Requirement for Special Purpose Vehicle Project Financing of a Large Complex Infrastructure Project - Coursework Example

Requirement for Special Purpose Vehicle (SPV) Project Financing of a Large Complex Infrastructure Project Name Course Name and Code Instructor’s Name Date Table of Contents Introduction 3 The requirement for robust business case 3 Reasons and Advantages for using SPV 5 The project financing process 6 Sustainability aspects 9 Conclusion 11 Reference 11 Introduction Special Purpose Vehicle (SPV) is a legal entity established to facilitate a transaction (Sarkar and Singh, 2010). SPV is also referred to as a bankruptcy remote entity whose activities are limited to the acquisition and financing of specific assets (Srivastava and Kumar, 2010). SPV is usually used for channeling funds from borrowers to lenders and carries out regulatory requirements of the funds (Wood, 2007). SPV acts as a legal buffer between the sponsor of the project and its backers. SPV is usually created to fulfill a special specific and limited use. The SPV is usually separated from the parent or sponsoring company for legal and tax reasons and may be under the control of several companies working together. The requirement for robust business case A business case is a kind of advice to executive decision makers. It presents a substantial argument for a project, program or policy proposal requiring a resource investment which often includes financial commitment. A business case can also be defined as a management tool which supports planning and decision making for investment by positioning the investment decision in the context of business objectives (Srivastava and Kumar, 2010). It provides an analysis of all the costs, risks and benefits associated with the investment proposal and provide reasonable alternatives (Tavakoli, 2003). The reason, the cost and the expected business value to be attained by the project ought to be considered comprehensively prior to making a final decision to proceed with the project (Sarkar and Singh, 2010). The business case is a multipurpose document which generates the support and participation required to turn an idea into reality. The document provides an explanation to the components of the idea, problem or the opportunity and how and who it will impact, what others are doing, each of the alternatives, the associated impacts, risks and cost/benefit of each alternative and thereafter makes recommendations (Srivastava and Kumar, 2010). The business case acts as a tool for supporting and planning decisions that are likely to impact on the financial results and other business consequences of projects. The audiences of business case include decision makers, partners and stakeholders, and the public (Tavakoli, 2008). Decision makers include the government, leadership, management and shareholders of public or private enterprises. Partners and stakeholders include organizations and individuals who are involved, provide input or have interests in or expectations from the proposal. A business case serves several functions (Tavakoli, 2003). First, it aims at convincing the target audience of the need, the feasibility, the cost effectiveness, the benefits, the financial viability and the manageability of risks involved in the proposal. Second, it helps in prioritizing the proposals. It also ensures that the strengths and weaknesses of the proposal are determined in a systematic and objective way. Furthermore, the business case acts as a tool for testing the validity of an idea prior to putting the case to others. A business case is essential for every project (Sarkar and Singh, 2010). It is required when reluctance to the proposal is foreseen and when the proposal is expected to have a significant impact on internal infrastructure arrangements or the delivery of services. It is also essential when the proposal brings substantial change in the way things are done and will require a significant allocation or reallocation of resources. There are several requirements for a robust business case. First, the business case ought to have sufficient or convincing argument for the proposal. Second, the business case should not have any ambiguity or unacceptable option assessment methodology. A robust business case also requires reliable input data. For the business case to be robust other priorities should take precedence. The development of the business case should involve thorough research, objectivity, and rigor and ought to have logical argument. The document should also be clear and be complete. Infrastructure projects are examples of projects which require robust business case. Business case is complex and time required for its development varies with the nature of the proposal (Sarkar and Singh, 2010). In some cases the development of a business case may take several months and sometimes a trial or pilot project may need to be in initiated to test the feasibility of the proposal (Tavakoli, 2003). The components of a business case include an executive summary; the need; the proposed project which entails project scope (project purpose, planned outcomes, project description, proposed timeframe and milestones) implementation plan, external funding arrangements and assessment of options (Akintoye and Beck, 2008). Reasons and Advantages for using SPV The creation of SPV isolates the parent company from risk and it is also isolated from financial risk at the parent company such as bankruptcy. The creation of SPV gives it separate legal entity from the parent company hence it act as a shelter of new inventions and other developments. SPV also allows risk sharing where several companies pool risky resources in an SPV and securitize them to raise funds (Bolinger, Harper and Karcher, 2009). SPV also allows isolation of the parent company from the risks of financing something and creates an entity just for financing which can become the face of the project (Mackenzie, 2010). The main advantage of SPV is that it helps in separating the risk and freeing up the capital (United Nations, 2010). Thus it allows protection of the SPV and the sponsoring company against risks such as insolvency which may arise during the course of the project. Another advantage of SPV is that it allows securitization of assets without the managerial relationship being disturbed (Sarkar and Singh, 2010). Thus, the arrangement allows securitization of any predictable income stream generated by secure assets (Alexander, 2010). This is important since a company is able to leverage future earnings to raise funds. The huge amount of funds required for the infrastructure sector can be raised by the SPV (Cheikhrouhou, and World Bank, 2007). The project financing process Project financing is a technique which involves an innovative and timely financing that is used in high profile corporate projects. It employs a carefully engineered financing mix to fund large scale projects. It has emerged as the preferred alternative method of financing infrastructure projects worldwide (Mackenzie, 2010). Project financing involves understanding the rationale for project financing, how to prepare the financial plan, asses the risks, design the financing mix and raise the funds (Tavakoli, 2003). Project finance differs from traditional forms of finance since the financier looks to the revenue and assets of the project in order to secure and service the loan. In project financing the financier has no or little recourse to the non project assets of the borrower or the sponsors of the project since the borrower or sponsors form SPV. The structure of the SPV for infrastructure projects addresses five areas (Alexander, 2010). These are finance ability, sources of funds, securities and agreements, sovereign support and credit enhancement. Finance ability structures the financial attributes of the SPV (Mantysaari, 2009). The structure here is to sell the idea in order to attract funds from lending and financial institutions. Sources of funds in cases of infrastructure projects include domestic capital market contribution and World Bank (Sarkar and Singh, 2010). Securities and agreements ought to be transparent, concrete and creditworthy. The process of awarding contract in infrastructure projects need to be competitive to reduce mistrust (Bolinger, Harper and Karcher, 2009). Sovereign support in infrastructure projects involves government stepping in and providing guarantees to investors in terms of payment guarantee and comfort letter. The sponsors’ contingency equity is essential in credit enhancement of a SPV. This helps in attracting many financiers and in the restructuring of the debt mechanism (Mackenzie, 2010). The setting up of SPV based on these five areas enables policy makers and sponsors to foresee the essential attributes governing the financial and legal aspects during the structuring of the SPV framework (United Nations, 2010). Since financiers deal with SPV, the credit risk associated with the borrower is not important. The identification, analysis and management of every risk associated with the project are important in the project financing (Daube, Vollrath and Wilhelm, 2008). Thus financiers are more interested in minimizing risks which could impact negatively on the financial performance of the project since sponsors risks are protected by SPV which is formed prior to seeking financing (Alexander, 2010). Such risks may include failure of the project to be completed on time, on budget or at all; inability of the project to operate at its full capacity; failure of the project to generate enough revenue that can service the debt and premature ending of the project. To minimize these risks, three steps are involved (Mantysaari, 2009). The first step involves identification and analysis of all risks that may impact on the project. The second step is the allocation of risks among parties involved. The final step is the creation of mechanism to manage the risks. In order to identify and analyze the risks involved in an infrastructure project, the project sponsors are involved in preparation of a feasibility study (Bolinger, Harper and Karcher, 2009). The financiers are involved in the careful review of the study and may hire an independent expert consultant to do supplementary analysis (Cheikhrouhou, and World Bank, 2007). Of particular focus is the proper assessment of the costs of the project and the accuracy of the expected cash flow streams from the project. Financial models are sometimes used to analyze some risks in order to determine the cash flow of the project and its ability to meet the schedules of repayment (Alexander, 2010). Economic variables are adjusted by examining different scenarios such as interest rates, inflation, exchange rates and prices for the inputs and output of the project. Risk allocation involves distribution of the identified and analyzed risks among parties via negotiation of the contractual framework (Mackenzie, 2010). The risk is often allocated to the party who is most appropriate to bear it and who has financial capability of bearing it. Uncontrollable risks are often allocated widely by financiers to ensure that all parties have an interest in addressing such risks. In cases of public and private partnership ventures, commercial risks are often allocated to the private sector while political risks are allocated to the state (Culp, 2001). Risk management step allow risks to be managed to ensure that the possibility of the risk event taking place is minimized and the consequences of such risk event are minimized in case the event takes place (Mantysaari, 2009). Financiers need to ensure that they are more informed and be ready to step in and take control of the project in cases where the risk involved is great (Daube, Vollrath and Wilhelm, 2008). The financiers have a responsibility of stepping in and taking over the project in case the borrower defaults since they take security over the entire project. To be able to do this, financiers ought to be involved in and monitor the project closely (Bolinger, Harper and Karcher, 2009). The financiers need to impose reporting obligations and controls over the project accounts in order to manage risks effectively. This measure may result in tension between the desired flexibility by the borrower and risk management mechanism required by the financier. Sustainability aspects Sustainability principles need to be applied throughout the lifecycle of a project from its inception to its final disposal. The sustainability principle ought to be balanced against each other so that outstanding performance in a single sector is not attained at the expense of others. There is need to have continuous improvements in the proposed solutions (Bolinger, Harper and Karcher, 2009). There is need for balancing of risks and liabilities, identification of benchmarks for long term success for all stakeholders and the creation of solutions that are sustainable for the environment, society and the resources utilized. Consideration about sustainability alters the process of decision making on major projects. Thus aspects such as the quality of technology employed, the degree of innovation used to secure enhanced whole life costs for the user and respect for the environment are used in comprehending the true value of an infrastructure project (Culp, 2001). Thus these aspects are nowadays articulated by the concept of sustainable development which comprises the maintenance of economic growth and employment, social equality protection and enhancement of the environment and prudent utilization of natural resources. To take into account sustainability concept and design, the procurement process, criteria of evaluation and selection, key performance indicators and contracts ought to be different. Adopting sustainable principles in infrastructure projects reduces risks, ensures protected and enhanced reputation, reduces costs and increases opportunities for generating revenue. Sustainability principles address economic, social and environmental aspects of sustainable development (Daube, Vollrath and Wilhelm, 2008). Economic aspects addressed include corporate viability, legal compliance, investment, risk assessment, initial project viability, ongoing project viability and marketing opportunities. Social aspects include health and safety, employees, community, equity and social opportunity and amenity (Tapiero, 2010). Environmental aspects include energy consumption, energy resources, water, waste, transport, pollution, habitat, materials, land use and noise and other nuisances. Thus for a project to be sustainable all these aspects need to be optimized. There are six major elements for sustainable development which include strategy, membership, integration, benchmarking, project development and feedback (Cheikhrouhou, and World Bank, 2007). Under strategy, the policies and procedures should be defined in such away that the route of accomplishing goals is agreed upon. The project objectives need to take into consideration the nature and characteristics of the client. Under membership, the partners should be able to identify companies whose skills and expertise are appropriate for certain project appointments and tasks (Daube, Vollrath and Wilhelm, 2008). For integration, the SPV ought to continuously identify objectives, costs and benefits and redefine its strategy to make improvements where required (Bolinger, Harper and Karcher, 2009). The SPV ought to carry out their tasks in such away that is acceptable to all stakeholders during benchmarking. Coordination is essential during project development to ensure that final objectives are attained in efficient way. The entire process ought to be analyzed and identification of any improvements made during feedback stage. Conclusion Infrastructure projects are often complex and involving many sponsors. To reduce risks of sponsors and financiers, sponsors usually form SPVs. The SPVs have proved to be successful in the financing and running of infrastructure projects. SPV is usually used for channeling funds from borrowers to lenders and carries out regulatory requirements of the funds. SPV acts as a legal buffer between the sponsor of the project and its backers. Reference Akintoye, A., and Beck, M. 2008. Policy, finance and management for public-private partnership. New York: John Wiley and Sons Alexander, A.J. 2010. Shifting title and risk: Islamic financing as a vehicle for global projects with Western Partners. 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Available at http://law.bepress.com/cgi/viewcontent.cgi?article=1231&context=unswwps Mantysaari, P. 2009. The law of corporate finance: general principles and EU law: cash flow, risk, agency, information. New York: Springer. Sarkar, A., and Singh J. 2010. Financing energy efficiency in developing countries—lessons learned and remaining challenges. Energy Policy, vol. 38, no. 10, pp. 5560-5571 Srivastava, V., and Kumar, A. 2010. Financing infrastructure project in India from corporate finance to project finance. International Research Journal of Finance and Economics, no. 2, available at http://www.eurojournals.com/irjfe_55_01.pdf Tapiero, C. 2010. Risk finance and asset pricing: value, measurements, and markets. New York: John Wiley and Sons. Tavakoli, J. 2003. Collateralized debt obligations and structured finance: new developments in cash and synthetic securitization. New York: John Wiley and Sons Tavakoli, J. 2008. 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