Building A Budget
CONSIDERATIONS FOR CHOOSING PROJECT FINANCING AS YOUR NEXT FUNDING OPTION
When telecom provider Digicel needed financing to build out its services in markets such as Papua New Guinea and Haiti, it turned to project finance, provided by sources including the International Finance Corporation (IFC), a member of the World Bank Group. The IFC had a mandate to lend in these areas to promote business, says Brian Devine, group head of Investor Relations at Digicel, which is active in 32 markets in the Caribbean, Central America and Asia-Pacific.
“We’ve gone into some risky countries,” says Devine. “It is important to have the right partner.”
Thanks to such financing, Digicel, launched in Jamaica 13 years ago, recently embarked on a contract worth $7 million to improve access to telecommunications infrastructure and services in Papua New Guinea. Digicel will be installing 59 communications towers across the country, bringing voice services to about 500,000 people.
Digicel is not alone in finding that project finance can be an ideal form of financing for infrastructure and industrial projects in emerging markets where financing might otherwise be hard to obtain. In project finance, individual companies or partners in a joint venture will typically use loans, bonds, equity or a combination of these options. While the deals tend to be complicated and can require a lot of up-front legwork, entrepreneurs often like this type of financing because the loans are completely or mostly secured by collateral and borrowers aren’t personally liable.
“The financing is done specifically out of the cash flows of the project,” explains Devine. “Lenders will typically only have a claim on those assets in the project.”
That said, project finance is not always a readily available solution. After the East Asian financial crisis that started in mid-1997, many projects with this type of financing stalled, thanks to factors like weak and unenforceable contracts and lack of planning for currency risks, notes a recent World Bank report. Private lenders and investors lost much of their appetite to support projects at the time.
Project finance has rebounded considerably since then, but in recent months it has slowed in some parts of the world, with global project finance volumes for the first half of 2014 dipping to a five-year low, according to the data from the firm Dealogic reported in the International Business Times. Volume was down 30 percent compared to the same period in 2013. Only 416 projects were completed around the world in the first half of 2014, not far above the 363 projects completed in the first half of 2009, according to the reported findings.
Meanwhile, Thompson Reuters found that in the first quarter of 2014, $41.9 billion worth of project-finance deals closed globally, down 7.5 percent from the same period in 2013. However, deal flow in the Americas was healthy. For the first three months of 2014, there were $14.1 billion worth of transactions, up 75.2 percent from the first quarter of 2013.
Is your business a good candidate for using project finance? Consider these questions:
1. Are you planning a big project in an emerging market where you want to reduce risks?
For many types of overseas ventures, more traditional financing such as a bank loan are perfectly adequate. Project finance is often used when companies in joint ventures want to build a substantial sized facility and don’t want the project on their individual balance sheets. “Maybe a series of different companies want to develop an oil field, an airport or road,” says Duncan Caird, a managing director at HSBC and head of Project and Export Finance.
According to Caird, the various parties involved will often set up a special purpose vehicle to obtain project financing that works for all concerned. “You need to design the financing for who the stakeholders are and what they need,” Caird says.
2. Will you be able to execute the project on schedule?
Since project financing is based on the cash flow from a project, it’s best suited for projects that show a strong likelihood of producing revenue on an expected timetable. To secure project financing, entrepreneurs need to make a strong and realistic case their undertaking will come to fruition on time.
Because the loans in project finance are usually non-recourse loans—meaning the lenders can’t pursue you as an individual for the debt—lenders will carefully consider a project from every logistical angle before approving a deal. Global tax and advisory firm Ernst & Young (EY) found in a recent report that even among very well-funded “mega projects” in the oil and gas industry run by major companies, a high percentage fail to finish on time or on budget. A firm without deep pockets may be especially vulnerable.
“We make sure the project will get completed on time and to cost,” says Caird. “If it doesn’t there are mechanisms in place to manage that risk.”
Delays on a project can jeopardize your ability to stay current on repaying your lenders, so banks are likely to inquire about logistical scenarios that could cause delays. Construction is a key area where projects can go awry.
“You need to make sure you have the right people with the right plans doing the construction,” says Caird.
Lenders will also look at factors like whether you will have access to the raw materials you need and whether the existing infrastructure of the area where you will launch the project is developed enough to support it. “If you build an airport you need to have roads, cars and trains,” Caird says.
That you have planned for other potential scenarios that could derail you, whether that is an unusually cold winter that slows progress on a job or labor unrest, is also something lenders want to see.
“If it takes you longer to build because of the weather, strikes, or the insurance hasn’t come through, there could be a need for more capital,” explains Caird. Even if there is no serious disaster, something like slow-moving government approvals for specific aspects of a project may affect its cash flow.
3. What are the costs of the deal?
In project financing, the interest rates you pay aren’t the only cost of a deal. The contracts for project financing can get extremely complicated, requiring a substantial investment in up-front legal help. “You’ve got to define the project very clearly in economic and legal terms,” says Andy Brogan, Global Oil & Gas Transactions leader at Ernst & Young. “Getting all that done and documented tends to cost quite a bit of money.”
For that reason, project finance tends to be used for larger-scale projects where the payoff will offset that cost. To find out if it will be worthwhile for you to pursue it, Brogan recommends getting advice from a professional who specializes in debt raising in the market you plan to enter. “They can tell you pretty quickly if this project is of a size and nature where project financing will be an advisable proposition,” he says.
4. What are your financing options?
Finding a lender interested in doing project finance may require you to get creative. “Your typical bank is going to take a long look at Haiti and Papua New Guinea and probably pass, given the political and geographic risks,” says Digicel’s Devine. Digicel has worked successfully with the IFC since 2002, when the bank supported one of its projects in Jamaica. The bank typically serves as a lead investor. “It’s gone very well,” Devine says. “It’s been a very fruitful relationship.”
Digicel has found that the cost of project financing has been competitive with other financing options available in the countries where it does business. However, many factors can affect the cost of project financing so it is important to check out your options thoroughly. For instance, the term of your loan can add substantially to the overall cost of a project. “The longer the debt, the more expensive,” says Caird.
On some projects, the planners start out relying on traditional bank loans and move on to project financing later, to limit the duration of the project-finance loan.
“Sometimes people like to use bank loans first, so they can build the project before it reaches its operational and cash-flow stage and reduce the cost of the debt,” says Caird. Realizing a big dream in a developing economy often requires getting the smallest details right.
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