Why is Project Finance Modelling so complicated?
To understand why project finance modelling is so complex, firstly we must understand Project Finance – also sometimes known as Infrastructure Finance as infrastructure is what it typically finances.
So, what is Project Finance? What differentiates it from corporate or leveraged finance? And why does it suit infrastructure projects? And what are infrastructure financing models all about?
Project Finance Basics
- Project Finance revolves around the financing of long-term infrastructure
- It is typically limited or non-recourse finance
- It is therefore highly structured to ensure that risks are mitigated
- Debt and Equity are paid back from cash flow generated by the project, and only this cash flow
- The lenders’ recourse is limited to project assets, including performance and completion guarantees and bonds
- Most large infrastructure projects are Project Financed as it enables long-term debt and separation from a company which may not be able to raise that sort of finance on their own accord
- So, what do we actually finance? A brand new SPV.
The Project Finance Model
Ok, how does this affect the modelling though? You will see a lot of the word ‘typically’ in the descriptions below. This is because project financings are so unique that to generalise them is very difficult. Each model is so different – hence the term ‘Structured Finance’! That said, there are some common characteristics that we will talk about below.
- Project Finance models are put together to assess the financial feasibility of a project to be undertaken by a new entity – in other words, off-balance sheet lending
- These models assess the cash flows on a period by period basis and show returns for shareholders
- They also show the banks that the projects are financially capable of repaying debt, with enough room to spare
- Banks want to ensure that there is ‘breathing room’ in the project – what if operations are disrupted and no cash flow is generated for some time?
- On the other hand, Shareholders want to ensure that returns are worth the risk of undertaking large, often infrastructure related projects with long-term (think 15-20 years) payback periods
- Non-recourse debt is used, where the assets related to the project are at risk if there is an event of default
- By separating the “project” from the rest of the sponsor company enables a higher level of gearing than would normally be acceptable to the company and the banks
- The level of debt can be anywhere from 50% to 85% depending on the project, the cover ratios and the certainty of revenue and what guarantees may be in place
- There are certain metrics which measure the ability to repay the debt
- This includes DSCR, LLCR, PLCR on a Senior and Total Level (Senior for Senior debt and Total for all debt in the project which may include subordinated debt)
- A project finance model is significantly different and often more structured than a typical financial model.
- It has to ensure that:
- money is reserved for ongoing CapEx, debt payment and potential shortfalls
- interest capitalised or paid during construction is funded as part of the initial capital raise
- cash flows are sufficient to pay off debt and pay dividends to shareholders
- cash flows over the life of the loan and the project provide breathing room in case of performance issues
Acronyms to make us look smart
Project Financiers, like financiers in general, love acronyms. In a project finance discussion, you may hear such terms as a PPA, DSCR, DSRA and PLCR or LLCR. These are the main ones you should know about in a model:
- CFADS: Cash Flow Available for Debt Service, typically revenue less expenses and tax
- DSCR: Debt Service Cover Ratio (CFADS / Senior Debt Service)
- LLCR: Loan Life Cover Ratio to measure the cover in the loan life
- PLCR: Project Life Cover Ratio to measure the cover in the project life
- LTA: Lenders Technical Adviser, who provides the lender with the assurance that the project is technically sound
- ECA: Export Credit Agency who may assist in providing insurance on loans
- EPC: Engineering, Procurement and Construction which is basically the party responsible for the construction part of the project
- O&M: Operations and Maintenance during operations of the project
- P-Value: The P-Value that the plant is assumed to run at, typically for projects where a statistical analysis of revenue can be performed and there is enough history to perform this analysis!
- PPA: Power Purchase Agreement for projects that generate power such as wind farms and solar farms
- PPP: Public-Private Partnership for projects that involve both government and the private sector providing crucial infrastructure for public benefit
Its all about cash
Other characteristics of project finance deals are:
- Distinct construction and operation phases – during construction typically there is no revenue, so interest on debt drawn down needs to be accrued or more debt needs to be drawn to pay the interest!
- The construction phase typically consists of consisting:
- No revenue as the revenue generating asset (think a wind farm or a public transport system) is being built
- Cash Flows in multiple currencies – especially if equipment needs to be procured from other countries and paid for in that country’s currency
- Set capital sources – project financing is characterised by a fixed amount of capital, and any cost overruns need to be funded by equity
- Penalties for construction overruns (LDs and PPAs being shorter)
- FX and Interest Rate Hedges to mitigate risks of uses of funds exceeding sources of funds
- Operations consisting of:
- Sometimes certain revenue and sometimes revenue that can fluctuate with usage or seasonality
- Long-term debt (double or longer the tenor of corporate debt)
- Multiple tranches of debt – senior and mezzanine debt that take on different risks depending on where they sit in the capital structure
- Debt that is highly structured (e.g. capitalised interest, drawdowns, sculpted repayments)
- A Financial Model that is:
- Up to 30 years’ time frame
- Monthly during construction but quarterly or semi-annual during operations
- Construction and operation phases which are very different
- Multiple scenarios, potentially Monte Carlo simulation
The financial model also needs to show clearly:
- Hedging Structures
- Senior Debt, Mezzanine/Subordinated Debt and Equity Returns
- Multiple scenarios and production/revenue stresses
- That delay LDs can cover debt repayments if required
- The cash flow waterfall shows the flow of cash as it comes in per period
- Revenues: Operating revenues and other income
- Expenses: Operating expenses and capital expenses
- Reserve Account Movements
- Debt service: Principal repayments and interest paid
- Distributions: Dividends to Equity and Shareholder Loan Repayments
- Net movement in cash balance
There are some key project finance characteristics here that are crucial for the financial model:
- Cash Flow Available for Debt Service or CFADS is used for all cover ratio calculations such as DSCR, LLCR and PLCR
- Cash flow before funding: This line is useful as a quick check against funding, to ensure that initial construction costs are being met by debt or equity (i.e. the project has to be fully funded)
- Cash flow available for debt service reserve account (DSRA)
- Cash flow available to equity to calculate distributions
- Net cash flow – Usually zero, unless cash is being restricted from being paid to equity
- The debt service reserve account (DSRA) works as an additional security measure for lenders
- The DSRA is generally a deposit which is equal to a given number of months projected debt service obligations (principal and interest).
- The purpose of a DSRA is to provide a cash buffer during periods where cash available for debt service (CFADS) is less than the scheduled payments
- This buffer allows some breathing room for operational issues to be resolved and/or, in more extreme situations, the debt to be restructured before the borrower defaults on the debt.
What else is different from a typical corporate finance model?
Other unique project finance features:
- When capital expenditure is lumpy and/or large it is common to need to consider and model a major maintenance reserve account (MMRA)
- During the operational phase of a project, capital investment is required to ensure that the project is able to continue operating as planned, this can even include minor maintenance and upgrades
- Examples of the above include:
- the resurfacing of a runway
- a planned lane widening on a toll road
- software upgrades
- replacement of wind turbines or solar panels
- The MMRA is designed to accumulate funds to ensure the funds are there when they are needed, instead of having a large cash requirement in that operating period
Is that all? Well, no, there is more
- A general Liquidity Reserve Account (LRA) can give the project breathing room
- An LRA can be used for working capital or to fund other shortfalls not foreseen
- Remember: We want to avoid a default at all costs or even a strain on the Debt Service Cover Ratio (which may lead to a technical default or a lockup on dividends)
- Financing the DSRA is particularly complicated as it is funded out of both debt and equity, but increasing the debt to fund the DSRA means increasing repayments, which the DSRA needs to cover, so the DSRA needs to increase, which increases the debt which partially funds the DSRA and so on
What about the uncertainty in revenue?
- A big risk for renewable energy developers is the lack of resource! A cloudy day can mean NO revenue
- To protect developers and lenders, we use P50 and P90 figures in the model
- Debt covenants will be measured on a P90 basis, while Sponsor IRR is measured on a P50 basis
- A P99 requirement of 1.00x is not unheard of!
- From a lender’s perspective, they need to ensure that the debt service is adequately covered per period (DSCR) and over the life of the loan (LLCR) and the project (PLCR)
- The lender also wants to ensure all of the project risks are covered (especially during construction!
- From a borrower’s perspective, they want to ensure the project will provide adequate returns and be cash generative while covering most of their risks.
- Remember that a plant that has been 95% constructed is not able to generate revenues or service debt!
To summarise a project finance model, it depicts a project in multiple Excel worksheets that show:
- Period by period analysis for up to 20 years
- A standalone entity with or without parent company guarantees
- Tax complications – differences between tax and accounting depreciation
- Often extended drawdown periods for debt (power plants and public transport systems take a long time to build!)
- Often extended payback periods / tenors
- Government, parent company guarantees
- Cross country political and other risks
- Extended project contracts
- Sometimes variability in revenues (renewable energy, tolls roads etc.)
- In some cases, reliance on a single offtaker to pay back debt
- Construction and Operation phases with distinct sets of risk that need to be mitigated
Still interested in project finance? Listen to the Financial Modelling Podcast episode where we interview Dario Musso, head of Infrastructure Finance at Rand Merchant Bank, on the importance of financial modelling for infrastructure projects.
Good luck and happy financial modelling!