all the facilities that are necessary to constitute an economically independent,

viable operating entity. For example, a project cannot be an integral part of another facility. If the project will rely on any assets owned by others for any stage in its operating cycle, the project's unconditional access to these facilities must be contractually assured at all times, regardless of events. Project financing can be beneficial to a company with a proposed project when (1) the project's

output would be in such strong demand that purchasers would be willing to enter into long-term purchase contracts and (2) the contracts would have strong enough provisions that banks would be willing to advance funds to finance construction on the basis of the contracts. Project financing can be beneficial to lenders when it reduces the risk of project failure, leads to tighter covenant packages, or facilitates a lower cost of resolving financial distress. For example, project financing can be advantageous to a developing country when it has a valuable

resource deposit, other responsible parties would like to develop the deposit, and the host country lacks the financial resources to proceed with the project on its own.