Financial Structuring

Project Finance Modelling Apr 21, 20231

Financial Structuring


Project Finance Terms in Private Analysis

• The table below illustrates the type of terms that are in renewable project finance transactions.


Other Loan Examples – Spanish Wind Farm

• The acquisition of 6 wind farms in Spain

Total Financing EUR 195 M

Total value of the transaction EUR235 M

Equity -- about EUR 40 M

Total 158 MW of Capacity

Generating about 350 GWh per year

Total cost 5 cents/kWh.

• Compute

Sources and Uses of Funds and Leverage

Cost per kW of Capacity

Capacity Factor

Turbine Capacity


Dokie Wind Energy Project – Canadian Example

• WestLB project financing for a wind farm in British Columbia, Canada.

• Capacity: 150 MW

• Sponsor: renewable energy developer EarthFirst Canada Inc.

• Loans: $214 million including a two-year construction period and will have a 20-year final maturity

• Average Life: 10- to 13-year range.

• Purchase Price Agreement: A 20-year power purchase agreement with British Columbia-based electric utility BC Hydro, which has a rating of AA' by Standard & Poor's.


Example of Loan Life

• BNP Paribas was in the market last week with a 144A for the Panoche Energy Center in California.

• The deal is $330 million in size,

• with a 21.5-year final,

• 14-year average life maturity.

• Standard & Poor's has a rating of BBB-' on the deal, which is expected to price this week.


Other Loan Examples – Spanish Wind Farm

• The acquisition of 6 wind farms in Spain

Total Financing EUR 195 M

Total value of the transaction EUR235 M

Equity -- about EUR 40 M

Total 158 MW of Capacity

Generating about 350 GWh per year

Total cost 5 cents/kWh.

• Compute

Sources and Uses of Funds and Leverage

Cost per kW of Capacity

Capacity Factor

Turbine Capacity


Dokie Wind Energy Project – Canadian Example

• WestLB project financing for a wind farm in British Columbia, Canada.

• Capacity: 150 MW

• Sponsor: renewable energy developer EarthFirst Canada Inc.

• Loans: $214 million including a two-year construction period and will have a 20-year final maturity

• Average Life: 10- to 13-year range.

• Purchase Price Agreement: A 20-year power purchase agreement with British Columbia-based electric utility BC Hydro, which has a rating of AA' by Standard & Poor's.


Example of Loan Life

• BNP Paribas was in the market last week with a 144A for the Panoche Energy Center in California.

• The deal is $330 million in size,

• with a 21.5-year final,

• 14-year average life maturity.

• Standard & Poor's has a rating of BBB-' on the deal, which is expected to price this week.


FPL Example (2003)

• DSCR

Average 1.86

Minimum 1.74

• Bond Rating

Moody’s Baa3

S&P BBB-

• Reserve Accounts

12 Months Debt Service Reserve Account

$15 Million Operating Reserve

Major Maintenance Reserve

• Regulatory Support

Guaranteed by Sponsor

• Covenants

Distributions allowed only if DSCR is above 1.3 times


Reserve Accounts – FPL Example

• The debt service reserve covers 12 months of debt service

funded at closing, either in cash or an Letter of Credit.

• The major maintenance account is funded at closing in the amount of $1 million initially to $3.5 million by 2020.

• The special $15 million O&M reserve is funded at closing, with either:

cash,

a letter of credit , or

a guarantee from a corporate entity with a senior unsecured rating of at least 'BBB'.


FPL Example

• Loan Amount $370 Million

• Operating Reserve to Cover Expenses $14 Million

• Debt Leverage – 52%

• Capacity – 700 MW

• Average PPA Tariff: $35/MWH (Excludes production tax credit)

• Most Projects already completed and FPL guarantees completion (limited construction risk)

• 2005 Loan

Higher Leverage – 65%

Additional Subordinated Debt – Total of 83% Financing


Disbursement Controls and Basic Covenants

• Disbursement controls in the form of conditions precedent to each drawdown under the construction loan, such as requiring the borrower to present invoices, builders' certificates or other evidence as to the need and purpose for which funds will be used.

• Borrower covenants not to amend or waive any of its rights under the principal project agreements without the consent of the lender.

• Borrower completion covenants requiring the borrower to complete the project in accordance with project plans and specifications and prohibiting material alterations without the consent of the lender.


Covenants that Restrict Dividends and Additional Debt

• Borrower covenants restricting the payment of dividends or other distributions by the borrower during construction and, thereafter, only after satisfaction of required debt service and other reserves, debt service coverage ratios and certification of no existing defaults.

• Borrower covenants prohibiting incurring of additional liens and debt or issuing guarantees.

• Requirements that project participants affiliated with the project sponsors enter into subordination agreements under which certain payments to such participants from the borrower under project agreements are restricted (either absolutely or partially) and made subordinate to the payment of debt service.

• The project loan typically will be secured by all project assets, including a mortgage on the project facilities and real property; assignment of operating revenues; liens on all personal property; and assignment of all project agreements and project permits, including any letters of credit or performance bonds to which the borrower is the beneficiary.


Cash Flow Waterfall – FPL Example

• The flow of funds is not standard but acceptable. American Wind will repay debt once annually, due in part to the annual variation of wind and thus power production. However, the issuer desires to make bi-annual distributions, and has structured the flow of funds accordingly.

• The trustee allocates funds monthly in the following priority;

O&M expenses,

the debt service fund (1/12 of the debt service requirement),

debt service reserve,

major maintenance reserve,

special O&M reserve,

an optional additional payment into the debt service funds,

payment on permitted debt (other than senior secured obligations).


Equity Returns and Re-Financing

7.8%

29.2%

37.3%

44.6%

7.7%

16.0%

18.9%

21.7%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

Low Base High Very High

Equity

IRR

Traffic Scenario

Equity IRR with and without Re-financing

Re-Finance

No Re-Finance


Project Finance Modelling of Renewable Resources


Teaching Objectives of Model Construction

• The best and perhaps the only real way to learn modeling is under the tense pressure of a real transaction – when a model must be created and audited under a tight deadline.

• Notwithstanding this, the exercises and lecturers are intended to provide:

A head start for those who have not created models and will have to learn the hard way.

Helpful ideas to experienced model builders in designing and structuring more efficient, stable, transparent and accurate models.

• The discussion covers how to build a well structured financial model that clearly delineates inputs, effectively presents key value drivers, uses separate modules to organize various components, accurately computes cash flow that is available to different debt and equity investors, and presents results of the analysis that accurately display risks of the investment.


A Financial Model is a Statistical Tool

• In developing a financial model, the basic thing you are doing is summarizing a complex set of technical and economic factors into a number (such as value per share, IRR or debt service coverage).

Forecasting has become an essential tool for any business and it is central to statistics -- in assessing value, credit analysis, corporate strategy and other business functions, you must use some sort of forecast.

Some believe economic forecasting has limited effectiveness and worse, is fundamentally dishonest because uncertain unanticipated events such as the internet growth, high oil prices, sub-prime crisis, falling dollar continually occur.

The whole idea of modeling, like statistics, is quantification. If a concept cannot be quantified, it is a philosophy. The fundamental notion of statistics is presenting and summarizing information, this is the same as a financial.


Danger of Believing too Much in Models

• Alan Greenspan, Financial Times.

“The essential problem is that our models – both risk models and econometric models – as complex as they have become – are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world.”

• Nicholas Taleb:

In the not too distant past, say the pre-computer days, projections remained vague and qualitative, one had to make a mental effort to keep track of them, and it was a strain to push scenarios into the future. It took pencils, erasers, reams of paper, and huge wastebaskets to engage in the activity. The activity of projecting, in short, was effortful, undesirable, and marred with self doubt.

But things changed with the intrusion of the spreadsheet. When you put an Excel spreadsheet into computer literate hands, you get projections effortlessly extending ad infinitum. We have become excessively bureaucratic planners thanks to these potent computer programs given to those who are incapable of handling their knowledge.


General Objectives of Model Analysis

How to screen projects and value projects

How to structure the financing of projects

How to analyze risk using models

How to develop detailed financing provisions

A database of information on the project


Financial Modelling Outline

Developing the structure and layout of alternative types of models

Notes on model structure, programming practices and model periods

Organizing time periods in a model

Value drivers and model inputs

Debt modules -- sweeps, traps, defaults and debt IRR

Fixed asset modules and depreciation and amortization

Income statement and tax schedule

Cash flow and waterfall

Balance sheet and other auditing tools

Presenting key valuation outputs of a model

Performing sensitivity and scenario analysis on model outputs


Introduction

• General Comments about financial models

“It all has to make sense in a financial model”

One of the benefits of project finance is the transparency of the cash flows as shown in the model

Major financial failures have occurred because the investors had no idea what was driving the value. Once problems occur when financial presentation is not transparent, panic often occurs.

• In understanding a transaction and writing language for project finance contracts (construction contract, loan agreement, concession agreement, purchase power agreement) cash flow is the ultimate issue. One must understand how much cash flow is generated, who gets the cash flow and the priorities each party has to the cash flow.


A Central Question in Economics and Finance is How to Evaluate Risk

• As the growth of trade transformed the principles of gambling into the creation of wealth, the inevitable result was capitalism, the epitome of risk-taking. But capitalism could not have flourished without two new activities that had been unnecessary so long as the future was a matter of chance.

The first was bookkeeping, a humble activity but one that encouraged the dissemination of the new techniques of numbering and counting.

The other was forecasting, a much less humble and far more challenging activity that links risk taking with direct payoffs.

• “The Remarkable Story of Risk”


Financial Perspective on Renewable Investments

• Lessons from Financial Crisis on Risk Assessment

Complex Structuring

Risk Analysis

Financing and return requirements

• Evaluation of risks of capital investments

Capital Intensity of Renewable

Which Risks are Most Important

• Rate of return required by private investors in wind farm investments

• Criteria for bankers in wind farm investments in order to accept risk


Financial Models – Standard and Poor’s

• A good financial model should:

Be relatively simple

Focus on key cash flow drivers

Clearly convey assumptions and conclusions

• Alternative Models

Back of the Envelope

Quickly run the impact of an acquisition on debt service coverage

Sensitivity of earnings to commodity price swings

Deterministic

Set a number of assumptions and translate into financial ratios and cash flow

Stochastic

Develop a range of possible inputs using Monte Carlo simulation. Used where there is a good and predictable history for value drivers.


Fundamental Financial Issues and Modelling

• Financial issues that must generally be addressed in valuation, financial structuring and credit analysis include:

What is the minimum level of the project IRR that is acceptable (relative to the weighted average cost of capital)

What is the level of the minimum required equity IRR with different amounts of debt on the balance sheet

What is the debt capacity of a project for senior debt and subordinated debt as measured by the minimum DSCR or the LLCR

What should be the credit spread on senior and subordinated debt

What is the tradeoff between risk and return in evaluating covenants


Resolution of Fundamental Financial Issues

• There are various ways to resolve the basic financial issues presented on the last slide:

Financial theory

Financial theory dictates that the CAPM should be used to compute the WACC, that the un-levered beta should be used to estimate equity returns, that options pricing models should be used for credit spreads, debt capacity and covenants.

Mathematical Models

Mathematical models include beta adjustments for the CAPM, statistical models for credit analysis, Monte Carlo simulation and value at risk.

Practical Market Information

Practical market information can be used to gauge required equity returns, required credit spreads, required financial ratios to achieve investment grade rating and other issues.

Direct Evaluation with Financial Models

Use of financial models to directly assess risks through sensitivity, scenario and simulation analysis.


Equity Returns for Tollroads

• The following slide illustrates equity IRR’s on selected toll-roads. This information more relevant than theoretical weighted average cost of capital calculations


Debt Service Coverage Criteria

• Standard & Poor's considers that minimum DSCR threshold tests for most contract-driven projects to be around 1.30 times (x), provided that this figure holds under stress analysis.

• Such levels are too low for merchant projects. Instead, minimum DSCR levels for equity distributions may need to exceed 1.70x for investment-grade transactions, depending on the industry.

• For example, one financial institution suggests that under base case assumptions the DSC should show not less than 1.2:1 for every year of operation during the loan life, and no less than 1.4 on average.

• Under a Downside Case, with up to 5 years added to the repayment period, the DSC should be no less than 1.0:1 for every year or less than 1.15:1 on average during the life of the loan.

• Projects with merchant exposure may find that leverage cannot exceed 50% if investment-grade rated debt is sought. On the other hand, contract-revenue driven projects, on the other hand, typically have had leverage levels around 70% to 80%.


Study of Problems with Project Finance Models

• Assumptions not Documented in Databook

• No Integrated Cashflow, P&L, Balance Sheet

• Significant Tax Errors

• Incorrect Accounting

Deferred taxes

Fees

Operating Reserves

• No Flexibility for Breakeven Analysis and Other Risk Analysis

Effect of cash flow sweeps, covenants and reserves

• Poor Presentation of the Model to Senior Management

- Scope of Model

- Model Conclusions


Example of Cash Flow Waterfall

Revenues and Cash Flow Distributions in DEPFA Base Case Scenario

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000

2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2054 2058 2062 2066 2070 2074 2078 2082 2086 2090

Income Tax

ASN Amortization

ASN Interest Payment

Funding of Distribution andSinking Funds

CAB Amortization

TIFIA Amortization

CIB Amortization

CIB Interest Payment

Bank Loan Amortization

Bank Loan Interest Payment

TIFIA Interest Payment and Fee

Deposit to EMRR

Major Maintenance (net of use ofMMRA)

O&M Expenses

Total Revenue and Liquidity

Total Revenue

Break Even Analysis

Traffic Growth Post 2026 0.0% Post 2016 Toll Increase 0.0% Wilton Farm Percent 70.0% Background Traffic Growth 0.0%

O&M Increase 0.0% EMRR Increase 0.0% Interest Rate Increase 0.0% TIFIA Final Payment 31-Dec-2043

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000

2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2054 2058 2062 2066 2070 2074 2078 2082

Income Tax

ASN Amortization

ASN Interest Payment

Funding of Distribution Account

Funding of Sinking Fund

CAB Amortization

TIFIA Amortization

CIB Amortization

CIB Interest Payment

Bank Loan Amortization

Bank Loan Interest Payment

TIFIA Interest Payment and Fee

Deposit to EMRR

Major Maintenance (net of useof MMRA)

O&M Expenses

Total Revenue and Liquidity

Total Revenue


Structure of Project Finance Models


Basic Model Structure

• A project finance model should correspond to the fundamentals of project finance:

Different equations for different phases of the project

Uses and sources of funds to define how project is financed

Repayment of debt corresponding to cash flow

Compute debt capacity and equity IRR

Account for the effect of covenants, cash flow sweeps and other debt features

Incorporate debt service reserves and operating reserves


Sheet Layout – Project Model

• Contents

• Input Sheets (Assumption Book)

Different colors, Arranging of inputs

• Working Sheets

Arrangements by revenues, expenses and capital expenditures

Arrangements by capacity, demand, and cost structure

• Sources and Uses of Funds (Monthly Construction Expenditures)

Conversion from Annual

Computation of Interest During Construction

• Debt Schedule (Sources of Funds)

• Depreciation Schedule

• Financial Statements

Income Statement

Balance Sheet

Cash Flow -- Waterfall

• Output Sheets

Valuation – IRR, Debt Service Coverage Ratios


Structure of a Project Finance Model

Revenue, Expense andCapital Expenditure Analysis

Working Capital AnalysisInputs:

Operating Drivers from

Contractsand Other,

EPC Contract,S-Curve,

Interest Rate

Tax

Profit and Loss

Taxes Paid, TaxesPaid and Taxes Deferred

Cash Flow Statement With Waterfall,Debt Defaults,Sweeps etc.

DSCRA Balance, Debt BalanceEquity Balance

BalanceSheet

Equity IRRDSCR, LLCR

Sources andUses of Funds

DuringConstruction

IncludingInterestRoll-up

Debt and DSCRA

Schedule

FixedAssetsInterest

CapitalizedFees and

Other


Model Sheets in Project Finance Model

Inputs – Prices, Costs, Capacity,

Technical Parameters

Working Sheet toDerive Revenues Expenses

and Working Capital

Annual Financials –Income Statement, Cash Flow

(CASH WATERFALL)

and Balance Sheet

Outputs – Free Cash Flow,

Equity Cash Flow

Value (IRR), DSCR

Debt Schedule –Debt Balance From

Drawdown Debt Balance,

Interest Expense

Source and

Use of Funds – Draw down, IDC, Equity Issues

and Capital Expenditures

Depreciation –Depreciation Expense

Plant Balance


Table of Contents – Example of Different Periodic Statements

Note that financial assumptions separated from operational assumptions

Different time period for different statements


Sources and Uses Example – Summarizes the whole project

The source and use statement together with the DSCRs and the IRR summarize the project and is the beginning of the analysis


Summary of Modelling Practises


Good Modelling Practise

• Divide the model into separate modules, beginning with an input section.

• Compute how the value drivers determine operating revenues, operating expenses and capital expenditures in a separate “working” module rather than in financial statements.

• Understand the starting point of the model as it relates to the valuation issue (balance sheet, sources and uses statement or both).

• Carefully define the time period of the model using codes that define alternative phases of the analysis.

• Work through every single balance sheet item showing the opening balance, changes and the closing balance for each the accounts. This analysis should be made for everything ranging from cash accounts to common equity.

• Include separate modules for debt issues, fixed plant assets, working capital and cash balances.


Simple Formulas

• The modeling practices are discussed in another sheet named spreadsheet conventions.

• The most important is keeping the formulas simple and making the sheets transparent and easy to read.

• The following should be in many other lines.


Balance Sheet Accounts and Cork Screws

• It is good practice to have accounts for all balance sheet items

• Some examples include:

The plant balance

The debt balance for each issue

Debt service reserve balances

Maintenance reserve balances

The NOL balance

The Un-amortised debt fee balance

The basis for changes in working capital

Common equity balance


Example of Terms for Wind Project

• Typically, the length of a loan is between 10 and 15 years, but loan terms have become longer as banks have become more experienced in the wind industry.

• The interest rate is often 1-1.5 per cent above the base rate at which the bank borrows their own funds (referred to as the interbank offer rate). In addition, banks usually charge a loan set-up fee of around 1 per cent of the loan cost, and they can make extra money by offering administrative and account services associated with the loan. Products to fix interest rates or foreign exchange rates are often sold to the project owner.

• It is also typical for investors to have a series of requirements over the loan period; these are referred to as ‘financial covenants’. These requirements are often the result of the due diligence and are listed within the ‘financing agreement’. Typical covenants include the regular provision of information about operational and financial reporting, insurance coverage and management of project bank accounts.


Development Analysis and Time Period Definitions in Models


Switches in Alternative Models

• Switches for time periods in alternative models

General Corporate Models

Switch for History versus Forecast

Switch for Terminal Period

Project Finance Models

Switch for Development Period

Switch for Construction Period

Switch for Operation Period

Switch for Debt Repayment Period

Leveraged Buyout Models

Switch for Transaction Period

Switch for Holding Period

Switch for Terminal Period


Steps in Project Financing

• Step 1: Development, Feasibility and RFP

RFP issues – bid evaluation system, communication, scoring, requirements, cost, stages

• Step 2: (Financial Close) Construction Financing

Funding provided progressively with drawdown procedures that carefully test that money has been spent. Capital market financings can involve up-front money.

Capitalize interest, finance up-front fees. Can have take-out at completion.

• Step 3: (Completion Test) Completion of the Project

“Performance completion test.” Before test is satisfied, there is careful allocation of debt and equity and there often is recourse to a credit worthy company for cost over-runs.

• Step 4: (Commercial Operation Date) Project Financing

Cash flows used to cover debt service. If do not meet completion test, do not become project financing.


Steps in Development Phase


Valuation of Development Expenditures and Probability of Proceeding

• Simple approach

If 10% chance of proceeding, development expenditure is worth 10 times as much as other construction expenditure.

Example: 2% of development cost really has a cost of 20% of the project


Uncertainty of Costs and Time to Development


Project Finance Timing and Finance

• Finance is critical path.

After the Commercial Operation Date, the Permanent Loan is Repaid.

The slower the loan is repaid, the better the financial results of the project.

Bankers are reluctant to make loans with tenors that extend for the life of the project.

After the Commercial Operation Date, the Project can Begin to Pay Dividends

Dividends or Distributions Define the Equity Cash Flow of the Project.

Dividend Payments can be Limited by Covenants and Cash Flow Sweeps.

Financial Metrics in Project Finance

Equity IRR – The amount of money you invest relative to the amount you get back.

Debt Service Coverage – The cash flow of the project on a year to year basis relative to the amount of money (interest and principal) you have to repay.


Project Finance from Development through Commercial Operation)

SponsorRisk

Time

Letter of

Intent

Fuel Supplyand PowerPurchase

Agreements

FinancialAgreements

Signed

Ground-breaking

Commissioning

Steady-StateOperation

Technicaland

EconomicFeasibility

Project Identi-fication

PermitsObtained

FinancialStructure

Negotiated

Construction

Time to Complete Task (months)

2 6 12 20 24 48 498

Completion Test


ProjectIdentification “Go-Ahead”

Approval

Site

O&M

FeasibilityStudy

Part

ner

(JV

A o

r JD

A)

Offtake Contract

Fuel Supply

Form

P

roje

ct

Co. Financing Negotiations

Development Stage CLOSE

“Pre-Development” Costs Phase I Development Costs & Expenses Phase II Development Costs & Expenses

EPC O&M

Site & Gov’t

Approval

Negotiations

Design, Engineering & Procurement

1 YR2-3

YRS.

Project Contracts

Other

Further Engineering

Finalizing EPC and Commercial Contracts

Timeline Before Commercial Operation


Separation of Construction and Operation Time Period

• Income Statement and Cash Flow Statement

• Distribute cash flow to equity

• Dividend distribution from the cash flow statement at the end of the cash flow waterfall

• Debt repayment included in the cash flow

• Interest expensed in the income statement

• Revenues, expenses and depreciation included

• Sources and Uses Statement During Construction

• No cash distributions to equity

• Sources and uses of cash to determine equity and debt issuance

• Debt drawdown and no debt maturities

• Interest expense capitalized to construction

• No revenues, expenses or depreciation


Sources and Uses Statement During Construction

• Interest During Construction

IDC is capitalized to construction cost -- this means that interest is not included on the income statements, but it is included as a part of construction cost.

Depreciation includes IDC in the base.

IDC can be computed from the debt balance.

Interest Income on Debt Reserves has similar computations.

• Monthly versus Annual Sources and Uses

The Only Reason for Monthly Analysis of Construction is for Accurate Representation of IDC, Otherwise Annual Would Be Fine:

Monthly sources and uses of funds statement computed in exactly the same format, but compute monthly interest

When computing interest expense, use the annual interest rate divided by twelve

Tabulate the monthly interest balance and replace the lines in the annual model with the sum of the monthly interest. (You could do this with debt balances as well, but that is not necessary.)


Equity IRR Issues

• While the equity IRR is the fundamental measure of return for a project, a number of ambiguities arise from its measurement. Some of these include:

Including shareholder subordinated loans in the calculation (these may depend on the tax law regarding the deductibility of interest for a particular country)

Including development fees that are paid to the sponsor but do not cover out-of-pocket costs for consultants, lawyers etc. as a cash inflow in the equity IRR calculation

Including assumptions with respect to debt re-financing which accelerates cash flows to equity holders.

• Basic rule: is money going into or out of the pockets of equity investors


Free Cash Flow

• Free Cash Flow (un-geared after tax cash flow)

Finance theory suggests analyzing free cash flow and the claims on free cash flow

PV of free cash flow discounted at the WACC defines the asset value or the Enterprise Value

Free cash flow is the same no matter how high or low the debt level.

Free cash flow determines the project IRR

Project IRR can be compared with the after-tax interest rate to determine the benefits from leverage

In contrast to free cash flow, equity cash flow should be discounted at a higher discount rate


Discount Rates and Valuation for Real Estate Projects

• Merrill Lynch performed a discounted cash flow (“DCF”) analysis on Equity Office, based on projections provided by our management.

The illustrative present value indications of unlevered free cash flows for Equity Office for the years 2007 though 2010 using discount rates ranging from 7.25% to 7.75%, based on the estimated cost of capital of Equity Office, which included consideration of historical rates of return for publicly-traded common stocks, risks inherent in the industry and specific risks associated with the continuing operations of Equity Office on a standalone basis,

The present value of the illustrative terminal value using estimated 2011 EBITDA based on terminal EBITDA multiples ranging from 17.5x to 18.5x, based upon total enterprise value to estimated 2007 EBITDA multiples for the selected comparable companies.


Free Cash Flow

• Free cash flow can be computed from the income statement or from the cash flow statement. The amount of free cash flow (free after all capital expenditures and operating expenses and taxes) is the sum of equity cash flow and debt service.

• From the cash flow statement, the formula is:

Cash Before Financing Plus: Interest Expense Less: Tax Shield on Interest

• From the income statement, the formula is:

EBITDA Less: Taxes on EBIT Less: Working Capital Investment Less: Capital Expenditures

• A complexity in measuring free cash flow is making adjustments for interest during construction. Interest during construction would not exist with no debt financing and the tax deductions on the depreciation portion that represents IDC would not exist.

• The first method is easier to compute, the second method is more intuitive.


Free Cash Flow Example


IRR, NPV and other Issues

• NPV calculations are misleading if used to compared two projects of different sizes

• IRR calculations exaggerate the value of early cash flows and understate the value of later cash flows

Projects are exposed to non-traditional risks (discussed earlier).

Have high and rapidly changing leverage.

Typically have imbedded optionality.

Projects have early, certain and large negative cash flows followed by uncertain positive cash flows.


Project IRR versus Equity IRR

• A central issue in finance is equity valuation (P/E) versus enterprise valuation (EBITDA). In project finance, the issue is whether investments should be assessed with project IRR on free cash flow or equity IRR on equity cash flow:

In theory valuation of a project is from free cash flow, and the capital structure is irrelevant.

A counter point is that financing provides essential valuation information on the risk and value of a project, this is how of banks and insurance companies are valued where financing drives value.

In project finance, the level of debt tells a lot about the risk of a project – if a project has more debt capacity, the free cash flows have less risk.

Begin with free cash flow and the project IRR to establish the “real” economics of the project. Then evaluate financial criteria such as covenants with equity IRR.


Project Finance versus Traditional Investment Evaluation

Traditional

Valuation driven by assessment of project IRR

Project IRR compared to all-equity cost of capital

Equity IRR and leverage do not impact investment decision

Project Finance

Valuation driven by the equity IRR

Equity IRR affected by debt leverage

Constraint on issuing debt is risk assessment of financial institutions

The constrained optimization can be used to measure risk


Project and Equity IRR Issue – Equity Bridge Loans and Recourse Debt

• In some projects, equity holders provide loans to the project from their balance sheet instead of equity. The issue arises as to whether these should be considered equity or debt.

• Example

Instead of providing equity, a sponsor secures a loan to the project.

The loan will be re-paid in a bullet at the end of seven years.

When the loan is re-paid, the sponsor provides equity to finance the loan.

• Issue

Should the equity bridge loan be considered debt or equity for purposes of computing IRR.

The loan uses resources of the parent and must be guaranteed by the parent


IRR’s in PFI

• IRR’s are negotiated in PFI transactions as part of the concession agreement where the IRR drives pricing in the contract.

• Concession agreements in PFI project financings limit increases in the IRR that come about from interest savings from re-financing. (e.g. share excess profit 50/50).

• In concession agreements, the IRR is used to monitor the performance of the project as well as for the investment decision.


Other Valuation Metrics – Payback and Discounted Payback

• The payback period measures the number of years that it takes before the cumulative forecast of cash flow equals the initial investment. It is criticized because it gives equal weight to cash flows before the payback and zero weight thereafter.

• However, if you are explaining the benefits of a project and you can tell an investor that the money he invests will be all paid back in three years, and everything else is gravy, the payback can be an effective analysis tool.

• The payback can be modified where cash flows are accumulated and the payback is measured using discounted cash flows. This is the discounted payback.


Hypothetical Investment Decision and Equity IRR Criteria

• Begin with the notion that management has a rate of return criteria where only projects that have an IRR of above 14% are approved for investment and projects that have an IRR below 14% are not. Further, assume that this rate of return is measured using equity cash flow rather than free cash flow, due to corporate objectives related to earnings per share (“EPS”) growth. In this hypothetical situation as long as free cash flow from the project is expected to yield a higher rate of return (project IRR) than the after tax cost of debt, the equity return can be increased if more debt is used to finance the asset. (Magnifying asset returns to increase equity return is the where the term leverage comes from). If, because of the reluctance of bankers to take credit risk, debt cannot be raised for the project, the equity return criteria will probably not be met. On the other hand, if a significant amount of project debt can be raised, the equity IRR will exceed 14% and the investment will be made. Therefore, in this hypothetical example the amount of debt directly affects the investment decision. Indeed, the investment is driven by the amount of debt that can be raised rather than by the beta of the project or the risk adjusted all-equity cost of capital relative to the project IRR.

• The notion that the leverage of a project affects cost of capital is demonstrated in the following quote from a rating agency:

Nonetheless, a project's leverage level is often an indication of its creditworthiness. For instance, a merchant project's ability to produce a stable and predictable revenue stream will never match that of a traditional contract revenue-driven project. Projects with merchant exposure may find that leverage cannot exceed 50% if investment-grade rated debt is sought. Contract-revenue driven projects, on the other hand, typically have had leverage levels around 70% to 80%.


DSCRs in Project Finance


DSCR - General Discussion

• Basic Definition – Cash into the project divided by debt paid to the bank

• Should find in the cash flow statement

• The rule is that the higher the risk, the higher the DSCR, since a larger multiple of cash flow has to be held in relation to debt-service.

• The DSCR used in Credit Rating and in Covenants – Measures the possibility of default

For example, if a wind project generates a net income of a1 million per annum and the bank requires a DSCR of 1.3, the project could take out a loan for which the debt service would be a770,000 per annum.


• Borrowed amount is based on a conservative commercial case

Lenders will analyze conservative assumptions because their only recourse is to the project and its cash flow:

Conservative reserves estimate (in case of oil & gas)

Product price forecast – low

Capital and Operating Costs – high

• Debt sized by conservative case Debt Service Coverage Ratio

Debt Sizing


Debt Capacity from Cash Flows with Different Volatility

• High Risk Cash Flows • Low Risk Cash Flows

High Risk Project has higher margin, shorter-term and declining debt service. Low risk has flat debt service, and longer-term and higher IRR on Equity

High Volatility of Cash Flow

Low Volatility of Cash Flow


Determining the Credit Classification of Project Finance Debt

• Determining the credit classification is important because:

Credit classification is probability of default

Credit classification and risk drives the credit spread

Credit classification drives the ability to gain bank financing

Achieving an investment grade bond rating or above drives access to investors in bonds

• Other than being used for covenants, the primary purpose of credit ratios such as the DSCR is to gauge the credit risk of a project loan.

• Credit risk in turn is determined by the probability of default of a loan.

• The reason a PFI project with a 1.2x DSCR and a merchant power plant with a 2.5x DSCR may have the same credit rating is that they both have similar probability of default.


Banks or Rating Agencies Value Debt with Risk Classification Systems

Internal Credit Ratings Code Meaning

Corresponding Moody's

1 A Exceptional Aaa2 B Excellent Aa13 C Strong Aa2/Aa34 D Good A1/A2/A35 E Satisfactory Baa1/Baa2/Baa36 F Adequate Ba17 G Watch List Ba2/Ba38 H Weak B19 I Substandard B2/B3

10 L Doubtful Caa - ON In EliminationS In ConsolidationZ Pending Classification

Map of Internal Ratings to Public Rating Agencies


Risk Classification and Target of BBB in Project Finance from S&P website


Updated S&P Stats


Traditional Credit Analysis – Backward Looking Credit Ratios to Gauge Bond Ratings and Bank Ratings

• Credit ratios are used gauge the credit classification from financial statements such as the debt service coverage benchmarks in project finance.


General Use of Financial Ratios in Establishing Credit Quality

Business Risk/Financial Risk

—Financial risk profile—

Business risk profile Minimal Modest Intermediate Aggressive Highly leveraged Excellent AAA AA A BBB BB Strong AA A A- BBB- BB- Satisfactory A BBB+ BBB BB+ B+ Weak BBB BBB- BB+ BB- B Vulnerable BB B+ B+ B B- Financial risk indicative ratios* Minimal Modest Intermediate Aggressive Highly leveraged Cash flow (Funds from operations/Debt) (%) Over 60 45–60 30–45 15–30 Below 15 Debt leverage (Total debt/Capital) (%) Below 25 25–35 35–45 45–55 Over 55 Debt/EBITDA (x) <1.4 1.4–2.0 2.0–3.0 3.0–4.5 >4.5

Credit risk impact: High (H); Medium (M); Low (L)

Risk factor Cyclicality Competition Capital intensity Technology riskRegulatory/Gov

ernmentEnergy

sensitivityIndustry H H H L M/H HAirlines (U.S.) H H H M M HAutos* H H H M M MAuto suppliers* H H M H L L/MHigh technology* H H H M M/H HMining* H H H L M LChemicals (bulk)* H H H L M HHotels* H H H L L MShipping* H H H L L MCompetitive power* H H M L H HTelecoms (Europe) M H H H H L

Key Industry Characteristics And Drivers Of Credit Risk


Strong Ratings

• Characteristics of Strong Ratings

Capacity to generate sufficient cash flow to maintain DSCR’s within industry norms for investment grade ratings.

Fully amortizing debt

Lender has control over cash flows and collateral

Strong management with track record of meeting budgets in the country

Comprehensive risk mitigation

• Characteristics of Weak Ratings

DSCR below 1.0 under moderate stress test scenarios

Bullet maturities

Reserve funds from operating cash flow

Lender has limited control over cash flow

Management has limited experience in the country


Ratings Assignment – Basel II Document

• Template of objective benchmarks that measure risk factors, such as DSCR’s, LLCR’s and break-even oil prices.

Simulation model that alters critical inputs changed that measures the likelihood of default (Monte Carlo Simulation with oil price varied to measure the potential for the DSCR to fall below 1.0)

Stress test to evaluate whether the transaction can withstand in a critical revenue or expense. Determine financial flexibility in the face of adversity.

Judgmental criteria and weighting systems that use descriptions to distinguish credit quality.


DSCR Drives the Debt Capacity

Debt Ratio and Debt Service Coverage

2.742.43

2.191.98

1.82 1.681.55 1.45

2.221.97

1.761.59

1.45 1.34 1.24 1.15

0

0.5

1

1.5

2

2.5

3

3.5

40% 45% 50% 55% 60% 65% 70% 75% 80%Debt to Capital Ratio

DS

CR

Average

Minimum

• The debt service coverage ratio is a financial output in a project finance transaction which cannot be determined by sponsors of a project in advance. The debt service coverage ratio statistic can be driven my many factors including the debt to capital ratio. Unlike the DSCR, the debt to capital ratio is driven by a decision by sponsors and lenders.

• There is a direct relationship between debt service coverage ratios and the debt to capital ratio once free cash flows have been established. The table above shows the average and minimum debt service coverage ratio for the combined cycle plant assuming that price levels for the plant result in a project IRR of 11.09%. The graph illustrates that a debt service coverage ratio of 50% is consistent with a minimum debt service coverage ratio of 1.76x and an average debt service coverage ratio of 2.19x.


General DSCR Criteria to Establish Debt Levels

• Electric Power: 1.3-1.4

• Resources: 1.5-2.0

• Telecoms: 1.5-2.0

• Infrastructure: 1.2-1.6

• Minimum ratio could dip to 1.5

• At a minimum, investment-grade merchant projects probably will have to exceed a 2.0x annual DSCR through debt maturity, but also show steadily increasing ratios. Even with 2.0x coverage levels, Standard & Poor's will need to be satisfied that the scenarios behind such forecasts are defensible. Hence, Standard & Poor's may rely on more conservative scenarios when determining its rating levels.

• For more traditional contract revenue driven projects, minimum base case coverage levels should exceed 1.3x to 1.5x levels for investment-grade.


More on DSCR Targets for Alternative Industries

• Ranges in DSCR estimates


Example: DSCR for Wind Power

• Typically, we want revenues after all operating costs and taxes to be about 50% higher than what we actually need to repay the debt. This means that on any given period, revenues can be a third lower for any reason (whether lower wind, poor operating performance, or lower electricity prices) and we will still have enough money to repay debt.

• This implies 1.5x DSCR

• Wind is highly predictable in the long run but highly volatile and uncertain in the short term, thus leading to strong comfort that the long term average will be close to predictions, but with an also strong likelihood that some seasons or even some years could see significantly lower production levels.

• The DSCR has increased from 1.40x to 1.45x according to a study by LBL.


DSCR Criteria (Reference)

• At a minimum, investment-grade merchant projects probably will have to exceed a 2.0x annual DSCR through debt maturity, but also show steadily increasing ratios. Even with 2.0x coverage levels, Standard & Poor's will need to be satisfied that the scenarios behind such forecasts are defensible. Hence, Standard & Poor's may rely on more conservative scenarios when determining its rating levels.

• For more traditional contract revenue driven projects, minimum base case coverage levels should exceed 1.3x to 1.5x levels for investment-grade.


Example of Project Finance as Risk Measurement Survey of Electric Plants


DSCR Criteria in PFI Transactions

• The DSCR in PFI transactions can be very low – in the range of 1.05 – 1.2. The low DSCR results from the tight coverage of revenue and expense fluctuations with contracts.

• With the low DSCR, small risks in other transactions can become large risks for project loans.

• For example, interest rate fluctuations may have a small effect on transactions where the DSCR is 1.8, but the fluctuations in interest rates can cause default in the very tight PFI transactions. This is why there are 100% interest rate swaps in PFI.


Detailed Issues in Computing the DSCR

• There are many intricacies in computing the DSCR despite it being a simple ratio.

• First, some general discussion

DSCRs are the primary quantitative measure of project financial credit strength. The DSCR is the ratio of net cash flow to principal and interest obligations. Cash from operations is calculated strictly by taking cash revenues and subtracting expenses and taxes, but excluding interest and principal needed to maintain ongoing operations.

Should also subtract changes in working capital and sustaining capital expenditures

To the extent that a project has tax obligations, such as host country income tax, withholding taxes on dividends and interest paid overseas, etc., these taxes are treated as ongoing expenses needed to keep a project operating.


Alternative DSCR Calculations

• Minimum DSCR

The most important ratio that measures the minimum DSCR the project will see through debt maturity. The minimum DSCR will likely point to the project's greatest period of financial stress.

• Short-term DSCR

looks forward three years, as a near-term measure of financial strength.

• The Average DSCR

averages all of the minimum DSCRs remaining through maturity (as opposed to calculating the average CFO and dividing by the average annual debt service). The average DSCR provides a general measure of a project's cash flow coverage of debt obligations.

• The average DSCR, when viewed alongside the long-term and short-term minimum DSCR, does provide another measure of project comparability.

• Generally, stronger projects will show annual DSCRs that steadily increase with time to partially offset the risk that future cash flows tend to be less certain than near term cash flows.


Difference Between Free Cash Flow and Cash Flow for the DSCR

• Free cash flow

Excludes interest income

Adjusts taxes to remove benefits of interest income

Includes proceeds from asset sales and insurance proceeds

Determines the amount the project would earn if there was no debt financing

Should make adjustments for interest during construction

• Cash flow for debt service

Includes interest income

Uses actual taxes

Excludes amounts that will not be available on an on-going basis to pay debt service


Issue 1: DSRA Balances in the DSCR

• A project has better quality if it has a debt service reserve account

• Why not include all cash available to pay bank, including cash in accounts

• According to S&P

• 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 funds.


Issue 2: Senior and Subordinated DSCR

• Senior DSCR:

For the senior DSCR, divide the net cash flow by the senior debt service obligations, exactly as it would if only one class of debt existed.

• Subordinated DSCR – Two Methods.

The first method calculates the ratio of the total net cash flow to the project's total debt service obligations (senior plus subordinated). This consolidated calculation provides the only true measure of project cash flow available to service subordinated debt.

The second method takes the net cash flow and then subtracts the senior debt service obligation to determine the residual cash flow available to cover subordinated debt service. This method, does not, however, provide a reliable measure of credit risk that subordinated debt faces. A combination of small subordinated debt service relative to the residual CFO could result in a much higher subordinated DSCR relative to the consolidated DSCR calculation. Moreover, the ratio of residual CFO to subordinated debt is much more sensitive to small changes to a project's total CFO than the consolidated measure.


Issue 3: Operating Reserves and Debt Service Reserve Account Movements

• Operating Reserves

If cash must be put aside into a reserve account for major maintenance or other lumpy expenditures, the cash that goes into the accounts should be treated as a cash outflow, like an operating expense.

When the operating expense occurs and funds are withdrawn, then the cash withdrawn is included as an inflow in the DSCR.

Therefore, the DSCR is smoothed out

• Debt Service Reserve Account

Sometimes, money is put aside in a DSRA account from operating cash flows.

If there are cash short-falls, then cash is taken out of the DSRA.

Is the issue the same


Other DSCR Issues

• In reviewing various transactions, various DSCR issues arise. Some of these include:

If there is a cash flow sweep, should an interest only ratio be computed, or should alternative ratios be used.

In computing break-even analysis should debt service reserves be included in the ratio.

If there are breakage costs for interest rate swaps, how should breakage costs be treated.

Should different ratios be used for backward looking analysis and forward looking analysis.

In using DSCR’s as triggers to limit dividends or to sweep cash flow, which ratios should be used.


Timing of DSCR Calculations

• The DSCR is not generally computed before the date of project completion. Therefore, language related to the definition of the completion of the project must be included in the loan agreement:

"Completion Date" means the first date on which the Agent receives notification from the Lenders' Technical Adviser that the following conditions have been fulfilled to the satisfaction of the Lenders' Technical Adviser:

[the completion tests under the Concession Agreement have been completed, the Authority has issued to the Borrower the [Completion Certificate] pursuant to Clause {cross-reference} of the Concession Agreement and the [Operating Commencement Date] under the Concession Agreement has occurred]; [and]

[the completion tests under the Construction Contract have been completed and the Borrower has issued to the Contractor the [Final Acceptance Certificate] pursuant to Clause {cross-reference} of the Construction Contract]; [and

{describe other Completion Date conditions}][;


Fundamental Events of Default

• The primary function of the DSCR is to measure the probability of defalut – a ratio of 1.0 implies a default. Fundamental events of default include

the failure of the borrower to pay debt service;

failure to comply with insurance requirements;

entry of a final court judgment in excess of a significant dollar amount which is not paid or stayed after a certain period;

abandonment of the project;

bankruptcy of the borrower;

failure of the sponsor to maintain ownership of the project (if the sponsor's ownership is a critical component of the evaluation of the project's credit risk).


Other Events of Default - Reference

• Other Events of Default Include:

operational covenants,

a merger or sale of assets

failure to deliver notices

failure to obtain or comply with governmental permits.

• Depends on Materiality

• Negotiated ad hoc.

• Agreements should provide for a clear and adequately described mechanism for allowing the parties to deal with the defaulted project.

• The hardest part of any negotiation is the definitions of the triggers (called "events of default") which allow banks, in theory, to have the right to take the project from the investors. It is not a simple task, as banks want to be able to step in as soon as something fishy appears, but on the other hand, they do not want to get too closely involved in the running of a project and the inevitable hiccups that happen; it also makes sense to step in only if there is a real problem which the investors seems unable or unwilling to solve. Investors emphatically do not want the banks to have the right to stp in the project, but they know that it is the price to pay to get the leverage they want (in the wind sector, banks usually provide 70-80% of the investment amount upfront)


LLCR and PLCR in Credit Analysis


LLCR and PLCR

• Loan Life Coverage Ratio (LLCR):

The LLCR computes the present value of cash flows over the debt tenor at the interest rate on debt as the numerator of the ratio. The denominator of the ratio is the present value of debt service at the debt rate. The denominator should equate to the amount of the debt.

The denominator should be reduced for debt service and other reserves

• Project Life Coverage Ratio (PLCR):

The PLCR is similar to the LLCR except that the present value of cash flows is computed over the economic life rather than over the debt tenor. As with the LLCR, the denominator of the PLCR is the present value of debt service at the debt rate.

The PLCR measures how much “tail” the project has from cash flows after the loan is re-paid.


General Mathematics of LLCR

• To see how the LLCR works, consider the following points

If all cash flow were invested at the interest rate in a bank account, and there was a bullet payment, then one could measure if that cash account was high enough to cover debt payments.

If the cash account in the above example were reduced by maturity payments, the end result would be no different.

If there is money in a DSRA, this could be used to make the requirement less, it is just like the concept of net debt in corporate finance.

The present value of debt service at the interest rate is the same as total debt


Loan Life Coverage Ratio (LLCR)

• Loan Life Coverage Ratio – the present value of cash flow before debt service – using the interest rate; divided by the remaining debt balance:

• LLCR = PV (debt rate, cash before debt service)/Debt Balance - DSRA

Essentially the LLCR is DSCR on a present value basis so that the credit quality of the whole project is measured.

LLCR numerator is the PV of the cash available for debt service, discounted at the pre-tax debt rate

LLCR denominator is the PV of debt service at the debt rate, which is the same as the initial debt issued for the project

The LLCR does not have a standard definition – it would make most sense to use free cash flow rather than the numerator of the DSCR


LLCR and Credit Quality

• The LLCR Concept can be used to gauge the economics of the project relative to the amount of debt outstanding:

If no dividends can be paid until all of the debt is paid, the present value of cash flow can be compared to the present value of the debt.

If the present value of the debt exceeds the present value of the free cash flow at the debt rate, there is no way the project can payoff the debt – the project has too much gearing.

If the debt holders get all of the cash flow before any equity, the present value of the debt relative to the present value of cash is an effective statistic that can measure how much a variable changes before a debt default occurs.

For example, if the cost increases by a certain amount, a LLCR of 1.0 measures the break-even point before which the debt cannot be repaid.


Project Life Coverage Ratio (PLCR)

• The PLCR or project life coverage ratio covers the residual cash flow of the project as well as the loan life period.

In the PLCR, the numerator uses the present value of cash flow over the life of the project rather than over the life of the debt.

The PLCR is related to the loan to value ratio if one assumes that the present value of the cash flow is the value of the project:

PLCR = Value/Loans

Debt to Value = Loan/Value

Debt to Value = 1/PLCR

As a rule of thumb, the present value of the operating cash flows before tax should be 1.5x the debt amount.


LLCR and PLCR

• The PLCR or project life coverage ratio covers the residual cash flow of the project as well as the loan life period.

As a rule of thumb, the present value of the operating cash flows before tax should be 1.5x the debt amount.

• Loan Life Coverage Ratio

Essentially the DSCR on a present value basis

LLCR numerator is the PV of the cash available for debt service, discounted at the pre-tax debt rate

LLCR denominator is the PV of debt service at the debt rate, which is the same as the initial debt issued for the project

The LLCR does not have a standard definition – it would make most sense to use free cash flow rather than the numerator of the DSCR

• Prospective DSCR and Borrowing Base


Debt Tenor and Average Life

• Lenders want to know how their risk reduces over the life of a project.

• If the loan was only for one year, the risks are less than a 20 year loan, if the cash flows are the same and the cash flow can support the debt repayment.

• In project finance, the risk associated with longer terms is measured by the average loan life.

• Average loan life is used in a similar manner to the payback period to check that the loan is not over-extended.

• The Average loan life accounts for the manner in which a loan is paid back – if the loan has a bullet payment, the loan life is the same as the tenor.

• The formula is simply the average outstanding amount of the loan divided by the initial balance of the loan.


Credit Ratings, Loan Pricing and Loan Value


Default Rates and Credit Spreads -- Note that Credit Spreads Increase When Default Rates Increase


Increase of 5% Credit Crisis

Credit Spreads


Bond Ratings and Yield Spread

• Credit classification is very important in establishing the access to funding and the cost of funding as illustrated on the graphs below:


Table of Bond Spreads

• The following is an example of bond spreads at a point in time (bondsonline.com). These spreads change over time.

Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yrAaa/AAA 5 10 15 22 27 30 55Aa1/AA+ 10 15 20 32 37 40 60Aa2/AA 15 25 30 37 44 50 65Aa3/AA- 20 30 35 45 53 55 70A1/A+ 30 40 45 58 62 65 79A2/A 40 50 57 65 71 75 90A3/A- 50 65 79 85 82 88 108Baa1/BBB+ 60 75 90 97 100 107 127Baa2/BBB 65 80 88 95 126 149 175Baa3/BBB- 75 90 105 112 116 121 146Ba1/BB+ 85 100 115 124 130 133 168Ba2/BB 290 290 265 240 265 210 235Ba3/BB- 320 395 420 370 320 290 300B1/B+ 500 525 600 425 425 375 450B2/B 525 550 600 500 450 450 725B3/B- 725 800 775 800 750 775 850Caa/CCC 1500 1600 1550 1400 1300 1375 1500

Note the Jump at BB+ to BB


S

P R

The credit spread (s) can be characterized as the default probability (P) times the loss in the event of a default (R).

The Credit Triangle

S = P (1-R)

Theory of Credit Spreads: Credit Spread on Debt Facilities

• The spread on a loan is directly related to the probability of default and the loss, given default.


EXPECTED LOSS

$$

=Probability of

Default

(PD)

%

xLoss Severity

Given Default

(Severity)

%

Loan Equivalent

Exposure

(Exposure)

$$

x

The focus of grading tools is on modeling PD

What is the probability of the counterparty

defaulting?

If default occurs, how much of this do we

expect to lose?

If default occurs, how much exposure do we

expect to have?

Borrower Risk Facility Risk Related

Expected Loss Can Be Broken Down Into Three Components


Comparison of PD x LGD with Precise FormulaCase 1: No LGD and One Year

• .


Comparison of PD x LGD with Precise FormulaCase 2: LGD and Multiple Years

• .Assumptions

Years 5 BB 5Risk Free Rate 1 5% 7Prob Default 1 20.8% PD 20.80%Loss Given Default 1 80%

Alternative Computations of Credit SpreadCredit Spread 1 3.88%PD x LGD 1 16.64%

ProofOpening Closing Value

Risk Free 100 127.63 127.63

Prob Closing ValueRisky - No Default 100 0.95 153.01 145.36

Risky - Default 100 0.05 30.60 1.53

Total Value 146.89 FALSE

Credit Spread FormulaWith LGD

cs = ((1+rf)/((1-pd)+pd*(1-lgd))-rf)^(1/years)-1


Probability of Default

• This chart shows rating migrations and the probability of default for alternative loans. Note the increase in default probability with longer loans.


Updated Transition Matrix


Market participants consistently report lower default rates, and especially lower loss rates on project finance than on other equivalent corporate exposure, largely because of the effect of transaction structuring and transparency and control of collateral.

Project finance transactions are by their nature, complex and require a strong understanding of the underlying markets and their risk drivers. Only a limited number of banks have dedicated project finance credit teams.

Project Finance and Default History


Study of Probability of Default for Project Finance


Default Rates by Industry


Defaults versus Long-term Average

Moody's Speculative Grade Trailing 12-Month Default Rates Actual Jan. 2000 to Aug. 2002 / Forecasted Sept. 2002 to Feb. 2003

6.2%6.7%

7.1%

7.7% 7.7% 7.9%

8.5%8.8% 9.0%

9.6% 9.8%

10.5%10.7%10.5%10.3%10.3% 10.5%10.3% 10.1%10.0%10.0%10.0% 10.0%9.3%

8.8%

9.8%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

Jan-

01

Feb

-01

Mar

-01

Apr

-01

May

-01

Jun-

01

Jul-0

1

Aug

-01

Sep

-01

Oct

-01

Nov

-01

Dec

-01

Jan-

02

Feb

-02

Mar

-02

Apr

-02

May

-02

Jun-

02

Jul-0

2

Aug

-02

Sep

-02

Oct

-02

Nov

-02

Dec

-02

Jan-

03

Feb

-03

Months

%

3.77%*

Note: *Long run annual default rate is 3.77%

Moody’s Forecast of Default Rates


Project Finance and Basel II

• The table below shows the default rates in a study conducted for Basel II


Recovery rates

• Estimating recovery rates

There is no market or highly illiquid market

Immediately upon announcement of default, after some reasonable period for information to become available, or after a full settlement has been reached

• Recovery rates of bond

Subordinated classes are appreciably different from one another in recovery realization

Difference between secured vs. unsecured senior is not statistically significant

• Recovery rates of bank facilities

Bank facilities( loans, commitments, letter of credit) are senior to all public senior bonds

Bankruptcy law and practices differs from jurisdiction to jurisdiction

• Distribution of recovery rates

Consistently wide uncertainty

Beta distribution


Recovery Rates


Project Finance Ratios

• Net cash from operations before debt service (CFO)

Revenues minus cash expenses, including taxes, but excluding debt service

• Minimum debt service coverage ratio (MDSCR)

Lowest CFO to annual principal and interest payment ratio

• Short-term minimum DSCR (STDSCR)

Lowest DSCR over the next three years

• Average debt service coverage ratio (ADSCR)

Average of annual DSCRs through debt maturity

• Loan life coverage ratio (LLCR)

Total remaining present value CFOs divided by outstanding principal balance


Debt Capacity and Pricing


Returns on Project Finance Loans

• The probability of default and the loss given default

Probability of default through 2002 – 13.3%

Large defaults in 2002 from telcom and merchant power


Project Finance and Basel II – Pre 2003

• Three approaches

Basic

PD and LGD defined from four supervisory ratings categories

Foundation

Bank estimates PD or other risk parameters and uses basic approach for other parameters

Advanced

Bank estimates PD, LGD, EAD

• Correlation of LGD and PD

• LGD 2001: Initial evidence on realised losses suggests that losses during difficult periods exceeds those of senior, unsecured corporate exposures.


F

V(T)

Equity

Debt

Payoff toclaimholders

Value of the company and changes in value to equity and debt investors

At maturity date T, the debt-holders receive face value of bond F as long as the value of the firm V(T) exceeds F and V(T) otherwise.

They get F - Max[F - V(T), 0]: The payoff of riskless debt minus the payoff of a put on V(T) with exercise price F.

Equity holders get Max[V(T) - F, 0], the payoff of a call on the firm.

Value of Firm in Time T

Nominal Debt Repayment


BA1 A2 Assets

Payoff todebt holders

The payoffs to the bond holders are limited to the amount lent Bat best.

Credit spread is the payoff from selling a put option


Telecom DSCR Criteria (Reference)

• Standard & Poor’s believes that a project’s credit is generally strengthened by covenants that limit, or even preclude, distributions to sponsors unless both robust historic and projected DSCRs are met, and reserve funds are fully funded.

• Given the merchant-type risk associated with most telecom deals, Standard & Poor’s would generally require that distribution test DSCRs be computed on a 12-months-back and 24-months-forward basis, using forecasts made by independent consultants, and be at least 2 times (x) for low speculative- and investment-grade projects.


Debt Service Coverage Criteria

• Standard & Poor's considers that minimum DSCR threshold tests for most contract-driven projects to be around 1.30 times (x), provided that this figure holds under stress analysis.

• Such levels are too low for merchant projects. Instead, minimum DSCR levels for equity distributions may need to exceed 1.70x for investment-grade transactions, depending on the industry.

• For example, one financial institution suggests that under base case assumptions the DSC should show not less than 1.2:1 for every year of operation during the loan life, and no less than 1.4 on average.

• Under a Downside Case, with up to 5 years added to the repayment period, the DSC should be no less than 1.0:1 for every year or less than 1.15:1 on average during the life of the loan.

• Projects with merchant exposure may find that leverage cannot exceed 50% if investment-grade rated debt is sought. On the other hand, contract-revenue driven projects, on the other hand, typically have had leverage levels around 70% to 80%.


Effect of Financing on the Required Cost of Electricity


Moodys S&P

Aaa AAA The debt has the highest rating. Capacity to pay interest and principal is extremely strong. Regarded as having maximum safety and gilt-edged.

Aa AA The debt has a very strong capacity to pay interest and repay principal. Regarded as ‘high-quality.’

A A The debt has a strong capacity to repay interest and principal. However, it is somewhat susceptible to adverse changes in circumstances and economic conditions. Regarded as upper-medium grade in terms of creditworthiness.

Baa BBB The debt is regarded as having adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances may lead to a weakened capacity to pay interest and repay principal for debt. These bonds/loans are lower-medium grade in therms of creditworthiness.

Investment Grad Bond Ratings


Moodys S&P Debt rated in the categories below are regarded as low grade and predominantly speculative.

Ba BB The ability of these entities to meet obligations may be moderate and not well safeguarded in the future. The lowest degree of speculative.

B B These issues offer poor financial security. Assurance of payment of obligations over the long term is small.

Caa CCC Very poor financial security. They may be in default of their obligations or there may be dangers present with respect to timely debt repayment.

Ca CC These entities are often in default or have other marked shortcomings. The highest degree of speculation.

C C This rating is preserved for debt that may have substantial risk; be in default; or extremely speculative. Potential recovery values are low.

D D The debt is in default and payment of interest and/or repayment of principal is in arrears.

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Non-Investment Grade Bond Ratings


Sutton Bridge Financial Ratios

Financial Structuring

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Transcript of Financial Structuring