FIN 338 Topic 4: Financial structuring

Key concept: Optimal mix

'Optimum' is defined as being the 'best compromise between opposing tendencies'. In reference to debt and equity for project financing, 'optimal mix' must be viewed from the perspective of each participant, with each participant fitting within a financing structure. The key to finding the 'optimal mix' is the ability to work within the parameters of debt and equity and within a given time frame to ensure a deliverable financial structure. The three major areas that determine the optimal mix are equity, debt and time. Equity and debt are discussed further below. Time is a constraint that is normally beyond the control of the parties involved in the transaction (e.g. a competitive privatisation might be announced that allows a bidding period of only two months). In this situation, a different optimal mix would most likely result if the same process was undertaken under a non-competitive acquisition negotiated over a year. The objective with time is to ensure that the financing is deliverable within the given time and the skill is to optimise the financing in the best possible way within this constraint.

Term

'Term' in the Australian market can range from one to 25 years, depending upon the form of finance. Typical bank debt will range from one to 15 years (some debt issues have reached over 20 years) with the preference for the shorter terms. Capital markets products can reach longer terms, particularly with CPI-linked bonds, although the local market is limited. Longer term capital markets issues can also be accessed through the US markets (e.g. through the 144a market). The term of the debt depends on the risk appetite of equity and the belief among the banks that any short-term funding can be refinanced. For example, most regulated utilities businesses have financing terms of between one and five years with substantial bullet repayments. The reasons for utilising shorter terms include cheaper pricing, less amortisation, fewer restrictive covenants, and a larger capital base. Due to the nature and risk profile of the business, there is a high level of confidence by banks in the ability of regulated utilities to refinance, thus assuring both debt and equity parties that assumptions regarding debt maturity profiles are reasonable and do not place undue risk on the business. In contrast, there would be significantly less confidence in the ability of a merchant power plant project to refinance a major bullet repayment in the early years, due to the market risk and the shorter time frame. In these circumstances, a mixture of longer and shorter-term maturity instruments are typically used and flexibility built in to allow early repayment/refinancing if the project performs as, or better than, expected. Refinancing triggers such as achievement of debt service coverage ratios (DSCR) and loan life coverage ratios (LLCR) hurdles (see section 4.6) may be included in the documentation. Conversely, if the project is considered highly risky (e.g. a telecommunications project where technology may be obsolete in 10 years), or resource projects with limited reserves, the term is likely to be short (three to seven years). However, debt would typically be fully amortised from project cash flows rather than through a bullet repayment. Projects that can support extremely long maturities are usually associated with monopoly infrastructure, government offtakes (i.e. private finance initiative (PFI) or public private partnership (PPP) transactions) or non-competitive positions such as waste treatment plants and toll-roads. The term of these projects can be up to 20 or 40 years.

A creditworthy long-term consumer of the product or service

A creditworthy long-term consumer of the product or service to be produced by a resource or infrastructure project may be a source of de facto capital in a number of ways including: • entering into long-term take or pay contracts. Depending on the strength of the take or pay covenant (i.e. the nature of contractual conditions to which it is subject) and the creditworthiness of the offtakes, it may be possible to increase project gearing, either generally or specifically (i.e. by securitising the offtaker's covenant) • advancing a cash sum (either as a prepayment for offtake or as a security deposit securing the obligations under the take or pay contract). Contractors may provide support in the form of fixed-price construction contracts (i.e. construction contracts in which the cost is guaranteed not to exceed a nominated price) or fixed completion date contracts. Provided the fixed-price covenant is 'firm' (i.e. subject to minimal exceptions or none at all) and provided the contractor is sufficiently creditworthy, project lenders will regard the covenant as having a value which can lead to a higher level of senior debt gearing than would otherwise be the case. In addition, contractors have been known, on occasion, to re-invest as project equity, some or all of the profit margin in the construction contract. Investment in a project may be a strategic move by a project counterparty to vertically integrate its business, either 'upstream' or 'downstream'.

Derivative debt structures

A range of other debt products have been previously utilised in the financing of projects. These products have included: • commodity-linked finance — gold loans, etc. • interest rate derivative products — utilised to mitigate interest rate exposure rather than as a source of funding.

Example: Domestic capital market funding

A range of projects have utilised the Australian capital markets including the Lane Cove Tunnel, the Sydney Airport acquisition, the Brisbane Airport Rail Link and the Southern Cross Railway Station in Melbourne.

Debt ratios

A set of standard debt ratios is normally used to assess the robustness of the project and its ability to function under various downside operating scenarios. Debt ratios are explained in section 4.6. The choice of debt ratio is based on the structure of the transaction and the nature and extent of the risks associated with the financing. For example, the longer the term of the debt, the more ratios are typically required to monitor the historical and forecast performance of the project

Equity versus subordinated sponsor loans

A subordinated sponsor loan provided by project sponsors to a project vehicle sometimes offers significant advantages (in terms of NPV return and flexibility) over conventional equity. If a sponsor loan is to be used, it will typically be fully subordinated to both senior lenders and any external subordinated lenders, so that it is the equivalent of equity from the perspective of external lenders. Senior lenders generally treat a subordinated sponsor loan as equivalent to equity capital for the purposes of debt service cover ratios and net worth ratios. Typically, if subordinated sponsor loans are used, they are used on a stapled basis with conventional equity. For example, project sponsors may contribute one dollar of conventional equity for each four dollars of subordinated loan. Typically, the equity and loan would be 'stapled' so that one element could not be transferred without the other, except with the consent of all other project sponsors. The selection of the ratio between equity and loan will be determined with reference to the considerations noted below. Note in particular Australia's thin capitalisation rules (discussed in section 5) for Australian projects involving direct equity participation by a foreign sponsor (i.e. non-resident for Australian tax). Subordinated sponsor loans have the following advantages and disadvantages over conventional equity capital.

Tax efficiency of sponsor loans

As a broad proposition, sponsor loans are generally tax neutral in so far as interest on the loans is assessable for tax in the hands of the sponsor and deductible in the hands of the project vehicle. However, that general proposition does not always hold. For example, sponsor loans are inefficient in the case of an incorporated project vehicle which is expected to accrue large early phase tax losses from the project, because the interest expense will not be deducted for some time, whereas it may well be immediately assessable to the sponsors. In this situation, if sponsor loans are still preferred for commercial reasons (e.g. to facilitate cash flow repatriation outside dividend restrictions), then one option may be to utilise interest-free loans (to avoid the tax inefficiency) and to repatriate surplus project cash to sponsors by way of loan principal repayments. Sponsor loans can also provide tax efficiency in some cases involving incorporated project vehicles.

Sponsor loans — consideration for foreign shareholders

As noted earlier, foreign sponsors face two particular issues in relation to sponsor loans: • Interest withholding tax of 10% will generally apply to all payments or capitalisation of interest in favour of a non-resident sponsor. If the non-resident sponsor receives the interest through an Australian permanent establishment (e.g. an Australian resident subsidiary or branch office), the interest will be subject to the full Australian corporate tax at 30%. The 10% withholding tax is generally creditable against the foreign sponsor's income tax liability in its home jurisdiction under relevant foreign tax credit provisions in that home jurisdiction (e.g. a US sponsor pays 10% Australian interest withholding tax, but then credits this payment against its 35% US tax liability, reducing the cash US tax to 25%). • Thin capitalisation. If relevant thin capitalisation ratios are exceeded in respect of sponsor debt, the project entity will have its interest-related tax deductions reduced.

Multilateral agencies - debt

As part of the package of support for projects in emerging markets, particularly in Asia, multilateral agencies may provide co-financing for the project, as a backup for the private sector debt. This support is provided in a number of ways including low interest loans, guarantees and political risk insurance.

Equity market investors — listed equity

As with institutions, investors in listed equities are passive investors motivated by the expected return on their investment in the form of dividends and capital growth. Equity raised on the market for project financing can be of a direct or indirect nature. Direct equity investment in projects tends to be yield driven, generating a stable and relatively certain utility-style cash flow. The risks to the equity investment are relatively low, with limited upside potential, and are measured against fixed interest-style investment alternatives. Thus, the kinds of projects for which this type of equity can be raised tend to be utility and infrastructure projects backed by long-term offtake contracts or concessions. This equity funding is raised by an on-market initial public offering (IPO) of the equity in the project vehicle. Indirect equity investment to fund project development is raised by the sponsor selling equity in itself to fund its share of the project equity contribution. If the sponsor's available financial resources are insufficient to meet its equity requirement, it can raise funds by selling equity in itself, via a placement of shares or rights issue. In this way, equity investors are subscribing for equity to fund the sponsor's contribution in the project.

Balancing debt and equity — finding the optimal mix

Balancing debt and equity — finding the optimal mix The words 'optimal' or 'optimise' are typically struck out of mandate agreements based on legal advice. By definition, a structure can never really be optimised as this is the equivalent of reaching infinity. Finding the 'optimal mix' is providing the best result obtainable within the constraints of the transaction.

Bank debt

Bank debt is a traditional senior ranking form of debt instrument, provided by both domestic and offshore banks. The key characteristics of the debt will depend on the nature of the development or acquisition. Most greenfield project developments require a level of construction finance that is usually fully capitalising, with equity and long-term debt takeouts at completion. The term debt will involve a level of principal amortisation over time as the asset matures. Acquisition assets that have been recently financed using project finance bank debt have had a range of terms from one year to nearly 15 years. At the short end of these terms, many of the facilities have been interest-only, with the banks and project companies assuming a level of refinancing risk at the maturity dates of these facilities. Banks can also provide other related products to projects that are not typically available from the capital markets. These include working capital facilities to cover short-term movements in the net debtor/creditor position, capital expenditure facilities to cover project expansions and letters of credit to provide an appropriate level of support where it is required. Bank debt is utilised in the majority of project financed products. Consider the following: • projects of a smaller size (less than AUD200 million) do not generally allow the capital markets to be accessed due to the costs involved • bank debt generally provides a cheaper solution from a fee and margin perspective • bank debt can be fully underwritten and arranged in a short time and provides a high level of certainty

Domestic capital market instruments

Capital markets instruments can be arranged by many of the large domestic and offshore banks and investment banks that have a presence in the project finance market. The product is generally able to provide a greater level of flexibility to project companies on amortisation combined with a longer term. In this regard, both interest-only and amortising products have been utilised previously in addition to products that involve CPI-linked or capitalising components. Both rated and unrated products are available. Rated products need a rating agency such as Standard & Poor's or Moody's to provide a rating on the debt that is then utilised to market the product to institutions. The agency usually regularly updates the rating. Many of the capital market issues that have been utilised in Australia have not been rated, as the holding institutions have been able to undertake their own credit analysis on the product. While these issues have been successfully placed, the market for this unrated product is limited. In providing a rating on a capital markets product, the rating agencies undertake a typical credit analysis such that the key project risks — offtake risk, construction risk, operating parameters and economic parameters — affect the ratings level. The capital market products that have been issued on green field projects are usually supported by bank instruments such as letters of credit that mitigate construction risk. Another issue that often complicates the utilisation of the Australian capital markets is the interaction of bank debt products and the inter-creditor provisions in the security structure that needs to be negotiated in this regard.

Cash yield

Cash yields are similar to EPS but are based on the cash returned from the project as opposed to accounting profits. Cash yield is simply a running yield analysis of the cash available to the sponsor over an annual period, divided by the equity invested. Project financings typically will generate more cash than accounting profits, mainly because of the effects of accelerated depreciation and the resulting tax profile of the project. Most institutional investors or fund managers focus on cash yield, as cash yields are one of the key measurements for industry performance. Fund managers are often rewarded according to the cash yield of their portfolio, and therefore there is incentive to maximise this variable.

Potential for deferred consolidation/equity accounting

Certain public company sponsors find infrastructure projects unattractive from an accounting and earnings per share (EPS) perspective if they are required to consolidate or equity account the project. This is because the project may initially show accounting losses, as a result of either low initial cash flows (e.g. projects with lengthy construction phases) or early year accounting amortisation of assets or goodwill. If the public company sponsor is a joint sponsor with other investors who are less sensitive about accounting presentation (e.g. certain institutional investors), then it may be possible to structure the arrangement so that the EPS-constrained public company holds a reduced equity stake, but with a higher level of subordinated debt, part of which could be convertible into equity at a time when EPS constraints have passed. If such an approach were adopted, then regard would need to be paid to certain tax issues including: • Restrictions on deductibility of convertible note interest: See s 82SA of the Income Tax Assessment Act 1936. Broadly speaking, convertible note interest expense is deductible to a borrower only if the convertible note complies with all the restrictions specified in that section. • Deductibility of interest on equity-linked debt instruments. Broadly speaking, interest on debt may not be deductible if it is linked to the after-tax profits of a project. This is sometimes referred to as the Boulder Perseverance principle (so called after a High Court decision of that name — see DCT (WA) v Boulder Perseverance (1937) 58 CLR 223).

Key concept: Consolidation

Consolidation (i.e. line-by-line consolidation of a subsidiary's accounting results) is required when a sponsor controls more than 50% of the voting and economic power of a project company. Consolidation means, for example, that debt of the subsidiary is shown as debt of the group (which includes the parent and its subsidiaries). In projects with slow revenue start-ups, consolidation can have substantial negative impact on EPS, debt/equity ratios and interest cover of group entities.

Controlling equity participants

Controlling equity participants are sponsors who either wholly own the project or command a controlling interest in the project.

Debt to EBITDA

Debt to EBITDA is more commonly utilised for established operations over greenfield transactions. Debt to EBITDA is measured by dividing total senior debt by the cash available to meet debt service on an accounting basis. Debt to EBITDA is used as a quasi-gearing test which measures the ongoing cash which is available to meet debt service. Debt to EBITDA is utilised when the balance sheet is distorted by intangibles or other accounting treatments that may not accurately reflect the operations of the project (e.g. the use of shareholder loans as equity rather than ordinary equity, resulting in a decreased balance sheet gearing over time as these loans are repaid). Debt to EBITDA can range from 14 times to 8 times and would normally decline over time, as would other gearing ratios.

Discretionary capital expenditure

Discretionary capital expenditure is the funding of capital expenditure outside the requirements for operating the project on the agreed business plan. This could include expansions, upgrades, efficiency gains or even new business areas.

Distributions to equity

Distributions to equity is the remaining cash flow that is available, either in the form of dividends, interest to shareholders, principal on shareholder loans or the repayment of capital

Institutions

Domestic institutions, such as the large superannuation funds and life insurers, can be sources of equity for projects. Rather than taking an indirect interest in the project by purchasing equity in the project sponsor, some institutions take a direct equity stake in the project itself. In recent years, as members of consortia bidding for privatised assets, institutions have been active providers of equity and subordinated debt in funding these acquisitions. However, domestic institutions such as Australian super funds have been relatively small investors in Australian infrastructure projects compared to the more traditional banking and finance sector. Typically, domestic institutions do not have the same risk appetite as other equity investors and they tend to invest in projects which generate a stable and relatively certain cash flow. These projects tend to be utility and infrastructure projects backed by a monopoly position in their respective market, long-term offtake contracts or concessions. Institutions investing directly in projects are not involved in the active management of the project or have other commercial relationships with it. The interest of these parties in making such investments is the equity return that is expected to be generated for their funds invested, given their assessment of the level of risk.

Earnings per share (EPS)

EPS is frequently utilised by publicly listed sponsors as a key investment criterion. It is one of the variables that stock market research analysts pay particular attention to in providing their research to the market, and is essentially the accounting earnings (profits) before abnormal items, divided by the outstanding shares on issue. Most publicly listed sponsors require that investments are positive to the EPS, thus increasing EPS and theoretically increasing the share price. This is typically a major concern for the board of directors or the executive committee as their performance-based remuneration component is frequently based on short-term share price appreciation. Occasionally, EPS may be allowed to be dilutive for one or two years, as long as on a medium to long-term basis the investment will be positive. More frequently, however, the accounting statements are structured to show at least some positive EPS in the early years. The EPS issue can have a serious impact on potential projects whose sponsor's share price is performing strongly. It can make new projects difficult as most project financings (particularly greenfield projects that value in a ramp-up of revenues) start with a low level of profit that must be built on over the life of the project. Significantly complex transaction structures have been implemented to try to deal with this issue.

EPS reduction if project equity is funded by a new issue of ordinary shares by sponsor

Even if a project's earnings are positive from the first day of the project, diluted EPS may be lower if new share capital is issued to fund project equity, but the project equity has lower earnings than the sponsor's other investments

Financial covenants

Financial covenants are used as a check or balance mechanism by the banks to ensure that if the performance of the business is sufficiently below the forecast level, a chain of events is set in motion which protects lenders and reduces the level of cash being taken out of the project by the sponsors. In addition, financial covenants are used to restrict the project from undertaking additional transactions that might have a material negative impact on it. Financial covenants typically include: • restricting core asset sales • limiting additional indebtedness • minimum interest/debt cover ratios • maximum gearing/minimum net assets tests. Financial covenants, if breached, usually lead to a cash lockup where no surplus funds are able to be released to the sponsors, or an event of default that will allow the banks to step into the transaction and take control. While the ultimate result of an event of default is for control of the project to pass to the lenders (a step which has very wide-ranging ramifications), those measures are more frequently used as a mechanism to ensure that all parties (including the lenders who, at that point, are in a position of bargaining strength) are brought to the table to negotiate a solution. As a result, financial covenants are only set at times when the business is unlikely to recover in the short to medium term without some form of restructuring.

Pre-completion development

For financing to be raised to fund project development, the investors need to be convinced of the project's feasibility. The project development cost is calculated from capital and operating costs estimated in the feasibility study and the financing costs estimated from the financing structure to be implemented. As part of the project financing, the sponsor will provide all, or a substantial proportion, of the necessary equity funding required to complete the project. As the financial backer of the project, the sponsor may provide a guarantee of the project finance loan prior to completion. In this way, the lenders have recourse to the sponsor for the repayment of the loan before completion, from which point the recourse of the lenders will be limited to the project itself. Alternatively, the sponsor's financial backing may take the form of a commitment to provide the funds necessary for the project to achieve completion. This commitment may be unlimited or it may be capped to a maximum amount. Depending on the financial substance of the sponsor and the ability of the lenders to accept the credit risk of this completion commitment, it may be necessary to commit funds in advance as collateral for the sponsor's liability, to be returned to the sponsor on completion if unutilised. Thus, the sponsor is effectively over-collateralising the project, and providing a more conservative gearing profile.

Gearing

Gearing is normally utilised to maximise the ROE and is the most common debt parameter to manipulate. Maximum gearing levels are a function of variables yet to be discussed, including amortisation and debt payback period. The maximum gearing is the highest level of debt that can be supported comfortably by the project within the set risk parameters and amortisation profile. Therefore, a PPP/PFI transaction, which involves a government offtake contract, is often geared up to 90%, whereas a commodity risk project with a short asset life and less certain cash flows in the long term is geared at approximately 50%. Essentially, this is because the risk associated with the cash flows received from a government offtake contract is usually quite low and the asset life of such projects is typically high. A commodity risk project on the other hand, normally has a short asset life cycle, uncertain cash flows and high amortisation.

Hybrid debt

Hybrid debt is a form of debt product that ranks behind senior debt with respect to security and cash flow priority. This debt may be provided either by third parties or the sponsors, and can have a variety of characteristics depending on the project. Due to the risk profile that ensures that the hybrid debt providers rank ahead of equity but behind senior debt, this type of product often allows a project to be more highly geared, increasing value to sponsor equity returns

Franking lock-up

If a corporate structure is the preferred vehicle for owning a project, 'franking lock-up' may emerge as a problem for the sponsors. This problem arises most typically in privatisations, where the amortisation of substantial goodwill payments results in accounting income (and hence dividend paying capacity) being substantially less than taxable income. If this occurs, the project entity will have franking credits which it cannot readily distribute to sponsors because it will not be legally able to declare a dividend to fully pay out the franking. Sponsor-subordinated debt will help solve that problem, because it is a means of reducing taxable income in the incorporated project vehicle and transferring pre-tax taxable income in the form of loan interest to the project sponsor.

Subordinated sponsor loansCash flow repatriation from corporate entities

If sponsor equity is provided in the form of conventional share capital to a project corporation, then the corporation is constrained in its ability to pay project cash flows to the sponsors (shareholders). Dividends can only be paid from a corporation's accounting profits (s 254T of Corporations Act 2001). In highly capital-intensive projects, or infrastructure projects involving the acquisition of government business with substantial payments for goodwill, it is likely that accounting amortisation of the capital assets or goodwill will result in accounting profits (and hence dividend-paying capacity) being substantially lower than after-debt service cash flow. Conversely, if sponsor equity is replaced substantially by subordinate debt shareholder loans, interest and principal payments can be made regardless of accounting profits. Similarly, sponsor subordinated loans are more flexible when it comes to repatriating equity capital to sponsors. Whereas a return of conventional equity capital requires a formal reduction of capital or share buyback, there are no formal requirements for the repayment of loan principal for a subordinated sponsor loan.

Equity participation in an unincorporated joint venture with accounting losses

If the project is conducted in an unincorporated form, sponsors will individually account for their share of the project profit or loss. As is the case with incorporated ventures, it may be possible to restructure the joint venture assets or activities so that loss-making assets or activities are held in an appropriately structured off-balance sheet vehicle.

Initial capital costs and construction delays

If there is a fixed price/fixed time contract there may be little risk of initial capital cost movements. However, these contracts are typically still subject to variations and force majeure that might impact on value. Therefore, sensitivities are normally performed on the results of price escalations, cost overruns, minor variations and delays, taking into account the liquidated damages regime in the construction contract. This is critical for projects which have a fixed concession term from financial close, as delays will impact the total return, while liquidated damages are usually limited and capped.

Overview of project finance

In a typical project finance structure, the sponsor, who is the project owner, provides the necessary equity funding, with lenders providing the project finance debt. As collateral for the loan, the lenders have recourse to the sponsor until the project is constructed, at which point lenders have recourse to only the project and its assets. The equity provided by the sponsor is fully subordinated to the project finance debt, in ranking and cash flow distributions.

Liquidity

In some projects, conventional equity may be extremely illiquid for a number of years. Generally speaking, however, most debt securities (even deeply subordinated debt) can be priced and sold into debt markets. Hence, in some projects, the use of subordinated sponsor loans as an additional, less risky layer of project equity, can offer project sponsors the prospect of being able to liquify part of their investment at a future time without diluting equity control.

Inflation

Inflation normally plays a major part in both the revenue as well as the operating expense results. Therefore, the variation in outcomes due to inflation is normally considered as a standard sensitivity. Inflation should be measured from both sides of the revenue and expense equation to ensure an accurate result. In most cases, a different level of inflation can be tested on both the revenue and operating expense to 'drive a wedge' between the revenue and expense growth profile. This is especially important in infrastructure projects where the government concession contains a limit on allowable price increases.

Equity accounting a project with accounting losses

It is possible to avoid consolidation by reducing a sponsor's equity interest to below 50%, but the sponsor may still be required to equity account its interest. Key concept: Equity accounting Equity accounting (unlike line-by-line consolidation) requires only a one-line entry in the profit and loss statement. Equity accounting is typically required for entities which are owned 50% or less, where there is a significant capacity to influence or control the activities of the entity (typically where ownership exceeds 20%). Debt of entities which are not controlled (usually where ownership is less than 50%) is not required to be disclosed on the investor company's balance sheet, although the investor company will be required to equity account the relevant share of the investee entity's profit or loss for the year. In certain cases, the sponsor may also be required to footnote certain details concerning the project, including percentage project ownership, total project assets and liabilities and net project income or loss. Where equity accounting of a project entity with an accounting loss results in an unacceptable earnings dilution profile for the sponsor, one approach is to create an off-balance sheet company (not equity accounted or consolidated with any of the sponsors) in which certain of the loss-making assets or activities are held. In order for that result to be achieved, there needs to be 'substance' to the off-balance sheet nature of the vehicle, i.e. that the use of the vehicle reflects a genuine allocation away from the sponsors of risk and reward associated with the assets held or activities conducted in the off-balance sheet vehicle.

Earnings dilution

Listed corporations are generally concerned to ensure, so far as possible, that their earnings per share (EPS) are not diminished by an equity investment in a project. Earnings dilution can occur in one or more of the ways outlined below. Consolidation of a project subsidiary with accounting losses As discussed above, some projects are unattractive if the sponsor is required to consolidate the project in its accounts.

Multilateral agencies

Multilateral agencies, including export credit agencies and regional supranational institutions, can be providers of both debt and equity funding to projects. These agencies typically provide funding packages, which complement private sector finance packages. This co-financing helps to procure private sector finance in emerging market countries where raising funds is difficult. The funding packages provided by these agencies tend to include the following: • political risk insurance policies — covering the private sector financiers for the risk of appropriation of assets, restrictions on repatriating assets and profits and civil war • subordinated loans — debt funding for projects, ranking behind the private sector debt raised • equity — providing a portion of the equity funding for the project and the ability to capture a portion of the potential upside returns. Thus, as part of a funding package, multilateral agencies may contribute a portion of the project's equity funding.

Non-controlling equity participants

Non-controlling equity participants are minority equity participants who are either active in the project or merely passive investors. They include the following: • minority joint venturers • equity market investors • institutions • specialist funds • multilateral agencies • project counterparties.

Non-discretionary capital expenditure

Non-discretionary capital expenditure is the funding (from cash flow) of the ongoing maintenance required to keep the asset at its 'normal' level of operations (i.e. maintenance that does not enhance operations, but merely maintains the expected operating level). The difference between non-discretionary capital expenditure and operating expenses is that non-discretionary capital expenditure is written off as capital expenditure over a period longer than one year according to standard accounting principles. Examples are the complete overhaul of a gas-fired turbine every four years or the replacement of belts on a coal conveyor every three year. These items must be maintained to protect the revenue-earning ability and value of the asset.

Topic learning outcomes

On completing this topic, students should be able to: • describe the structure of project financing using appropriate combinations of debt and equity • discuss how different market conditions affect the appropriateness of debt and equity as sources of finance • discuss the issues involved in the preparation of a finance plan • describe the major taxation issues relating to project financing and infrastructure investment.

Defining debt parameters

Once the equity objectives and the variables by which these will be measured have been established, one can start to analyse how the debt package can best be structured to meet these objectives. The debt package should always be driven by the equity objectives and not be allowed to take control of the finance plan. Even though most financings rely on the majority of funding to come from debt, it is the achievement of the equity objectives that ensure that the project proceeds to development. The debt parameters below provide an outline of the major issues that are normally addressed in seeking to 'optimise' the debt within the equity objectives.

Optimising equity outcomes through manipulation of debt parameters

Once the equity objectives have been agreed and general market parameters for the debt established, the process of optimisation can begin. Typically for equity, the ROE and EPS measurements are the key tools of analysis. It is necessary to ensure that debt parameters are deliverable (i.e. bankable) for that transaction based on the criteria of ROE and EPS. As the exact criteria for what determines the bankability of a transaction change consistently over time, it is difficult to give a summary of what they are. Determining the bankability of the transaction parameters is usually done by practitioners who are active in the market and, to a certain extent, it represents an 'art' rather than a precise science. To maximise ROE, the aim is, among other things, to maximise gearing, minimise debt pricing, limit amortisation and minimise tax. To accomplish this, a significant number of financial solutions are at the disposal of the practitioners through modelling and other structuring tools. Based on the detailed analysis of a number of alternative debt and equity sources and structures, the outcomes which best meet the objectives of the sponsors (and can therefore be considered 'optimal') can be summarised and presented. The final structure will form the basis of the finance plan which will then be implemented. It is vital that even after it has been agreed, any finance plan is allowed to continue to develop and be redefined and optimised as due diligence and changing debt and equity requirements raise new issues. Frequently, this continues to be the case until financial close is reached.

Operating costs

Operating costs sensitivities include: • Labour — typically the largest input and one of the most variable due to the change in working conditions in Australia and close links to the CPI. • Production rates — especially in resource projects. • Production inputs — there are typically a number of major inputs that, either through pricing or access to supply, have a substantial impact on the project. Production inputs may include electricity, water, gas and materials.

Operating expenses

Operating expenses are the number one priority in the cash flow waterfall to ensure that the project can continue to earn revenue that in turn protects the value for the financier's asset. Operating expenses include all costs required to operate the project that can be expensed in that year using standard accounting principles. This may include operating margins to third party suppliers as the involvement of such parties is essential for the operation of the project, as well as revenue, royalties payable to governments, technology and licence providers or production.

Other blocked accounts controlled by the agent

Other blocked accounts controlled by the agent but not included in the cash flow waterfall may include: • Insurance account — the insurance account is a blocked account in which the agent acts as the signatory. Any insurance proceeds are paid into the insurance account and distributed by the agent in the appropriate manner according to the finance documents. • Compensation account — the compensation account is also a blocked account in which the agent acts as the signatory. Any compensation proceeds from the contractor or operator in the form of financial damages (usually liquidated damages) are paid into the compensation account and distributed by the agent in the appropriate manner according to the finance documents

Other costs associated with financing

Other costs associated with financing include agency fees, independent consultants, syndication costs, swap costs etc.

Asset financiers

Part of the financing package for a project may be finance raised specifically for particular assets of the project that are to be developed. Various specialist asset financiers provide a particular asset in the project, e.g. a power plant, on a 'build own operate' (BOO) basis, and then charge an ongoing fee for providing the asset, as long as the project operates. This fee payable to the contractor providing the asset includes both the cost of developing and financing that asset and the operating cost. Economically, this is similar to a secured asset financing which has been carved out of the general project financing facility for the project.

Project counterparties

Parties who have commercial relationships with a project, either as supplier to the project or purchaser of product from the project, also often have minority equity participation in that project. As part owners, these parties contribute their proportions of the equity funding required for the project development. The key commercial interest of these parties in providing this equity may not necessarily be to generate a return on this investment. The investment parameters of these parties are focused on the returns available from the overall commercial relationship. As a substantial supplier of raw material or services to the project, or as a purchaser of project output, these counterparties are stakeholders in the project and have a commercial interest in its success. Being a part owner of and equity provider to the project can often be a precondition for that party to gain its contract with the project, and a demonstration of its commitment to the project. Alternatively, in order to protect its commercial interests in the project, the counterparties may seek to be part owners and equity providers. A supplier of a product to a proposed resource or infrastructure project may also be prepared to support a project by guaranteeing part of the debt associated with the facilities that will consume the raw materials, or by agreeing to a fixed supply contract.

Payback period

Payback period analysis is used to ensure that debt can be repaid within the economic life of the asset. The payback period analysis is normally undertaken on a downside case to test whether the debt could be repaid within a reasonable time if the asset is not performing at forecast levels. The overall debt payback period should be consistent with the economic life of the asset and provide a sufficient level of comfort to financiers that on a downside case, their debt is able to be redeemed before the asset effectively becomes obsolete (in economic terms) or ceases operation (in resource projects). Depending on the asset and industry, this may be between 20% and 30% short of the economic life of the asset.

Private equity investors — unlisted

Private equity investors typically include corporations, development funds and other institutions which invest in projects as part of a wider development strategy. These investors may include corporations which wish to gain an exposure to a given asset class or enhance their portfolio yield through a particular investment. Infrastructure investment may also provide the benefit of portfolio diversification to corporations which have previously invested in the property sector. Many of the large listed infrastructure companies started as unlisted private investors. Usually a reasonable level of funds under management needs to be achieved before a listing can be contemplated.

Process risk

Process risk may or may not rest with the project, depending on the construction and/or operating contract (e.g. frequently the contractor is required to pay liquidated damages if a project does not perform to a certain agreed technical specification). However, if the process risk rests with the project, then the realistic boundaries of those risks should be sensitivity-tested based on input from an independent expert. Process risks can include such things as product recoveries in minerals projects, heat rates for power stations, filtration levels for water plants, throughput volumes for gas pipelines and capacity levels for fibre optic cables.

Interest expense on debt used to fund an investment in an incorporated or unincorporated project entity

Project debt is most often provided to the project entity, and the earnings dilution effects of interest on that debt can sometimes be dealt with by using off-balance sheet borrowing vehicles. However, where a sponsor borrows to fund its equity investment, there is considerably less scope to ameliorate the earnings dilution effects of that interest expense. It was previously possible to raise debt finance through a captive finance company which was deconsolidated for accounting purposes. However, accounting rules now generally require consolidation of such entities.

Construction

Projects with high construction costs typically use fixed time/fixed price contracts to minimise the risk of construction overruns and delays to sponsors and financiers. In these types of contracts, the construction drawdown schedule is fixed at financial close to match the payments required to be made to the contractor under the construction contract, which allows for a high level of certainty about the drawdown program. As the drawdown schedule for construction is fixed, the associated interest rate hedging can also be fixed and incorporated with a high level of certainty. Once construction commences, funds are drawn down from the financiers according to the fixed drawdown schedule and deposited into a construction escrow account. The construction escrow account is under the control of the agent. Once the agent receives a drawdown request from the borrower and certification by the independent engineer that the work corresponding to a particular payment of funds has been done as required, the drawn down funds are released from the construction escrow account into the proceeds account. Once the cash is in the proceeds account, the funds can be forwarded to the contractor by the borrower. If the contractor falls behind schedule or the work done has not been certified by the independent engineer then the funds associated with this work remain in the construction escrow account under the control of the agent. Eventually when the work is certified, the funds will be released into the proceeds account. If the work is never certified, then the funds may be used in settlement of damages as they are still in the control of the agent. In these circumstances, should the contractor perform ahead of schedule, the funds are not usually provided early, due to the fixed nature of the drawdown schedule. In certain circumstances, the bank group may agree to an amendment to the drawdown schedule, but this situation is rare. In other projects where fixed term and price construction contracts are not used, funds are drawn down and released to the borrower to pay the contractor upon confirmation by the independent engineer that the payments are valid and reflect the amount of progress achieved.

Reserve account payments

Reserve accounts are used to ensure that special allocations of cash are maintained in reserve and applied as agreed under the finance documentation. Reserve accounts may include the following: • Debt reserve account — this account retains sufficient cash to service interest or total debt service for the next one or two service periods. If the project falls into financial difficulties and is unable to service debt from current cash flow, this reserve allows the project to continue making debt payments for a period, providing sponsors additional time to improve the company's operations, and additional time for the financiers to refinance the debt (as required). • Maintenance reserve account — if scheduled non-discretionary capital and/or maintenance expenditure is significant, annual cash payments may be set aside earlier to fund future non-discretionary capital and/or maintenance expenditure. • Tax reserve account — if future projected tax payments may jeopardise the robustness of the project then cash may be set aside in a tax reserve account. This may be particularly useful in the years when a project goes from being a non-taxpayer to being a taxpayer. Due to the timing of tax payments, the cash flows can be distorted. • Ramp-up reserve account — this account allows the project to make payments for a specified amount of time to the lenders to meet debt obligations during the ramp-up period of a project when the demand profile is most uncertain. Toll roads and rail projects commonly utilise ramp-up reserves. Once the project reaches certain agreed parameters and the debt service reserve account is fully funded, the unused balance of the account may be distributed to equity.

Revenue

Revenue sensitivities include: • Seasonality — most projects operate in a seasonal mode (i.e. power, commodities, transport etc.). Typically, semi-annual cash flows are utilised to mitigate this risk but the result needs to be verified so as not to jeopardise the project. • Growth — a range of growth possibilities should be analysed both from a historical perspective and based on forecasts from an independent expert. • Regulatory — the effect of forecast regulatory or potential legal changes impacting on the industry as a whole. • Competition — the historic and independently forecast reaction of the market to the project, both in terms of price, output, terms etc. • One-off events — include project shutdown due to unforeseen events (i.e. weather, strikes, political unrest etc.) or any other one-off event that may occur. • Price — for commodity-based projects, a range of prices reflecting the historical variability in market prices of the products.

Sensitivity analysis

Sensitivity analysis is used to test the robustness of a project and to indicate a suitable level of debt financing and equity returns, given the risks of the project. Sensitivity analysis should be used at three levels. Level one is a likely outcome in, for example, a movement in operating costs of ±5%, or materials by say ±2.5%. These would be considered normal and the project should be able to operate satisfactorily under a given debt structure without breaking financial covenants or agreed ratio levels. Level two is the extreme downside scenario in which the ratios and covenants are breached but the project is still able to repay debt, though maybe over a slightly longer period. Level three is the disaster scenario in which debt cannot be repaid. If level three is a realistic outcome that cannot be insured or mitigated against then the project is either too highly geared or the risks are not allocated properly.

Soft costs

Soft costs are initial costs that are not paid for in cash upfront but are funded as debt to the project by the provider of the service such as contractors, technology providers, service providers (e.g. power, gas, water) and advisors. The provider of the service will usually apply a premium to the normal cash fee. The benefits of soft costs are that they do not necessarily result in a diminution of equity in the hands of the existing shareholders.

Risk sensitivity

Sponsor representatives from the various divisions will nominate key risk areas that must be addressed in the financing plan (e.g. operating, regulation, market). These areas of risk and boundaries of acceptability should be defined at the beginning of the finance process to ensure that any financing addresses the relevant issues.

Group tax rate

Sponsors frequently differ in their tax positions, with some being substantial taxpayers and others paying no tax for the foreseeable future (due to the existence of built-up tax shelters). In any case, it is important to understand the sponsor's tax objectives. If the sponsors pay substantial tax, they may want to access the tax losses that are often associated with the early years of project financing. The tax losses are typically due to interest expense and a high level of depreciation. This will allow the sponsors to reduce their tax rate. If the sponsors are unlikely to pay tax in the foreseeable future, then they may choose to structure a transaction mechanism that passes tax losses to a third party for economic benefit. Lenders will also need to consider the impact of any consolidated groups (see section 3) for taxation purposes and whether or not tax-sharing agreements have been entered into. Projects need to be evaluated on the correct after-tax basis, for example, if initial project tax losses are assumed to be carried forward to offset future taxable income, grouping and use of those tax losses when they are accrued by a consolidated group will reduce the future cash flows available for debt service, unless compensating payments are made to the project vehicle. Another consideration for tax is franking credits for publicly listed companies in Australia. Some listed corporates prefer to pay the full tax rate in order to provide fully franked dividends to their shareholders.

Growth capital

Sponsors often look at capital growth in the value of the projects over time, as do fund managers which run growth-oriented funds rather than yield funds. Key components to capital growth include refinancing benefits from re-leveraging the project once stable long-term revenues are achieved, thereby enabling large one-off returns of equity. Another factor in capital growth is project re-rating as a result of de-risking the project over time. Example: Growth capital Toll roads are a good example of growth capital. They often have an equity IRR of 13% plus at financial close when the project has construction risk and unknown traffic performance. A mature toll road will, however, have an equity IRR of below 9% for its remaining life, thereby delivering an improved risk/return profile to its owners.

Credit rating

Sponsors that have, or are seeking, a credit rating may not wish to risk a downgrade due to a project financing. If the project is of significant size (comparable to the sponsor) and is perceived by the ratings agency to be associated with significant risk, the project financing could jeopardise a rating, despite the debt being limited recourse to the project (rather than the sponsor). This rating is due to the fact that the sponsor may have contributed significant equity and may be reliant either on the cash flows of the project or on the materials from the project for the operational performance of other operating divisions. The loss or downgrade of a credit rating could increase the cost of debt, limit the investor base or restrict the ability to attract capital. Corporate treasury areas are frequently rewarded on their ability to retain a certain level of credit rating or borrowing cost structures. Therefore, treasuries have the incentive to create lower risk structures.

Defining equity objectives (variables)

Sponsors utilise a variety of financial tools to satisfy the required investment criteria. A variety of criteria must be reviewed and 'optimised' to the satisfaction of the internal divisions of the sponsors. Normally these divisions include: project development, accounting, tax, treasury and risk management. In addition, members of the board of directors or executive committee may have their own specific investment criteria of interest. Before the 'optimal mix' can be worked out, all the major investment criteria of the various divisions within the sponsor group must first be identified and prioritised. Many transactions in the market have faltered and sometimes been terminated because an investment criterion was introduced late in the process and was unable to be accommodated. Therefore, it is essential to meet with the various executives in the respective divisions to ensure that the investment criteria are identified and prioritised before the process of optimisation or, for that matter, determination of the financial structure commences. This includes meeting with the key decision-makers on the board of directors or executive committee where the final decisions are undertaken. Key investment criteria that typically form the basis of decision-making at the sponsor level are set out below.

Tax treatment of subordinated loan interest

Subordinated loan interest will be deductible to the project entity and assessable to the sponsors. If interest is paid each year, the result is a neutral position for an unincorporated project structure, although in the case of an incorporated project entity, there may be an arbitrage opportunity to the extent that the project entity is subject to a different rate of tax. If interest accrues and capitalises, but is not paid on a cash basis, then typically the project entity will be entitled to deduct interest, and the sponsors will be assessable on interest as it accrues (Div. 16E, Income Tax Assessment Act 1936). One approach typically adopted is to select a market-based interest rate on the subordinated debt (debt rate plus a margin of 3% to 4%), but to make interest payable only to the extent of available cash flow (after necessary provisioning etc.) in the project vehicle. Any excess interest is non-cumulative, meaning that the shortfall is not made up in later years, and that the project vehicle does not deduct, and sponsors are not taxable on, the unpaid interest.

Taxes

Taxes can fall in various positions on a cash flow waterfall, depending on the materiality of the tax, the jurisdiction (e.g. local, regional, federal), and the tax structure. Taxes are normally placed as a high priority as most financiers are conscious of their social responsibilities and do not wish to draw negative publicity from government agencies. In addition, in a default and foreclosure situation, it may be difficult to realise the value of the asset with government bureaucracy playing a role as an unsecured creditor.

US capital market instruments

The US capital markets can be accessed through the public/144A market or the private markets through a placement. The product characteristics that were outlined above are generally available in the US markets. Differences may include: • a greater capacity in the US market to absorb longer term issues • greater flexibility on amortisation in the US market. Domestic borrowers, however, will need to consider the mitigation of currency risk on a US issue. The US markets will usually require a rating to be issued by a rating agency to support a product issue. The market does, however, have greater capacity to issue and cover poorer credit risks, particularly those that are not investment grade.

US capital markets

The US debt capital markets are the deepest and most liquid in the world and have a long history of financing independent power projects (IPP) in the US. With the development of the high yield bond market, the depth of investors able to accept the risks of project finance increased, and thus the types of projects which can raise debt in this market have also increased. This was an active source of project finance debt, often in competition with traditional bank-sourced project finance debt. The global financial crisis resulted in a temporary disruption to these markets during which time debt finance from the US was difficult to obtain. Rated debt securities issued by IPPs have long been a source of project financing in the US debt markets. Most IPPs have a long-term offtake contract with a power utility and thus have a stable and predictable revenue stream. With the deregulation in power markets around the world, private investment in power projects increased dramatically and several IPPs have been developed in Asia, Latin America, Europe and Australia. Some of these have raised debt by issuing securities into the US capital markets. An example of this was the Paiton B financing in Indonesia in 1996. In the late 1990s, there was a dramatic growth in the high yield debt market in the US. With increasing liquidity in debt markets, investors sought higher yielding instruments and thus moved down the credit curve. The market allows issuers with a sub-investment grade rating to access the capital markets, at a higher cost of debt than investment grade issuers. Given the risks and complexity associated with a project financing, the debt raised to fund the development is typically below investment grade. Thus, the development of the high yield market has enabled projects which would traditionally be financed by banks to access the public debt markets.

Credit rating

The ability to provide debt at certain amounts, pricing and maturities may be associated with the level of capital that can be allocated against an asset. A credit rating from a reputable credit agency can be a useful step in providing access to a level of financing or more favourable terms. Many financiers and institutions are limited to lending only to investment grade projects. In addition, credit ratings by the various credit rating agencies mean that decisions require less diligent analysis, which opens the project up to lenders who may lack certain credit skills or capability, or who have limited resources.

Balancing debt and equity — securing cash flow waterfall

The cash flow waterfall in project finance is a summary of the project's cash flow and is used to define the priority of payments and the establishment of specific project accounts. Project accounts are used for specific purposes and to 'ringfence' specific cash flow allocations from operating cash flow. Most accounts are secured to the benefit of the project and in some cases, the bank agent is a joint signatory to the account.

Distributions to equity

The debt providers typically have little or no access to the upside returns from the project and require that the sponsor's equity commitment ranks behind the debt as risk capital. Project finance debt providers will typically require that the equity contributed by the sponsor has a 'true' equity profile and that it is fully subordinated to the project finance debt. The sponsor's entitlement to distributions of project cash flow and the ability to enforce its rights, will rank behind the project finance debt. The lenders typically require that minimum reserve account balances and cash flow coverage ratio hurdles are satisfied before they release cash flow to equity. Project finance lenders normally receive the benefit of first ranking security and restrictive covenants and thus, the ability of the sponsor to deal with the assets or raise further leverage is limited.

Debt service coverage ratio

The debt service coverage ratio is calculated by taking the cash available to service debt for a defined period and dividing it by the debt service requirement for that period (i.e. including interest and principal). The debt service coverage ratio is used to determine the minimum cash flow and hence the operating performance required to service debt. The debt service coverage ratio is used when there is some form of mandatory amortisation. Debt service coverage ratio can range from 1.2 times to over 2 times, based on the nature of the project cash flows. Debt service coverage ratios are commonly utilised to 'size' total debt amounts in projects (i.e. the maximum debt allowed by financiers in a project is commonly based on a minimum agreed forecast debt service coverage ratio). Debt sizing is discussed in further detail in Topic 5.

Domestic capital markets

The domestic public debt markets have historically been a source of project finance funding for both greenfields developments and asset acquisitions. While not a general financing alternative to the bank debt market, the domestic capital markets can deliver longer term financing for certain types of projects. The risk appetite of capital market investors is normally lower than that of banks and thus the types of financings which can access this market are of a more stable nature than those financed in the bank debt market. However, the public debt markets can offer longer term financing, which may have significant advantages to equity providers over shorter-term debt packages. Greenfields projects financed in the domestic market tend to have a long-term stable cash flow, generated from a long-term government offtake contract or concession. Private sector financings of public infrastructure assets have accessed the public debt markets. Such assets include airports, schools, hospitals and toll roads, which have either a contracted revenue stream with a government counterparty or a concession to operate the project. Included in the securities issued to fund this type of development, have been CPI-linked bonds (i.e. principal indexed amortising bonds). Domestic investors will usually not accept completion risk on these projects, requiring that the construction bank provide collateralisation of the debt prior to completion. Private sector developers of public hospital and school assets have long-term contracts with the relevant state government, underwriting the projected cash flows generated by the project. As these financings have mostly involved limited risk transfer to the private operator, there is sufficient certainty of the receipt of payments under the contract, for domestic bond investors to accept this exposure. Private sector developers of toll roads have long-term concessions in place with the state government to construct and operate the project for a fixed period of time.

Feasibility funding

The feasibility stage could cover costs relating to the definition of the resource, market studies, design and technology costs, and pilot plant capital and operating costs. If the project requires a new technology, then it is likely that the feasibility study would include a pilot or demonstration plant to prove up the viability of the project from the perspective of capital and operating costs, and demonstrate that the project works on a significantly larger scale than a desktop study. As the feasibility stage is an expensive part of the development process (excluding the cost of the pilot plant costs which can exceed $10 million), prior to undertaking the work, a substantial amount of planning needs to be done so as to maximise the value of the feasibility. Normally, feasibility finance is provided by equity and from the same sources as above, including the soft costs providers, and could also include offtakers of the product (i.e. those who have entered in an agreement to purchase the outputs of the project) and major aligned public companies (such as major mining houses). Private equity funds or institutional equity may be introduced at this stage. In addition, some financial institutions may lend money into a feasibility study but take equity in the form of options or warrants.

Equity

The financial structure of the project and the relative proportions of debt and equity are determined primarily by the level of gearing that can be raised from debt providers. The gearing ability of the project is determined by the level of risk that is to be borne by the lenders, being a function of the allocation of risks among the various risk acceptors including the lenders, the sponsors and other project counterparties. The returns to equity providers are typically optimised by a financial structure incorporating the maximum level of debt and the minimum level of equity. Thus, the level of equity required is determined by the residual funding requirement for the given gearing level.

Debt providers - Banks

The growth in the number of banks active in the Australian project finance market was dramatic during the 1990s. The large domestic banks as well as the local branches of large international banks were active during this period. Large project financings to fund the acquisition of privatised assets, particularly in the Victorian power and gas sectors, attracted foreign banks to the domestic market, where they had not previously been active in Australia. European and American banks, in particular, were active participants and underwriters in large project financings. A further important development for banks occurred in 2010 with the publication of a new regulatory framework for International Banks (Basel III) designed to strengthen regulation of capital and liquidity and improve market stability. Phased in over eight years from 2013, the rules require banks to reduce leverage, increase capital adequacy reserves and reduce overall risk exposure. Bank loans for infrastructure projects in Australia tend to have tenors between one to five years reflecting the short-term financing terms of Australian banks (Regan et. al. 2017). Given the emphasis on matching project cash flows, these short-term loans create refinancing risk and exposure to interest rate variability for borrowers. As it takes effect, Basel III is expected to reduce the traditional source of project finance originating from banks with future supply expected to come from sovereign wealth funds, fund managers and insurance companies attracted to the risks and returns of longer term infrastructure projects.

Initial development

The initial development stage of a project typically involves undertaking studies and analysis to assess the viability of the project. From the results of this analysis, an initial decision regarding the project viability is made, followed by consideration of whether to proceed with the development. If there is sufficient indication of project viability, further detailed work is required to proceed with the project to the point at which it will become 'bankable', i.e. when debt providers will lend funds for the development of the project. This work typically takes the form of a feasibility study, which involves detailed planning of all elements of the project, as discussed in Topic 2. The project sponsor typically funds the early development, up to the point at which it becomes 'bankable'. Before the project reaches bankable status, any investment in it will be speculative and this funding will be of an equity nature rather than debt nature.

Interest coverage ratio

The interest coverage ratio is calculated by taking the cash available to service debt for a defined period and dividing it by the interest service for that period. The interest coverage ratio is used to determine the minimum performance needed to service interest when there is no mandatory amortisation or variable amortisation. Interest coverage ratios can range from 1.4 times to over three times for performance criteria. Alternatively, some lenders use earnings before interest, tax, depreciation and amortisation (EBITDA — an accounting measure) divided by interest which can be audited from the normal corporate accounts.

Internal rate of return (geared, ungeared)

The internal rate of return (IRR) (ungeared) and related discounted return on equity (ROE) (geared) are the most common measurements used by the project development team in determining the investment criteria. The IRR provides a view of the return of funds invested over the investment horizon (typically 20 to 30 years). The ROE for project finance ventures in Australia can range from a low of approximately 8% up to 35%. The range represents the diversity of projects that encompasses everything from a low-risk regulated utility and public private partnership (PPP) transactions to a high-risk telecommunications project. The ROE can be manipulated and is highly sensitive to the timing of equity and the gearing of the cash flows. In order to understand the effect and benefits of gearing, sponsors frequently analyse the project on an ungeared IRR basis (i.e. 100% equity funded). If the effect of gearing and the risks attached are not understood, the ROE may not accurately reflect the risk and reward outcome sought by the sponsors. Ungeared IRR analysis allows the sponsors to understand the potential absolute returns on an investment in a project and the level of increased returns associated with gearing. This can then enable them to understand the trade-off between the benefit in ROE of higher gearing against the associated risks. Some companies also evaluate new projects on a purely IRR basis as the funding mix is often the responsibility of a different treasury department within the company. In this way, the evaluation of alternative projects initially depends on their fundamental economics and not the means by which they are financed. Project development teams are normally rewarded according to the performance of their investments in terms of the IRR or ROE.

Debt

The key source of funding for project finance is debt. While traditionally, project finance debt has been sourced from banks and multilateral agencies, the project finance debt market has developed to the point where funding can be accessed from the broader capital markets. As the providers of funding have increased and the depth of the market has developed, the nature and form of various debt funding instruments has also progressed. In most project financings, it is in the interest of the sponsor to maximise the amount of debt funding in the structure, thereby maximising the returns to equity. The repayment profile and the cost of the debt also impact upon returns to equity. Returns to equity are maximised by delaying repayments on the project debt and lowering the cost of debt.

Finance lease providers

The leasing market in Australia and offshore can add value to projects that have been funded using project financing techniques. The most common structure to be utilised in this market involved a 'sale and leaseback' of assets. This procedure may provide tax benefits, through arbitrage opportunities between different regimes, or as a result of the project gaining access to depreciation charges that may otherwise be inaccessible. These transactions have been implemented within Australia, and also through accessing offshore markets that generate benefits through different jurisdictional treatment. The major offshore markets that have been utilised are the US, UK and certain parts of Europe.

Amortisation

The level of amortisation is dictated by the risk appetite of both debt and equity but is usually determined by the economic and physical life of the asset. For instance, infrastructure assets that have a long commercial life typically have amortisation profiles longer than the term of the debt (i.e. have a bullet component at the end of a comparatively large debt term of, say, 15 years). For long-life assets such as regulated utilities, it can be assumed that the refinancing of bullet payments occurs in perpetuity and that any level of amortisation is based on sponsor objectives rather than the requirements of financiers. For assets that have a defined economic life such as resource projects, telecommunications or gas-fired power stations, one expects to see the debt amortised to zero well inside the economic life of the project or asset.

Loan life coverage ratio

The loan life coverage ratio is the net present value of all forecast cash available for debt service over the term of the borrowing, discounted back to the present at the loan rate, divided by the principal outstanding at the period of test. The loan life coverage ratio is used to test for future problems that relate to meeting debt service (i.e. this is a forward-looking test as opposed to the other tests outlined in this section which are based on historical performance measures). A fall in this ratio could be caused either through a forecast decline in revenue or a forecast increase in operating costs not contemplated at the initial time of borrowing. Loan life coverage ratios are normally used in projects with longer maturities and typically range from 1.4 times to 2.5 times at the initial test.

Export credit agencies

The major type of debt product that is provided by export credit agencies is used to support the development of export-focused projects. These agencies can also provide political risk insurance and guarantees. The key export credit agencies include Export Finan

Net assets

The net assets test is another adoption of the gearing ratio. The net assets test is the total assets less total liabilities and is essential for monitoring the shareholders' funds and retained earnings. The net assets test is used when the gearing test is impractical because of a distortionary accounting treatment within the balance sheet (e.g. shareholder loans). The net assets test ensures that equity maintains a sufficient level of capitalisation in the balance sheet to provide a buffer for debt between the value of assets and the value of liabilities. Typically, the net assets test can fall to 60-70% of the level at the ongoing funding date.

Payback period

The payback period is the term over which the initial equity investment is fully repaid. This investment criterion is not one of those more commonly utilised for equity but is sometimes requested by boards of directors or executive committees. Payback period is normally considered an out-dated mechanism as it provides no level of risk assessment unless it is calculated on a discounted cash flow basis (discounted payback).

Pre-feasibility funding

The pre-feasibility stage is one that takes an idea to a potential project, through economic and technical analysis and may include, for example, drilling and laboratory testing and external expert validation of the idea or process. Pre-feasibility funding will be by way of equity and soft costs. The providers of equity at this stage are likely to be individuals, private companies, farm-ins from other interested mining companies and also the same parties that provide the soft costs.

Proceeds account

The proceeds account is the main project account through which all cash flow passes at some stage. This account is typically secured by the borrower and held by the agent. All revenues and other income including interest income are deposited in it. A borrower may typically withdraw amounts from the proceeds account only for the following purposes and in the following order of priority: 1. during construction, to fund capital expenditure payments to the contractor 2. after construction, all operating expenses (including revenue and production royalties) 3. taxes 4. maintenance and non-discretionary capital expenditure 5. financing costs 6. other costs associated with financing 7. reserve account payments 8. subordinated debt financing costs 9. voluntary prepayments 10. discretionary capital expenditure 11. distributions to equity. The measurement of the cash flow waterfall is done either on an accrual basis or on a cash basis for both revenue and expenses. An accrual basis is usually the preferred method from the lender's perspective, as accounts are prepared and audited regularly by the sponsors. Further, an accrual basis allows for a more accurate reflection of the performance of the business. A pure cash basis for the cash flow waterfall can be distorted by either the timing of payments or the manipulation of cash in various accounts.

Passive equity investors

The providers of equity finance to projects can also include passive equity investors who have an indirect ownership interest in the project. These investors do not control the project or act as project counterparties, but are primarily motivated by the expected equity returns to be generated from investment in the project. These passive equity investors take various forms: • institutions • equity market investors — listed equity • multilateral agencies • private equity providers — unlisted.

Equity providers

The source of equity contributed as part of a project financing is determined by the ownership structure of the project. A requirement of any project finance debt facility is that a minimum level of equity is committed by the owners to fund the project development. Project owners are either: • controlling equity participants • non-controlling equity participants.

Sponsors

The sponsor is the controlling owner of a project, having either sole ownership or joint ownership with other parties. As the controlling owner, the sponsor undertakes the initial project development, provides equity funding for the project development and provides the required financial backing until project completion. Types of sponsors were discussed in Topic 2. Equity providers are risk takers whose reward for risk acceptance is return on equity. The higher the risk, the higher the expected return. Risk profiles change over the project life and as the risk profile changes, so do the providers of capital. Project risk decreases as the project progresses from an idea through pre-feasibility, then feasibility, construction, commissioning and ramp up, and finally to steady state operations.

Gearing

There are two frequently used measurements of gearing: • Debt to equity — which is the total amount of senior liabilities (debt) divided by shareholders' funds (including subordinated debt and shareholder loans) and movements in retained earnings. • Debt to debt plus equity — which is the total amount of senior liabilities (debt) divided by the sum of senior liabilities (debt) and shareholders' funds (including subordinated debt and shareholder loans) and movements in retained earnings. Gearing is dictated by the amount of forecast cash flow available to service debt. The following table outlines typical gearing levels for different examples of projects (debt to debt plus equity basis).

Subordinated debt financing costs

This means the service of all interest and scheduled/mandatory repayments of subordinated debt.

Financing costs

This term refers to the service of all interest, plus scheduled and mandatory repayments of senior principal.

Voluntary prepayments

This term refers to the voluntary prepayment of senior or subordinated debt principal awarded above those specified in the amortisation schedule.

Identifying variables and parameters that determine optimal mix

Transactions are always driven by sponsors and the investment requirements of equity. Normally sponsors have a significant number of competing criteria that must be addressed by the various divisions of the sponsor. These criteria may impact on the overall structure of the company (e.g. credit rating, EPS, internal rate of return (IRR)). Sponsors for individual transactions place different levels of importance on investment criteria. This is one of the reasons why project finance can be challenging, as each transaction is different from the last. Once the sponsors' investment criteria are defined, practitioners seek to work within the bounds of those criteria to provide a deliverable debt package. Occasionally, the constraints of the investment criteria mean that no debt package can be delivered. If this happens, it is necessary to either modify the investment criteria, adjust the transaction economies (if possible) or halt the transaction.

Minority joint venture parties

Within a joint venture, there can be large controlling parties and smaller minority parties. Each party in the joint venture is required to meet its pro rata share of the equity commitment towards funding the project. A minority joint venture party is often the original project owner, who does not have sufficient finance to develop the project on its own. It may fund its share of the development of the project by selling down part of its stake to another party, or by being 'free carried' through the development by another party, thereby having its share of the project ownership diluted. As a project sponsor, a minority joint venture participant is subject to the same subordination and restrictive covenants as outlined above.