Capital markets are highly diversified. Whether one should use such a source of finance is dependent on many criteria, such as its cost, the type of assets to be financed, the guarantees required, flexibility of use, and conditions of acceptability by the financial market. The financial engineering of a project consists of seeking out the optimal terms and conditions of finance and cover for the project based on analysis of the financial constraints and risks of the market.
Implementing financial engineering is a sensitive and complex exercise, sensitive because of the commitment of the financial partners over periods that can be very long, complex because of the multiplicity and increasing sophistication of the financial tools available in the market. It is also essential to understand that the financial project engineering must first and foremost conform with a pragmatic logic that is dictated by common sense and a thorough understanding of the issues. It should not be based on a desire to use sophisticated finance and cover mechanisms for their own sakes.
Once the financial profitability of the project has been determined, the SPC must define the structure of its liabilities, that is, the value of its equity and quasi-equity and the value of its debts.
In project financing schemes, the structure of the SPC’s liabilities directly stems from the project’s ability to service its debts. The main measures being used in this respect are:
These three ratios enable one to assess from the outset the amount of the debt with limited recourse that is acceptable to the banks. From this flows the amount of equity and quasi-equity required to finance the project.
If the shareholders’ aim in financing the project is to enable the project to benefit from a nonrecourse or limited recourse loan, then this means that the repayment ability of a project may be less than the amount of external finance that the shareholders wish to obtain. In this case, the loan will be split into several tranches differentiated according to the degree of recourse the lenders want to be granted with respect to the project shareholders; this is called subordinated debt or mezzanine debt. In this case, these financial resources are considered to be the same as the partners’ current accounts, namely quasi-equity.
But, as always happens in financial analysis, the discounted value of a series is preferred to its average value because the time value of money is taken into account. For this reason, we prefer the NPV DCR, which is defined as follows: NPV DCR = NPV of cash flow available for servicing the debt ÷ outstanding debt. The discount rate used in calculating the NPV is that of the average interest rates of the financial debts. As regards the period over which the NPV is calculated, there are two possibilities: the length of the financing cycle, in other words the length of the loan (the loan life cover ratio [LLCR]), or the length of the investment cycle or concession contract (the project life cover ratio [PLCR]). If the debt is not repaid by the time the loan agreement expires, subsequent cash flows will be used to pay it off.
What are the minimum requirements for these ratios in the case of a port project? In practical terms, it is difficult to suggest precise thresholds for the foregoing ratios that could apply to all projects. However, it seems reasonable to state the following, as far as project financing in Organisation for Economic Co-operation and Development (OECD) countries is concerned:
These thresholds are given only as potential indicators and do not apply to all cases, nor do they take into account the country risk factor. Clearly, their final assessment is contingent upon the overall project risk analysis described in Part A of this module.
Debt markets are highly diversified. Consequently, in complex transactions, debt is often broken down into several tranches (segments) of different loans. The aim of structuring the project’s debt consists of seeking the optimum finance conditions for each of these tranches to reflect the requirements of the project’s various financial partners.
Debt financing is usually defined by a set of intrinsic characteristics. The four main ones are:
Some terms include deferred repayment or a grace period, which means that over a certain period (rarely more than two years) the borrower pays only interest to the lenders. Deferred repayment may prove necessary for projects in which the ability to generate operating income significantly lags behind project costs. This is usually the case with greenfield port projects.
The average duration of a loan is given by the formula:
Outstanding amount i represents the various annual outstanding amounts of the loan over its lifetime. A variation of average duration of the loan introduces the discount factor and represents the “center of gravity” of the finance flows over time. A credit sequence [F1, F2, ...,Fn] at a discount rate of t has a duration of:
This latter measure of duration is more often used as an instrument for measuring and managing the rate risk.
To finance public service infrastructure, the first two methods that spring to mind are public budget finance and investment prefinancing by the project sponsors. Both of these methods are referred to as corporate financing. This implies the inclusion of the amount of the investment in the public accounts of the concessioning authority as well as in the company accounts of the constructor, respectively.
These finance solutions have the major disadvantage of being a burden on the investment capacity and balance sheets of the parties. This is particularly true in the case of transport infrastructure where the sums to be financed are large and the balance sheet ratios (see above) are weak in the first few years of the project due to the slow increase in revenue generating traffic. An alternative to these methods is project finance.
It is difficult to define the characteristics of a typical project finance set-up because tailormade solutions are so important. However, the financial set-ups have one essential point in common: repayment of the loan is either primarily or solely dependent on cash flows generated by the project itself. In the first case, this is called limited recourse financing and in the second, nonrecourse financing.
The two characteristics common to limited recourse financing are that the loan is repaid on the basis of cash flows generated by the project, and that the lender has no guarantees other than the assets of the project itself, which often are not financially recoverable for port projects.
One way of reducing exchange risks is to obtain financing in local currencies. However, this type of financing quickly reaches its limits in developing countries. In fact, the weakness or nonexistence of a national money market, high local currency interest rates, and the absence of investors willing to provide finance over periods compatible with infrastructure projects all combine to exclude local currency debt or at least restrict its use to a short-term revolving line of credit designed to finance operating expenses. Foreign currency debt also poses problems of exposure to the residual exchange risks of convertibility and transferability.
Export credits and financial credits with a multilateral “umbrella” export credit agencies (ECAs) and multilateral agencies (MLAs) offer guarantees or “cover” that can mitigate political risks associated with port projects and therefore open up new financing possibilities. When the commercial banks are to a large extent freed from worrying about political risks, they can concentrate their efforts on the commercial risk within the framework of terms offered by these agencies. The fact remains that these agencies are themselves subject to term and cost constraints that must be taken into account (particularly the OECD Consensus for export credit agencies).
Export credits can prove very useful when the project is located in a developing country and involves the contribution of foreign technology. Among export credits, one must distinguish between supplier credits (credit granted directly by the exporter) and buyer credits. Buyer credits, the more common of the two, are granted by commercial banks for a maximum length of two years to a foreign borrower to enable the borrower to pay cash to the supplier (the exporter) according to the terms of the commercial contract. Buyer credits free the exporter from the financial risk of making a credit-based sale to the buyer.
When an export sale is supported by a buyer credit, two distinct cross-referenced contracts are signed: the commercial contract between the exporter and the foreign buyer, and the credit agreement between this same buyer (as a borrower) and the lending banks. The commercial contract spells out the respective obligations of the supplier and the buyer. It must indicate the payment modalities (in particular the down payment to be made before delivery and the overall payment schedule) that will serve as a basis for the buyer credit. The credit agreement is signed between the commercial bank and the foreign buyer. Under this agreement, the bank commits itself to pay the exporter and the buyer agrees to pay back the bank for all amounts paid to the supplier according to terms and modalities spelled out in the credit agreement.
Buyer and supplier credits can both benefit from public support for medium- and long-term export financing. This support, governed by the consensus rules drafted by the OECD member countries, can be expressed in two ways:
Buyer credits are of three varieties:
Export credit agencies exist in most industrialized countries: COFACE in France, SACE in Italy, HERMES in Germany, ECGD in England, CESCE in Spain, and Ex-Im Bank in the United States and Japan.
In a port project, this source of financing relates more to port equipment (for example, handling equipment, container gantries, and computer systems) than infrastructure (for example, civil engineering or dredging), which is usually subcontracted locally. To enjoy the export credit cover, the project must fulfill certain criteria. The first of these is that payments made under the contract concluded with the exporting equipment manufacturer must represent 85 percent of the share able to be repatriated (national share + foreign share). Box 10 describes how the concepts come together in an example.
It should be pointed out that while the principal activity of export credit agencies is now to cover political risks, some of them have project financing teams and are beginning to consider covering the commercial risk in some projects. Furthermore, there is an increasing number of major project financing contracts in the form of multisourcing operations, in the sense that they are structured either by major multinational groups that can source from different countries through their subsidiaries, or by multinational consortiums organized on a cocontracting or subcontracting basis. This change can be explained by the fact that the ever increasing size of the investment level of the projects does not always coincide with the total commitment limitations (geographic or sector) set by the export credit agencies and governments within the framework of their risk policy (see Box 11a and 11b).
Multilateral organizations, such as the World Bank Group, through the International Bank of Reconstruction and Development (IBRD) or regional development banks (European Bank for Reconstruction and Development [EBRD], Asian Development Bank (ADB), and Inter-American Development Bank [IDB]), are also involved in these types of transactions alongside commercial banks and export credit organizations. This is referred to as cofinancing.
Most of the time cofinancing is carried out in the form of parallel financing where the project is split into separate lots, each covered by a World Bank loan or a commercial debt granted by a bank or a buyer credit covered by an export credit agency. These cofinancing methods, relating to financing of separate lots, should not be confused with the technique of joint financing, which combines several sources of finance in a single lot, according to a percentage agreed to in advance.
In practice, the involvement of a multilateral agency in this type of set-up leads to the financial credit being structured at two levels (or in two segments): an A-loan granted by the multilateral organization itself, and a B-loan underwritten by commercial banks under the multilateral umbrella.
The World Bank, through the IFC, can be involved in A-loans in three ways:
As far as B-loans are concerned, the notion of a multilateral umbrella does not mean that the multilateral organization gives the commercial banks any kind of guarantee on this credit. It simply means that the banks will feel reassured by the participation of the multilateral organization because the host states are unlikely to take detrimental measures against the project because of their presence.
Finally, although multilateral institutions are often unwilling to bear certain risks, they have the advantage of being able to offer much longer loan periods at fixed rates than the commercial banks.
Bonded debt is a source of long-term financing that is currently enjoying widespread popularity, particularly in financing transport infrastructure. It is used extensively in the North American market and is reserved for institutional clients. This option should not be confused with bond issues for public savings.
Issuing bonded debt (under what is referred to as Rule 144A) enables financial terms (margins and fees) to be obtained as well as maturities that are more favorable than those available in the banking market. This method of financing is fairly recent, as it only took off in the early 1990s and it has still not reached maturity. In fact, it is only in the last few years that the market has come to agree to cover financing requirements during the construction period. It is therefore more a method of refinancing for banks than of financing for investors.
It should also be noted that using this type of financing source can create problems for intercreditor relations. While the problem of seniority between the debt categories can be easily solved, the ability of the various quorums to call in their sureties and the differences in the level of information supplied to the protagonists poses major problems (for example, a club of a few banks does not receive the same information as a large, liquid syndicate of heterogeneous investors).
Equity is a financial resource that is flexible enough to earn its return over a variable and unspecific time frame, without creating any risk of financial sanction by the equity holders. In other words, equity refers to financial resources placed under the control of the company and designed to cover the materialization of project risks.
Equity Provided by the Public Sector. There are many ways in which the public sector can become involved in port investments. Which of these is applied depends to a large extent on the configuration of the project. In a nonexhaustive way, one can list the following options:
There are many financing vehicles for the public sector to contribute equity to the SPC. The intervention can take the form of:
With the exception of export credits, the beneficiary of this type of financing is the host state of the project, which then retrocedes the credit, frequently granted on concessionary terms, to the port authority concerned. While this technique has an undeniable advantage for the lenders of avoiding the risk of a shortfall caused by the local public authority, given that the credit enjoys a “sovereign guarantee,” the fact remains that in some developing countries (in Africa in particular) this procedure of the state retroceding the credit is carried out on terms and conditions that are not always favorable to the local company, as the state wants to make a profit on the transaction.
Financial analysts compare all of these public sector financial investments in the project to equity, whether or not the concessioning authority is one of the shareholders of the SPC. The risk that these resources will not be made available to the private concession holder remains. This risk is an integral part of the political risk. One can therefore understand why the private concession holder (and the banks in particular) have tended to prefer investment subsidies, payable right at the start of the concession, to operating subsidies.
Equity Invested by the Project’s Sponsors. Equity contributed to the project by its sponsors is paid into the SPC’s share capital. This is determined according to the minimum required by legislation and the available funds of the future shareholders. Banking requirements are usually not too strict in terms of the amount of share capital required, as only the value of the equity and of similar funds is significant in terms of financing structure. The equity balance is usually given to the SPC by the sponsors in the form of confirmed letters of credit in the name of the shareholder.
Equity Invested by Multilateral Institutions. Some multilateral institutions have financial tools that enable them to invest in these operations as a shareholder of the SPC in the same way as the project’s sponsors. The best known of these institutions is the International Finance Corporation (IFC), a subsidiary of the World Bank Group, which invests in private companies in developing countries. It acts as a catalyst, in the absence of a government guarantee, by providing coinvestors with protection against noncommercial, expropriation, and profit repatriation risks.
There are three ways in which the IFC can be involved:
Equity Invested by Bilateral Institutions. Some bilateral institutions become involved in these projects by investing in the SPC. In France, this is the case with PROPARCO, an investment subsidiary of the French Development Agency (ADF). Established in 1977, PROPARCO (Société de Promotion et de Participation pour la Coopération Economique) has a mission to promote the creation and development of private enterprises in developing countries, particularly in Africa. PROPARCO’s equity participations are to be sold after an average of six years, when the enterprise reaches a satisfactory growth rate.
Specialist Investment Funds. In some cases, the use of specialist funds (geographic, sector, or religious) can also finance major projects. These sophisticated sources of finance are usually similar to quasi-equity because the invested capital is mostly supplied to the SPC in the form of mezzanine debt.
This subordinated debt, which is junior in ranking to traditional bank debt, is frequently given to the project for a long term and attracts a much higher rate of interest than traditional bank debt. This type of financing is therefore reserved for highly specialized private investors, for example, pension funds, institutional investors, or finance company subsidiaries of major groups.
Exogenous financial risks are a category of market risks as opposed to political risks. They arise from the perpetual changes in the capital market. Such risks usually relate to interest rates, exchange rates, and counterpart risks. With regard to interest rate and exchange risk cover, there are two main families of markets that although different, are also interdependent:
While the cover principles are identical in both of these markets, the methods employed in their operation are quite different. Three reasons explain why:
The financial engineering of a project in terms of risk cover always has to be tailor made. As such, it must adapt itself to the configuration of the project and its environment, the cover requirements sought by the investors, and the local conditions of the country. Also, the products available on the capital market are not applicable to all developing countries.
Several previously described methods of financing already incorporate cover against certain financial risks in their design. This is particularly the case with guaranteed credits, which, depending on circumstances, can offer the SPC exchange or interest rate guarantees. Also, while it is easy to dissociate the method of financing a project from the cover for financial risks in theory, in practice it is more difficult. Designing the financial engineering of a project must therefore fall within a global approach where the financing and the financial risk management methods are dealt with simultaneously.
All of the cover products (detailed in the following paragraphs) are used more during the operating period than the construction period for two main reasons. First, cover requirements are without common measure in terms of duration, a few years for construction and typically a minimum of 20 years for operation. Second, using such products requires an accurate prior knowledge of the amount of flows to be covered, an exercise that is much more difficult to achieve during the construction stage.
The principles of cover are based on the notion of transfer (and not removal) of the financial risk to a counterpart. The counterpart agrees to bear the risk for payment of a premium because its cover need is the opposite of that required by the investor. In other words, all these mechanisms involve the notion of counterpart risk, which can be difficult to manage in the case of a project financing set-up.
The market sees new risk management and cover instruments every day. Their sophistication is limited only by the imagination of the financiers. It would therefore be futile to attempt to deal with this field exhaustively. The goal of the following section is to make the mechanisms understandable and explain the issues, specifically within the framework of a project financing set-up.
As already mentioned, debt financing usually involves a variable interest rate, consisting of a reference rate (variable) and a margin (fixed). As far as the SPC is concerned, the interest rate risk occurs when the reference rate rises and, along with it, the financial costs of the project. Given that concession contracts are concluded for long periods, the concession holder’s main concern is to try to cover itself against the risk of rates rising in the long term.
Several issues regarding interest rate risk management merit further explanation. The risk associated with rising reference rates (for example, EURIBOR or LIBOR) can result from two independent sources, the first being an increase in inflation in the countries in which the reference index is calculated, that is, the developed countries. This creates a need to neutralize the negative impact of inflation on the cost of the debt, since it will make the debt more expensive. Neutralizing the effect of inflation is possible only if the price indexing parameters laid down in the concession contract make provision for this. Delaying the adverse affect of inflation is the existence of a lag factor, of varying length, between the time the real interest rates rise and the time they are passed on in the concession holder’s interest charges. This increase might lead to an increase in the project’s revenue if the project is carried out in one of the indexing countries, thereby partially offsetting the affects of increased inflation and interest rates.
The second source is an increase in real interest rates wherein the annual increase is not offset by a parallel increase in available cash flow for servicing the debt. This implies a corresponding rise in the cost of the debt. Consequently, the SPC bears the whole brunt of the rate rise if no other cover mechanism was originally provided in the set-up.
Conversely, interest rates could fall significantly during the operating period. If the SPC had managed, either directly through the loans granted to it or indirectly through the cover instruments it contracted, to maintain a fixed interest rate on its debt, it would experience higher interest expenses than competitors with variable rate debt. This would imply that the port’s customers would have to bear this surcharge through the prices they were charged. In other words, setting up a fixed rate loan during a period of falling rates would translate into a less favorable competitive position for the SPC (compared to other competing ports or terminals that may have opted for a variable rate loan), leading to a rise in the commercial risk. A prudent mix of fixed and variable rate loans is therefore advisable, on the understanding that there is no ideal formula. Although a 50-50 ratio is often used as an initial approximation, the final determination of this cover threshold is an extremely complex exercise as it assumes the ability to forecast long-term rate trends over a 10-, 15-, or 20-year financing cycle.
Finally, let us remember that existing cover instruments are used more during the operating than the construction period. It is harder to determine the rate risk and fix drawings on the loan in time (dependent on the state of progress of the works) than to fix the repayments that are stated in the loan agreement.
Interest Rate Swaps. The use of swaps to protect against the risk of interest rate changes, particularly long-term rates, has become popular over the last few years. Banks have played a lead role in the development of this market. A swap is an exchange of interest rates between two dealers, the bank usually acting as an intermediary and charging a commission. A rate swap can also be obtained where two counterparts are involved in different currencies. In practice, the SPC with a variable rate debt pays the corresponding interest and receives in return interest calculated on the basis of a fixed rate. This effectively provides the SPC with a fixed rate debt.
In project financing, it can be difficult to find a counterpart who will agree to swap interest rates with the SPC, primarily for two reasons: first, the SPC can only offer the cash flows produced by the project as a guarantee. Also, the credit risk attached to the SPC, which the counterpart will have to accept, depends on the project configuration. In countries subject to significant political risks, a possible but difficult to implement method consists of transferring this credit risk to the project’s sponsors by asking them to guarantee the swap if the SPC were to fail. The second reason it is difficult to find a counterpart to swap with is that a variable rate loan granted by a banking syndicate usually has a repayment profile based on the profile of the cash flows produced by the project. It is extremely rare for this to correspond perfectly to the counterpart’s cover requirements. It is also common for the swap to relate only to a fixed portion of the loan repayment (possibly smoothed out over the financing period), the balance remaining exposed to the rate risk. This is known as a residual interest rate risk. This technique enables the SPC to enjoy a possible rate reduction on the uncovered portion of the loan, while at the same time enjoying cover on the portion with the fixed rate in the event of a rise.
Firm Financial Instruments in the Overthe- Counter Market. Two firm financial instruments exist on the over-the-counter market, a forward-forward rate, which enables a company or an investor who wishes to borrow on a future date and over a set period to fix the cost of borrowing now, and a forward rate agreement (FRA), which enables a company or an investor who wishes to borrow on a future date and over a set period to cover the rate position with a bank or financial institution.
While these two products offer excellent protection against rate risks, they differ on one essential point. The FRA completely dissociates the rate guarantee transaction from the financing transaction, which is not so in the case of the forward-forward rate. For this reason, FRAs are more frequently used in project finance, given the diversity and specific nature of the loans granted in these set-ups.
Firm Financial Instruments in the Organized Markets. In the organized markets, futures are also able to offer efficient protection against interest rate risks. The standard contracts traded in these markets are undertakings to deliver (for the contract vendor) or to receive (for the contract purchaser), on a clearly defined date, fixed-income financial securities with features strictly specified by the contract itself, at a price fixed on the day the contract was negotiated.
The general principle with these cover transactions is to take a position in the contract market opposite to that held in the cash market of the underlying security, the loan transaction in this case. In practice, an SPC wishing to cover itself against an interest rate rise (particularly longterm interest rates) will sell forward standard contracts. The number of contracts sold is calculated in such a way that the duration factor, defined in advance, is equal in both transactions.
Conditional Financial Instruments (interest rate options). An option confers a right on its holder to buy or sell the underlying security of the option (for example, financial securities) at a rate fixed in advance (called the exercise price or striking price). This right can only be exercised during the life of the option, that is, up to the exercise date. If the option grants its holder an option to buy, it is called a call option; if the option grants its holder an option to sell, it is called a put option. In return for the right resulting from the purchase of the option (regardless of whether it is a call or put), the purchaser pays the vendor of the option a premium, which the vendor keeps whether the option is exercised or not.
There are two main types of interest rate options available to an SPC fearing a rise in rates, one is a cap that enables borrowers to set an interest rate ceiling beyond which they no longer wish to borrow and will receive the difference between the market rate and the ceiling rate. This product is perfectly suited to the cover requirements sought by an SPC, while at the same time enabling it to benefit from a gain in the event of rates changing favorably, which in this case would translate into a rise in rates. The other interest rate option is a collar that is a combination of a cap and a floor (which enables a borrower to set a floor rate). This product enables a dealer to set an interest rate fluctuation range outside of which it has to pay the difference between the market rate and the floor rate and within which the counterpart will have to pay the dealer the difference.
Although these products exist on organized markets, they are more commonly traded on the over-the-counter market, which offers the purchaser of the option, the SPC, a product tailor made to meet its requirements.
The principal limiting factor in the use of these cover instruments is the sometimes extremely high premium associated with them, that is, the cost of the option. As the volatility of the underlying security depends on the exercise date of the option, a cover application from an investor relating to a very long period of time will automatically result in a rise in the return required.
For a company investing in a foreign country, the risk of a change in foreign exchange rates traditionally materializes in two different ways: a consolidation exchange risk or asset risk that arises when the financial results of a subsidiary company (the SPC in this case) are included in the consolidated accounts of the sponsors in different currencies, or a transaction exchange risk that arises when investments or operating income and expenditure involve several currencies.
The consolidation exchange risk, although sometimes overlooked by financial analysts in privatization projects, is a major concern for the project’s sponsors. The ways of managing it relate to the accounting and taxation details of the consolidation, which will not be dealt with here because there are large local disparities in these details between one country and another. We note simply that the consolidation risk is usually approached from the point of view of tax optimization of the project and is dealt with once the methods of financing and risk cover have been set.
As far as the transaction exchange risk is concerned, several risk management methods were mentioned in the section devoted to risk management. These techniques are intended to eliminate the risk by pricing the port services in foreign currencies (the project is then said to be foreign currency generating) or obtaining a loan in local currency or transfer the exchange risk to public entities by obtaining an exchange rate guarantee over the period of the concession from the host country’s central bank (at the request of the ministry of finance), which converts the exchange risk into a political risk.
These techniques, although highly desirable for the concession holder, are a challenge to implement. Depending on circumstances, the SPC will have to bear a part of the exchange risk. Against the backdrop of an international economy characterized by floating currencies and wide fluctuations in currency rates, managing the foreign exchange risk is a necessity for an SPC. Consequently, it will strive to transfer this risk to a counterpart expert in dealing in the foreign exchange markets.
The foreign exchange market is the most challenging segment of the capital market. Spot and forward transactions between banks occupy a central position in the market. It would be wrong, however, to think that the foreign exchange market is reserved for these interbank transactions. Since the beginning of the 1970s, new markets, the derivatives markets, have gradually developed.
Within the derivatives markets, it is customary to make a distinction between standard contract markets, which are located in stock exchanges that have clearinghouses, and nonstandard contract markets, which are a compartment of the interbank market in which over-the-counter deals are transacted. Within these standard contracts, there is a further distinction between futures and options.
All of the methods relating to interest rate risk cover also exist for exchange risk cover. Thus, the cover products available on the derivatives markets are:
As a rule, investors involved in project finance set-ups tend to prefer the over-the-counter market, which is more flexible in terms of the choice of amount to be covered (which may exactly match the expected amount of flow), maturity dates, and exercise prices in the case of foreign exchange options.
With regard to the options market, there exists an “option option,” which has proved to be a particularly interesting product for the investor at the stage of bidding on a tender. The project profitability calculations carried out by the company are based on certain assumptions about exchange rates even though the company is not certain of winning the contract. If it wins the contract after the invitation to tender, it is not uncommon for the market to have shifted significantly in the meantime. Also, an option option gives the option holder the right to buy a foreign exchange option whose exercise price is close to the reference exchange rate used, thereby covering itself as early as the tender stage. If the company is not successful, it doesn’t exercise its option option. Also, it is worth mentioning that since the volatility of the price of an option is less than the volatility of its underlying security (in this case the foreign currency), the price of the option option tends to be low.
Finally, the use of these cover products, as in the case of rate risks, requires an accurate, prior knowledge of future foreign currency cash flows. This is referred to as the company’s “net foreign exchange position.” Determining this position is a difficult exercise, particularly during the operating period. Assessing the value of the basket of currencies to be covered can therefore only be a “guesstimate.” Nevertheless, it is important to estimate these flows carefully during the financial modeling of the project. This point will be discussed further at a later stage.
All of the techniques mentioned in the Part A of this module relating to risk management are based on the principle of risk sharing in project financing set-ups: to minimize the costs of covering risks, they must be borne by the party in the best position to assume it. This involves transferring each identified risk to a private counterpart. The risk that any of these counterparts may disappear is what is called the counterpart risk or credit risk.
The counterpart may be directly involved in the project and therefore belong either to the SPC or the bank syndicate. But, it may also take no direct part in the project other than through the risk it agrees to take on, either because it counter balances an opposite cover requirement or because it expects payment for doing so.
Also, with regard to counterpart risk management, a distinction must be made between the credit risk relating to the sponsors of the project and the credit risk resulting from the other counterpart, as the financial cover instruments used are of a totally different kind.
The need to cover the counterpart risk in a project financing set-up stems principally from a requirement of the bank syndicate that structured the loan and wishes to satisfy itself as to the solvency of the various sponsors of the project (for example, builder, operator, supplier, owner, or shipper). To satisfy itself that these parties will honor their financial contractual commitments, which might be expressed in terms of contract penalties, the bank syndicate may require the establishment of guarantees known as performance bonds. These are usually issued by one of the party’s “friendly” banks, which must also have an acceptable rating. The bank syndicate is then confident of being indemnified if any of the project’s sponsors become insolvent. This is also a good way for the arranging banks to limit their liability, by only accepting projects with top ranking partners as sponsors.
Counterpart risk cover instruments also include credit derivatives that are beginning to appear in the project financing market. For the moment, however, they are still handicapped by a certain lack of liquidity and a small choice of available counterparts.
As far as the other financial counterparts of the project are concerned (banks, insurers, and specialist financial institutions), the use of credit risk cover products is still not common today. In fact, project financing set-ups remain a reserve of a small number of players of international stature who usually have an excellent rating.
Political risk is an expression that covers all risks resulting from unfavorable and unilateral decisions taken by the public authorities of the host country of the project, whether they are the state, local authorities, or port authorities. Financial engineering of political risk management consists of setting up adequate insurance products to mitigate any financial consequences that may result from a public decision that is detrimental to the viability of the project.
The separate presentation of political risk and market risk (the exogenous financial risks presented in the previous sections) within the framework of this module needs to be distinguished. The risks of nontransferability and nonconvertibility of the local currency, which are components of foreign exchange risk, can be used as an example. While it is clear that fluctuations in foreign exchange rates are partly due to market dealings, the fact remains that they are also dependent on the monetary policy either set by the national central bank or the government. It is impossible to determine with precision the exact split between these two classes of risk and, hence, to design the optimal cover arrangement. This example illustrates a “grey” area that makes the financial analyst’s challenge a little more complex.
The financial treatment of political risk management harks back to the notion of investment guarantee, which poses the difficult question of knowing under which balance sheet headings to place this cover. While the answer may seem obvious with regard to the guarantees offered by secured loans (which were dealt with in the section covering the financial structuring of the project), existing insurance products relating to investment guarantees can, depending on the type of policy, relate either to a guarantee of equity invested by the sponsors or a guarantee relating to all the project’s assets. This distinction, which is fundamental in terms of its potential consequences, is difficult to grasp in practice.
The calling in of these guarantees and indemnity procedures provided by insurance policies in the event of default is not without problems. Without going into detail, it should be mentioned that the notions of “events of default” and “subordination of rights” between an investment guarantee and a secured loan in practice prove to be particularly complex and difficult to manage for all private partners.
The best known of the multilateral agencies offering investment guarantees is the Multilateral Investment Guarantee Agency or MIGA; its goal is to “encourage investments for productive purposes between member countries of the World Bank Group.” In this sense, it is in a position to guarantee the SPC’s investments against losses that may result from noncommercial risks, including:
Since 1994, the World Bank (Bank or IBRD) has promoted the use of political risk mitigation guarantees to address the growing demand from sponsors and commercial lenders contemplating financial investment in the infrastructure sectors of developing countries. The Bank’s objective in mainstreaming guarantees is to mobilize private capital for such projects on a “lender of last resort” basis while minimizing the host government’s requisite indemnity to the Bank as a condition of providing the guarantee.
Bank guarantees are provided to private lenders for infrastructure financing where the demand for debt funding is large, political and sovereign risks are significant, and long-term financing critical to a project’s viability.
The Bank offers commercial lenders a variety of guarantee products: partial risk, partial credit, enclave and policy-based guarantees in IBRD countries, and partial risk guarantees in IDAonly countries. Broadly speaking, all guarantees provide coverage against debt service default arising from sovereign risk events. Each guarantee is tailored to match the specific need of an individual transaction.
IBRD guarantees are offered for projects in IBRD-eligible countries, with the exception of certain foreign exchange earning projects in IDA-only countries. IBRD guarantees can be both partial risk and partial credit in nature. Bank guarantees are generally available for projects in any eligible country, irrespective of whether the project is in the private or public sector. The Bank may, however, at times limit the availability of guarantees in certain countries, for example in countries undergoing debt restructuring.
IBRD partial risk guarantees ensure payment in the case of debt service default resulting from the nonperformance of contractual obligations undertaken by the government or their agencies in private sector projects. Sovereign contractual obligations vary depending on project, sector, and circumstances. The obligations typically include:
Partial risk guarantees may also cover transfer risks that may be caused by constraints in the availability of foreign exchange, procedural delays, and adverse changes in exchange control laws and regulations.
Partial risk guarantees are used in IDA member countries in sectors undergoing significant reforms. IDA guarantees are offered on a pilot basis to private lenders against country risks that are beyond the control of investors and where official agencies and private markets currently offer insufficient insurance coverage. IDA guarantees are available selectively, where an IBRD enclave guarantee is not available. IDA guarantees can cover up to 100 percent of principal and interest of a private debt trench for defaults arising from specified sovereign risks, including government breach of contract, foreign currency convertibility, expropriation, and political violence.
Partial credit guarantees cover all events of nonpayment for a designated portion of the financing. While these guarantees historically have been used to encourage extension of maturity by covering the later years of the financing, the Bank recently structured a partial credit guarantee to cover a single coupon interest payment on a rolling basis throughout the life of the facility, plus the final principal repayment.
Enclave guarantees are highly selective partial credit guarantees structured for export-oriented foreign exchange-generating commercial projects operating in IDA-only countries. Enclave guarantees may cover direct sovereign risks such as expropriation, change in law, war, and civil strife, but may not cover third-party obligations (such as those of an output purchaser or input supplier), nor will it guarantee transfer risk. In all cases, the scope of risk coverage under the guarantee would be the minimum required to mobilize financing for a given project.
Bank guarantees facilitate the mitigation of risks that lenders cannot assume, catalyze new sources of finance, reduce borrowing costs, and extend maturity beyond what can be achieved without the bank guarantee. They also provide more flexibility in structuring project financing. Clearly, within the World Bank Group, IFC, and MIGA are the preferred sources of support to the private sector. As such, sponsors and financiers should consult with IFC and MIGA concerning their potential interest in financing or covering the project. IFC supports private sector projects through equity and debt financing, the syndicated Bloan program, security placement, and underwriting and advisory services. MIGA provides political risk insurance primarily for equity investments, but it can also cover debt financing as long as it is also covering equity finance for the same project. These agencies cannot accept host government guarantees.
Export credit agencies also issue guarantee policies covering investment operations abroad. These instruments usually provide a guarantee for the SPC against the political risks of an attack on shareholders’ rights and nonpayment and nontransfer of the payment, or nontransfer of the investment or of the indemnity provided in the concession contract, in the event of nationalization.
The guarantee package (with a cover ratio in the region of 90–95 percent) relates not only to the initial investment, but also to the selffinancing produced by the project, that is, the profits to be reinvested and the profits to be repatriated. Generally, there is a ceiling on the basis of cover relating to the self-financing produced by the project: in the case of COFACE in France, the cumulative limits are respectively 100 percent (with respect to profits to be reinvested) and 25 percent (with respect to profits to be repatriated) of the initial investment.
Finally, it should be noted that securing such a guarantee is conditional on the existence of a bilateral investment agreement between the country of the export credit agency and the host country of the project.
Private insurers sometimes offer viable alternatives to public insurers for covering political risks. The cost of this insurance may be quite high, but it is sometimes the only alternative for making financing of projects in difficult countries possible.
A private insurer covers the banks against the occurrence of a political risk causing the loan to default. Private insurers are sensitive to the monitoring procedures that the banks put in place to assess the political risk and its development. The banks must therefore provide evidence of their ability to assess and avoid political risks during the project set-up stage; this is a condition of underwriting the policies.
){kind=link}
){kind=link}
){kind=link}