The Risk Allocation in Project Financing - Coursework Example

Risk allocation in project financing Introduction Project development and management is an essential element for modern economies meant to help accommodate changing social demographics and effectively sustaining the rapidly increasing capacities of populations. Project development entails establishment of commercial, industrial and residential facilities, communication and transport infrastructures and energy plants. Every project requires project financing. Project financing entails sustainable funding of industrial and infrastructural projects such as production plants, railways, bridges and bypasses founded on the anticipated cash flows of the actual venture than on the balance sheets of the project sponsors1. Project financing involves a funding structure that has varied equity investors referred to as the project sponsors and a consortium of financial institutions such as banks that offer loans to finance the project operations and project activities2. The loans offered by the financial institutions are non-recourse meaning they are secured by a promise of collateral but the project borrower is not legally responsible. When the project borrower fails to pay, the financial institution seizes the collateral3. If the collateral does not fully amount to outstanding balance, the variation between the value of the property and the value of loan becomes a loss to the financial lending institution/ bank. These types of project loans are limited to more than half the percentage of the value of loan ratios, in order for the property to generate more value than the collateral of the loan. Project financing helps in allocating and mitigating risks to the projects4. Involved parties of the project including sponsors, lenders and project owners are prone to risks and therefore, they establish risk allocation templates throughout the project financing structuring level in a bid to effectively, allocate risks among concerned project stakeholders5. This report will analyze project financing in a bid to answer the question on who is supposed to bear the project risks between the project sponsor, project contractor and the project lenders. Parties to a project As mentioned above, the equity investors of a project be it industrial of infrastructural projects are referred to as the project sponsors.6 The project lender is the bank or any other financial lending institution that offers loans to finance the project while the project contractor is the party that oversees the construction and management of the project, facilitating communication of the project progress to all concerned stakeholders and supplying essential resources such as labor, equipments and services to implement the project. The project contractor can hire specialized suppliers or subcontractors to carry out parts or a whole section of the construction. Additionally, the project contractor files for building permits, secures project property, supplies temporary utilities during construction work, facilitates safe and efficient waste disposal, supervises project schedules and project cash flows and keeps relevant and updated records. Benefits of public financing Project financing offers the project parties with beneficial opportunities that would otherwise would be unavailable in traditional financing methods. Public financing allows eradication of recourse by the project lender to the project sponsor, it sanctions an off the balance sheet serving of the project loans or debts and it helps in increasing the project’s leverage to attract more investors as highlighted by Buljevich & Park7. In addition, project financing helps the project sponsor to evade any limitations committing them under their relevant financial and surety commitments and it helps in gaining better financial conditions when the risk of credit of the project is superior to the credit standing of the project sponsors8. Project financing offers the project lenders with an opportunity to assess the project in a bid to gauge whether the project has the potential to generate sufficient project cash flows to help service the project loans or debts and at the same time, generate sufficient returns on equity at the lowest risk cost9. It is critical to indicate that through project finance, the project sponsors and the project are not only able to obtain favorable tax treatment, but also are able to ease political risks influencing the project. This occurs through involvement of the government as a project stakeholder. Forms of project financing Effective project financing helps to draw in fresh investments by structuring the funding on using the assets and operating cash flow of the project devoid of extra sureties from the project sponsors10. The two forms of project financing are limited recourse project financing and the non-recourse project financing. The limited recourse project financing entails that the banks/ financial institutions has several recourse to the project sponsor in terms of signing a pre-completion surety and pledge of any form of endorsement for the project11. This type of project financing is more widespread for projects in emerging markets and high-risk projects. The non-recourse project financing on the other hand as mentioned by Fight12, the lending financial institution does not have a recourse to the sponsor. The security for loan includes assets belonging to the project company and those being funded and operating cash flow created by the project firm. Project financing is beneficial in improving the accessibility to finance for the project and minimization of potential risks to manageable point for the project stakeholders. Risks and project financing In order to effectively and efficiently spread and allocate the project risks, the project stakeholders can prepare several forms of project accords that includes among others production sharing agreement, concession contracts, power purchase pacts and off-take agreements. Identifying potential risks to a project and effectively allocating the risks is crucial to creating project sustainability. For projects, that have more risks than others they do, attract limited recourse financing secured by an indemnity from the project sponsor13. High-risk projects may integrate corporate finance, insurance provisions, securitization and options among diverse collateral enhancement systems in a bid to alleviate the unallocated threats to the project. Types of risks To best know who is to borne the risk of the project, it is important to analyze what risks are there in order to establish who is best placed between the project sponsor, lender and project contractor to borne what risk and why.14 Among diverse number of potential risks to project include Financial/ credit risks Banks that lend to projects using limited recourse project financing need a guaranteed flow of cash for the loan term. Lenders need the project sponsor to project revenues be assigned and mitigated any risks to project revenues15. Financial risks are also risks linked with establishment and construction, operations and maintenance of the project assets and getting the right market for the project output16. Additionally, sufficient returns which the project sponsor needs to provide forms part of financial risks. For the lender to safeguard himself by guaranteeing constant project returns to service the loan, he can incorporate a clause requiring the project sponsor to offer the agreed finances into the project in order to steady cash flow and financial reserves and replenish the deficit brought by the pre-completion project proceeds17. Economic risks These includes risks connected to fluctuating interest rates on loans by the lender, volatility of the rates of inflation, currency risks, energy risks and policies on global price movements of materials and equipments as indicated by Finnerty18. Environmental risks Projects are prone to environmental risks that include rapidly changing climatic conditions and stringent environmental laws on waste disposal, resource allocation and use and non-election of projects in catchments areas19. Environmental risks may arise from damages caused to equipments and project layering rising from floods, tsunamis and earthquakes and eventual time wastage associated with the environmental disasters. Legal and regulatory risks A legal and regulatory risk arises in having inadequate unstable, unclear and unreliable laws and regulations on project development and management20. An amendment of laws and policies runs a law risk that the anticipated legislation of bill will not pass to be law either through lack of forum or through lack of lack of sufficient support by the policy makers or lawmakers. Regulatory risks occur when it is not possible to acquire consent and licenses to implement the project21. Political Risks This type of risk is subject to projects in politically unstable and volatile locations. These locations are prone to politically provoked violence which impacts on the project negatively either by the project stalling or destruction to project equipments and developments22. To mitigate political risks, project sponsors can involve a bilateral or multilateral to be among the project lenders and acquiring an insurance policy covering political risk from the involved multilateral or bilateral23. Contemporary multilaterals offer loans accompanied by an insurance policy covering political risk to subsidize pre-completion sureties. This is beneficial since the obligation of project sponsor under pre-completion surety ends before the project is completed when a political risk event happens24. Completion risk A project runs the risk of non-completion. The risks lie in the failure of the project to be completed in anticipated time, within the set budget and fail to complete fully owing to failures stemming from labor and technicalities25. This poses the risk of lacking sufficient cash flow to service the loan and may lead to accumulation of interests on loan and failure to acquire market for the project’s outputs and loss of supplier contacts to supply required materials and utilities26. Completion risks can be mitigated by expert’s analysis of the project inputs and outputs, entering into sustainable supply contracts to safeguard against shortages of utilities and materials and payment of minimum payments to the project by the sponsor27. To allocate and mitigate project risks, the stakeholders can decide to undertake pre-completion sponsorship, develop security sharing systems, involve one or more multilateral or bilateral lenders, take political risk insurance coverage and engage in intricate offshore and onshore security systems as suggested by Hoffman28. So far, the report has determined that all project stakeholders are engaged in looking for means to mitigate any potential risks that may occur during and after the project completion. Nevertheless, the project sponsor and the financial lending institution seems to carry the larger portion of risk financing compared to the project contractor and the government. The burden of risk management should however, be shared among all the project parties or among other stakeholders that may be involved.29 This ensures that risk is proportionally allocated among them and help in project sustainability. It is important to mention that, when the project sponsor shares the risk of the project, it gives them confidence and adequate resources to finance other numerous projects. Lack of this means, that one project may have so much risk that it may cost the project sponsor all the available resources and reserves such as finance and capital, making it hard for them to sponsor another project.30 After establishing the potential risks facing a project, which may vary across geographical location and depending on the type and size of the project31, the next step involves allocating the risk. The involved project parties can negotiate a contract or agreement to help guide risk allocation exercise. Project risks should be allocated the project stakeholder who is the most suitable to borne it. This means that the project party who is in the best position to manage, control and indemnify against the project risk is allocated the risk32. However, it is important to note that a project party may be in a position to manage, control, indemnify against a risk, and lack sufficient financial ability to do so. Therefore, risk should be borne by the project party that is able to not only manage, control and indemnify the risk, but also have the financial ability to do so. Even though the project lender holds the highest potential to bear a risk, the sponsor and the project contractor bears portion of the project risk. Especially for high cost risks and those that are not easily manageable, it is critical to spread the risks to all involved parties to ensure every stakeholder has the motivation and commitment to mitigating such project risks33. This is because, if such risks were borne by one party, the rest of the parties may not be as co-operative and interested in effectively managing the high costs and unmanageable risks. In most instances, financial, credit, completion and environmental risks are borne by the private sector comprising of the project sponsor, the lender and the contractor while political and economic risks are borne by the government. When bearing project risks, the risk bearer is required to manage the risk by preventing the risks from occurring and when it does occur, the damage is on the low side. This entails being informed and having ample control over the project34. For instance, if the risk bearer is the bank, it has the right to enforce reporting accountability on the borrowing party and take greater control and management of the major accounts of the project. The need for compelling all project parties to bear proportional risks is associated with the high tension between the flexibility required by the other parties and the risk management systems used by the risk bearer, which may hinder smooth progress and development of the project. According to Wood completion of one project is dependent on the completion of another and therefore, the project sponsor can help smooth completion of a project that depends on another by sustaining assurance on one project pending the completion of the others35. The author indicates that the purpose of the project sponsor is limit commitment to endorse the project company while the project sponsor who carries out the duties of a contractor, their purpose is to make feasible projects in order to earn additional return36. On the other hand, the purpose and aim of the lender is to ensure the project is creditworthy and it gets return on investments and ensure that majority of commercial risks are borne by another party and not itself37. The government’s intentions in projects are to attract and retain foreign funding and to safeguard national interests through effective use of available natural resources. In addition, create adequate infrastructures; have limited financial exposure to the project in order to limit bearing of financial risk38. Project contractors’ purpose is to negotiate basic protective commercial contracts with minimal or no obligation to endorse the bank funding39. By identifying the different objectives of the project parties is helpful in illustrating the need to spread the risk to all project parties since the objectives and goals of carried project parties are completely different. According to Wood, project contract has varied components in order for it to be considered valid and feasible, which includes bankability, matching, force majeure, absolute obligation, assignability, dispute resolution and governing law40. (Wood, 2007, p.36) indicates that it is not common for the project lenders to bear all the project risk or offer full funding for the project and that the project sponsor is compelled to take some portion of risks and financing of the project. The project sponsor can bear some of the risk and financing of the project either through equity or through subordinated equity41. In most instances, the project sponsor subscribes capital to the project company prior to a loan advance or upon project completion that has a long –stop date, which creates a credit threat to the sponsor. Alternatively, the lender can provide a loan, which is assured by the sponsor42. Default by the sponsor necessitates the lender to file for damages that are subject to terms and conditions pertinent to breach of a contract43. This risk can be, averted by using equity support as financial indemnification of the loan so long as the surety ends pro tanto as the equity endorsement is supplied. The subordinated debt occurs when the project sponsor gives capital as a subordinated debt. The project company bears the risk of increasing construction costs, which the company transfers to the project contractor in a fixed –price construction agreement as mentioned by Hoffman44. The project purchaser such as the government bears the political risk since it is in a better position that the project company to manage; control and indemnify political affairs. This is as highlighted by Wood who mentions that risk should be allocated to project parties with high risk tolerance45. However, the author warns that is it hard to quantify the degree of tolerance to risk a project party has. Regardless of the project party that bears the risk of the project, the project party can effectively manage risks by avoiding the potential risk, reducing the risk by minimizing the possibility of the undesired outcome and minimizing the consequence of the undesired outcome46. Additionally the risk bearer can transfer or deflect the risk by seeking policy cover from an insurance firm and procuring services of subcontractors or through risk retention47. In order to estimate the risk of the project, the project parties can look at the attributes of the project that are likely to supply high cash flow to help service the loan and at the same time generate sufficient returns on equity to the sponsor. Among project contracts that are able to produce adequate cash flow to service the loan and enough returns on equity as suggested by Finnerty48 includes take and pay project contracts as highlighted by Hoffman49, off take agreements, low cost producer contracts, contracts with high coverage ratios and project contracts with creditworthy project sponsors. From the discussion, it is apparent that the lender plays a significant role in ensuring the funding of the project occurs and remains sustainable. The security interests of the project lender in financing a project onshore and offshore securities. The offshore securities involves allocation of rights in the offshore project accounts of the project company, allotment of the rights of insurance by the project company, dispersing the rights of the project company under project contracts and charging the project’s company receivable accounts. Additionally, assignment of the rights of the project sponsor in terms of subordinated debt or preference stocks of the project firm and surety to the lender by the sponsor of their stocks in the project company50. The onshore securities on the other hand entails a surety of the assets belonging to the project company, guarantee of the rights in the onshore project accounts belonging to the project company and an assurance of the movable assets belonging to the project company. Based on various sources used in capturing information used in this report, the underlying fact is that all parties to a project are legally responsible to bearing not necessarily all the risks, but they are required and they should be compelled to borne a share of the risks.51 The project parties that are liable to shouldering the project risk include the project company, the project sponsor, the project contractor, the government, a multilateral or bilateral guarantor, an insurance firm, and the project lender. This is particularly important in cushioning all the project parties from massive losses if the risks identified and anticipated, actually occurs. When one project party is made to bear all the risks of the project, it becomes particularly hard for the other parties to operate freely since, as it stands the bearer of the greatest risk owns the project and therefore, they have the central control of the project. This creates a conflict of interest among the project parties. In addition, the party bearing all risks may withdraw their support since they may perceive the project as not being financially viable and feasible to invest in. this is detrimental to the project since it will take longer to complete the project or the project may remain undone52. Sharing in the risk makes business sense and is essential in making all the project parties accountable to all the activities, systems and processes they are involved in53. At the same time, the project parties become more committed, motivated and interested in ensuring the potential risk does not occur and if the risk does occur, they efficiently put measures into place to alleviate the negative consequences of the risk. It is essential that the project party that borne the risk has a high risk tolerance and has the capability to manage, control, identify the risk and have adequate financial capacity to help in effective mitigation and management of the risk. Currently, the project company, the project sponsor and the project lender carry the highest risks of a project. Conclusion Project financing is an important practice for modern economies in helping share and spread risks. Due to the varied number of risks available during project initiation, development, implementation, different project parties are compelled to share in bearing the risks. Among project risks borne include completion risks, economical risks, credit risks, regulatory risks, environmental risks and political risks among others. Among project parties that share in bearing the risks as stated in the report includes Project Company, project contractor, project sponsor, project lender, insurance firms and the government among others. This report has analyzed project finance in a bid to answer who should bear the risk of the project. The answer as indicated in the report is that all project parties are liable to sharing in the risks depending on their risk tolerance, financial ability and the ability of the project party to manage effectively, control and indemnify project risks. Conclusively, public financing allows eradication of recourse by the project lender to the project sponsor, it sanctions an off the balance sheet serving of the project loans or debts and it helps in increasing the project’s leverage to attract more investors. References Buljevich E & Park, Y Project financing and the international financial markets, Springer, Sidney, 1999. Cleland D & Ireland, L Project manager's handbook: applying best practices across global industries, McGraw-Hill Professional, New Jersey, 2007. Bapat C & Parekh, N Risk mitigation in project financing. Retrieved from http://www.projectsmonitor.com/detailnews.asp?newsid=16380, Accessed on 9th April 2011 Fight A Introduction to project finance, Butterworth-Heinemann, London, 2006. Finnerty, J Project financing: asset-based financial engineering, John Wiley and Sons, New York, 2007. Hoffman, S The law, and business of international project finance, Cambridge University Press, Cambridge, 2008. Nervitt P & Fabozzi, F Project financing, Euro Money Books, London, 2000. Wood, P Project finance, securitizations, subordinated debt, Volume 5, Sweet & Maxwell, London, 2007. Read More