Project Finance

Types of Project Finance

The project finance model most usual in projects involving tunnelling works is the BOT model (Build, Operate and Transfer). The central agreement in BOT is the licence or concession to construct and then operate the project. The concession is usually granted by the Government Agency and usually is for a fixed period. At the end of that period the consortium hands back the concession to operate the facility and generate revenue.

There are a number of variations of the above project finance model. The DBFO road schemes in the UK transfers part of the risk of traffic flows to the consortium. Road users are not charged a toll directly by the consortium. Instead its revenue is generated from the government directly based on shadow tolls.

The PFI model (Private Finance Initiative) is simply another version of the BOT model. There are essentially two types of PFI concession. In the first the consortium is entitled to charge the public and in the second it receives a fee from the government agency for the service. There are hybrids particularly on mass transit projects where there may be an element of government subsidy together with revenue from the users. The level of public revenue is usually a key factor in the choice of the consortium at the bid stage.

The Government Agency’s Perspective

The Government Agency will normally adopt the following guidelines when implementing a Project Finance project and in its selection of the successful consortium:

• the private sector must genuinely assume risk

• the private sector and not the public sector must control the consortium

• there must be a stated and defined limit to the public sector’s financial contribution

• the allocation of risk and reward between the public and private sectors must be defined and agreed

• the project must represent value for money for the public sector contribution.

The Host Government owns the project that provides a public service, so it normally requires the consortium to design the project to a specification defined by the Government Agency. The construction, operation and maintenance will be to strict specification, and will be subject to periodic inspections.

During selection of the consortium the Government Agency will wish to ensure that the selected bidder has underwritten finance and that financing will not collapse before final agreement. The consortium will be reluctant to provide true underwriting since this will involve the considerable expense of an underwriting fee and the costs of a due diligence exercise by the banks and its advisers. This problem is not easily resolved without either the bidder incurring substantial bidding costs, or the Government Agency eroding its negotiating position. In many cases the Government Agency will choose a preferred bidder without making this public, whilst advising other bidders that they are held in reserve.

The concession agreement terms will include sanctions allowing the Government Agency to run the project itself if the consortium does carry out the project to the required standard. In addition the Government Agency may terminate the concession agreement for breach or in case of insolvency.

Funder’s Perspective

During the bid stage the funding institution will evaluate the technical feasibility of the project and its financial viability. A funder will rely upon security to assure that the loan is serviced and repaid and this will include, where appropriate:

• a mortgage over the land, and perhaps other assets of the consortium;

• special mandated bank accounts to control expenditure and channel revenues;

• dividend and ‘change of control’ restrictions over the consortium;

• collateral warranties for the contractor, operators and, if possible, the public authority, ensuring a contractual undertaking to perform their commitments to the project;

• the right of assignment of the benefit of the project agreements from all the contributors, including consultants and contractors.

Contractor’s Perspective

One of the main reasons for a contractor to be involved in Project Financing is the profit from the construction work itself. In addition the initiative will stimulate new work in the particular market. The added benefit is that the relationship with other consortium members created by the initiative, may itself open up new markets for the contractor. Finally the involvement is an investment which like any other can be realised by selling the equity in the project once the value of the shares has risen.

The Consortium

Due to the investment involved at this stage, usually in competitive tender situations, it is normal for the parties involved in a particular consortium to enter into exclusivity agreements. The enforceability of such clauses will depend upon the anti-trust or anti-competitive legislation that applies in the particular host country.

If the consortium is in the form of an unincorporated joint venture, then because of the lack of separate legal personality, it is necessary to appoint one of the parties as the leader or operator. The leader manages the project and has day-to-day control, but is normally overseen by a management committee. The committee is made up of representatives from each of the parties to the consortium. The committee takes all major policy decisions and decides on the share of costs for the project and runs the joint account. The unincorporated joint venture does not itself provide any limitation on liability, but the parties may each create limited liability companies especially for the project.

The consortium, however formed, will incur substantial losses during construction since at that stage there will be no revenue. These losses will normally be used to reduce the taxable profits during the period when the project earns revenue.

Construction Contracts

The construction risks are well known and include the risk that the project will not be built on time, within budget, and to the required performance standards. Generally these risks are borne wholly by the construction part of the consortium. The funding institutions will generally tightly control the passing of that risk to the other consortium members.

Contractors will need to examine carefully the contracting procedures, as these are likely to be substantially different from normal competitively bid work. The funding institutions prefer turnkey arrangements, where the contractor carries design and build obligations through to meeting the stated performance criteria. Contracts often include ‘guaranteed maximum price’ clauses.

The administration of contracts is normally exact. Funding Institutions insist upon project documentation being finalised before payments will be passed. Entitlements to extensions of time or additional payments are tightly controlled. Payments are normally on a ‘pay when paid’ basis. Where the consortium carries the risk, the contractor will in any event bear its proportion of any unrecoverable costs.

Operation of the Facility

One of the operation risks is that costs of maintenance and staffing will be as predicted and budgeted. This risk is reduced if attention is paid to the operation of the facility during the initial stages of the project. It is important to involve the operator member of the consortium in the conceptual and detailed design.

Another major operating risk is that the ‘revenue stream’ from the project will meet the required levels. It is important that the predictions that are made are very robust and based on a sound economic model. Depending on the nature of the scheme, both the public and private sector participants may bear a proportion of certain categories of operational risk.