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Can't Afford to Ignore 'Financial Engineering'
Project Finance is a means of financing assets with limited or no recourse to the Sponsor. It relies on the future cash flow of a project as primary source of repayment, and holds the projectís assets, rights and interests as collateral security. In this article, Vishal Gupta, VP Project Advisory & Structured Finance, SBI Capital Markets Limited addresses the topic of project finance from the perspective of a non-financial project manager/executive.

It is ideally suited for a company that wants to implement a new project without encumbering its existing balance sheet. The company could consider establishing a Special Purpose Vehicle (SPV) that implements the project and raises the funding. In doing so the corporate balance sheet is protected against the risks associated with a large project. The SPV is legally independent from its shareholders. This provides a safeguard for the project in the event of failing shareholders dragging an otherwise healthy project into distress or vice versa. It may be noted that while Project finance structures are typically housed in a SPV, we can also create a project finance structure within an existing company by ring fencing the project assets and cash flows.

The diagram below illustrates the relationship between the main parties in a project financing and the agreements that govern their relationships.

Risk Allocation Matrix
The key to structuring in project financing is the identification of the key risks and their mitigation. Table I gives the risk allocation matrix for a typical project.

Key Requirements for Project Finance When a company thinks of a project or a business opportunity it would be focused on the internal due diligence and experience and inputs from its in-house teams who may be having considerable experience but do not have sufficient credibility for a project to be financed through project finance. The lenders will be particularly keen to ascertain the certainty about the cash flows of the project and would like a reputed independent agency to verify the details.
The following information will be required to establish the technical and economic viability of the project

Detailed Project Report from a reputed technical consultant who would vet the technical aspects of the project and verify the project cost.
• Marketing plan for selling the products including demand supply data in the target markets.
• Availability and cost of input materials for eg. For a steel plant it will be iron ore and coke, and energy sources, whereas for a coal fired power plant availability of coal.
• Comprehensive financial model with sensitivity and scenario testing.
• Availability of supporting infrastructure, logistics and communication links.
• Comfort with regard to the experience of project participants, eg management, contractors and operators.
• Satisfactory legal due diligence and contractual arrangements.
• Sat isfactor y Envi ronmental Impact assessment study has been carried out, R&R issues if any have been suitably addressed.
• Permits and approvals required for implementing the project have been obtained.
• Identification of all project risks and mitigatory measures and risk transfers to be put in place.

Key Success Factors for Project Finance Project finance, due to its reliance on certain cash flows requires that the technology employed is proven and is working satisfactorily elsewhere. Unproven technology increases completion - and operating risk.

The Sponsors should have a track record in completing and running projects successfully. The Sponsors should have sufficient resources to bring in the equity for the project. Normally the lenders would specify an upfront equity contribution before the first drawdown of debt.

From the sponsors perspective they would like to minimise the equity contribution as equity is more expensive than debt as well as they would like to back end the equity contribution whereas the lenders would like it vice versa as from their perspective the higher the leverage the higher is the risk. Typically for infrastructure projects the gearing is around 70 per cent with an upfront equity contribution of around 25 per cent. For projects in the non-infra/ core sector the gearing is typically lower at 60 per cent and upfront equity contribution is higher.

If the projected available free cash to service debt is substantial, then the chances of success are improved. This is usually measured in terms of a high Debt Service Cover Ratio (DSCR).

Typically for steel and other commodity projects the lenders look at an average DSCR of around 1.7 for infra projects such as power and road sector lower ratios of around 1.4 are also acceptable. The basic issue is the certainty of the cash flows.

Conclusion
Project Finance aims to get the project off the balance sheet of the sponsor. By doing so the funding that is required will be repaid from the revenues of the project only. Any project financing therefore requires positive cash flow. As compared to corporate financing, Project financings are highly geared. In raising the capital a structure is required that is bankable. Complex contractual arrangements will tie down the rights and obligations of the different parties and allocate the risks between them.

Each project is unique and there are a number of complex issues that need to be suitably addressed to achieve an optimal financial plan so a promoter seeking finance for a new project should preferably seek the services of a technical and financial advisor to assist with the feasibility study of the project and appoint arrangers to raise the funding.