the economics of large scale infrastructure project finance an empirical examination of the propensity to project finance

The Economics of Large Scale Infrastructure Project Finance: An Empirical Examination of the Propensity to Project Finance A Thesis Presented to the Faculty Of The Fletcher School of Law and Diplomacy By RAJEEV JANARDAN SAWANT In partial fulfillment of the requirements for the Degree of Doctor of Philosophy DECEMBER 2007 Dissertation Committee Prof Laurent Jacque, Chair Prof Patrick Schena Prof Bruce Everett 3320163 3320163 2008 ii Abstract This dissertation empirically examines a financing and governance structure called Project Finance that typically funds large scale, capital intensive, infrastructure investments in risky countries. Separate incorporation by investing firms (sponsors), long term detailed contracts between suppliers and buyers, vertical integration, high debt levels and non-recourse lending characterizes project finance. Project finance finances tangible, decaying assets with low growth options that do not require strong managerial skills. UK’s North Sea oil fields, Ras Laffan gas company in Qatar, and Chad Cameroon pipeline are examples of project financed transactions. Lenders achieve a high degree of transparency for project financed transactions due to the non-recourse nature of the debt which also entails higher setting up costs and cost of debt compared to corporate finance. Theoretical research hypothesizes that project finance solves the problem of potentially opportunistic concentrated suppliers/buyers facing large sunk investments in risky countries. Theory also hypothesizes that project finance mitigates underinvestment resulting from conflict between debt and equity holders within a firm. The dissertation compares project financed and corporate financed transactions in the oil, gas and petrochemical industry to test these hypotheses. I compile a dataset of over 400 investments by 340 firms in 74 countries over 17 years to test these two theories. I find that the propensity of firms to use project finance is high and statistically significant when large sunk investments have concentrated buyers/suppliers in risky countries. The propensity for project finance is high when debt coverage ratios are low after controlling for leverage and the volatility of the debt coverage ratios but weakly so. Project finance therefore fulfills the role of a self regulating contract that reduces transaction costs. iii DEDICATION To my parents, Janardan and Charulata Sawant whose passion, encouragement, dedication and personal example made all this possible, Manisha for patience and understanding, Mehr and Manav, my personal investments in the future, and Rahul for constant and loyal support. iv ACKNOWLEDGEMENTS I thank my committee members for their advise, rigor and generosity. I especially thank Prof Laurent Jacque for his insightful, penetrating, incisive and rigorous feedback, for his patience, compassion and faith in me. I thank Prof Schena for his attention and enormous help with the econometric details and Prof Bruce Everett for his tremendous knowledge of the oil and gas industry, for enabling the data collection effort and for his sense of humor. I thank Prof Paul Vaaler for starting me off and supporting me as his Teaching Assistant and Prof Robert Nakosteen who selflessly gave of his time with statistical advice. I also thank the Hitachi Center for financial support and for selecting me as a Hitachi Scholar. None of this would have been possible without the dedication, passion, and superb teaching skills of my teachers particularly Prof Richard Shultz, Prof Carsten Kowalczyk, Prof Steve Block, Prof Joel Trachtman, Prof Ravi Sarathy, Prof Sanjiv Das, Prof Julie Schaffner. Finally I thank Carol Murphy the International Student Advisor for her enormous patience, Nora Moser and the Registrars Office for their understanding and support, Miriam Seltzer, Paula Cammarata and the staff of the Ginn library, Shelley Adams, Dorothy Orszulak and Jenifer Burckett-Picker for making the Fletcher experience an incredible one. All errors and mistakes are entirely mine. v TABLE OF CONTENTS Introduction 1 Chapter 1: Literature Review of Project Finance 4 1.1 Introduction Project Finance 7 1.2 Project Finance Applications 8 1.3 Project Finance loan characteristics 10 Chapter 2 : Theories of Project Finance 15 2.1 Project Finance as an asset specific investment by an initial user and a ‘redeployer’ of an asset 16 2.2 Theory of Incumbent management’s control benefits 19 2.3 Signaling Theory of Project Finance 21 2.4 Agency costs of free cash flow 23 2.5 Agency Costs of Risky Debt (Underinvestment) 25 3. Solutions to the Underinvestment Problem 29 3.1 Design of ex-ante contracts 33 3.1.1 The case of New Debt’s Strict Subordination to Existing Debt 34 3.1.2 The Case of New Debt’s Complete Seniority to Existing Debt 36 3.1.3 The Case of Project Finance 37 3.1.4 The Case of Secured Financing and Leasing 39 3.1.5 Analysis of corporate structure (Separate project finance structure or combined corporate structure) 41 4. Project Finance Asset Characteristic – High value under default 43 4.1 The case of high project value under default and low cash flow variance 44 4.2 The Case of high asset value under default and high cash flow variance 45 4.3 The case of low asset value under default and high variance in cash flows 46 4.4 The case of low asset value in default and low variance in cash flows 47 5. Agency Costs of Opportunism or Asset Specificity (Hold-up problem) 48 5.1 Introduction 48 5.2 Solutions for the hold up problem 50 5.2.1 Vertical Integration 52 5.2.2 Long term contracts 54 5.2.3 Use of debt 58 5.3 Empirical Research on the hold up problem 62 6. Conclusion 64 Chapter 3: Development of Hypotheses 66 1. Introduction 66 2. Testable Propositions from theory of Underinvestment 67 3. Testable Hypotheses – Transaction Costs of Opportunism or Hold-up 71 4. Table of Explanatory Variables 78 5. Conclusion 79 vi Chapter 4: Description of Data 81 1. Introduction 81 2. Data Collection Methodology 81 2.1 Corporate Financed Investments 81 2.2 Project Financed Investments 84 3. Data description 89 4. Conclusion 92 Chapter 5: Econometric Model Specification 93 1. Introduction 93 2. Model Specification 93 3. Logit and Probit models 95 4. Omitted variables bias 98 5. Treatment of JV partners 100 6. Conclusion 101 Chapter 6: Results of Econometric Analysis 102 1. Introduction 102 2. Bivariate Analysis 102 3. Panel 1 – Lead Firm In a project 104 4. Probit Model Results – Panel 1 109 5. Probit Model Results – Panel 2 114 6. Robustness Testing of the Results 116 7. Conclusion 121 Conclusion 123 Reference List………………………………………… ………………………………131 List of Sources 130 vii List of Tables Table I: Summary of Theoretical & Empirical Literature……………………………… 9 Table II: Analysis of Asset Risk…………………………………………………………46 Table III: List of Explanatory Variables…………………………………………… 82 Table IV: Summary of Data…………………………………………………………… 93 Table V: Statistical Properties of Corporate Vs Project Financed Investments… 93 Table VI: Summary of Statistics – Explanatory Variables………………………………94 Table VII: Pairwise Correlations………………………….……………………… 106 Table VIII: LPM, Logit and Probit Model coefficients… ……………………… 109 Table IX: Probit Model Marginal Effects, Panel 1……………………………… 113 Table X: Probit Model Marginal Effects, Panel 2…………………………………… 117 List of Figures Figure I: LOWESS of PF Propensity and Size of Investment…………………………120 Figure I: LOWESS of PF Propensity and Country Risk…….…………………………121 Figure I: LOWESS of PF Propensity and Fuel Exports…… …………………………122 Figure I: LOWESS of PF Propensity and Debt Coverage Ratio….……………………123 1 Introduction The financing and governance structure known as Project Finance has been used since Roman times 1 . In modern times Project Finance has grown as the form of financing structure for building pipelines, refineries, drilling oil wells, gasification plants 2 and other large capital-intensive infrastructure projects. Infrastructure Journal reports that project finance reached $212 B in 2006, an increase of 35% over 2005 3 . Project Finance has traditionally been a significant tool for cash strapped governments seeking to develop vital infrastructure. In fact according to a 2005 report by the Asian Development Bank, Japan Bank of International Cooperation and World Bank, Asia alone needs to spend $1 trillion over the next five years in road, water, communication and other infrastructure projects to meet the rapid rise of urbanization, population growth and growing demands of the private sector 4 . The European Union plans to spend €300B up to 2013 on infrastructure assets 5 . An understanding of project finance and its determinants is therefore likely to be helpful to governments, lenders, infrastructure funds and firms investing in these assets. Stulz and Johnson (1985), Berkovitch and Kim (1990), John and John (1991) and Esty (2003) all contend that firms use project finance to lower “deadweight” costs induced by stockholder-debtholder conflict (underinvestment), and by the threat of opportunism between project sponsors and suppliers, customers and host governments 1 Buljevich and Park (1999) 2 The Suez Canal was built on a PF basis as were the UK’s North Sea oilfields. 3 Global Investor, Feb 2007. 4 ADB, JBIC, and the World Bank, "Connecting East Asia: A New Framework for Infrastructure". Accessed Jan 2008. Available from http://www.adb.org/Projects/Infrastructure- Development/infrastructure-study.pdf. 5 Financial Times, Oct 22, 2007. 2 arising from high asset specificity. Although the theoretical literature is well developed, supporting empirical evidence has largely been restricted to case studies (Esty 1999, 2001). I fill this empirical research gap with a large sample statistical study to formally test the transaction costs problem and the underinvestment problem. Since investments are a result of firm-level factors as well as project characteristics I focus on why and how firm-level factors as well as project characteristics induce managers to decide on the financing and governance structures of new investments. Theory posits that the deadweight costs of underinvestment require an investigation of individual firm level characteristics while deadweight costs from asset specificity and opportunism between project sponsors, customers, suppliers and host governments requires investigation of individual project characteristics. To this end I use firm-level stock market and balance sheet data comprising both project finance and corporate financed investments to test underinvestment variables. I use project-level supplier, customer, and host government data comprising both project finance and corporate financed investments to test the transaction costs from the threat of opportunistic behavior. I construct a database of project finance and non project finance investments restricting the sample to the oil and gas industry. Consistent with the core contention of the underinvestment and transaction costs theory, I test whether firms with high underinvestment and transaction costs are more likely to undertake project finance than corporate financed modes of investments. I conduct this test by regressing the propensity of a firm to undertake project finance against a set of control variables and key explanatory variables suggested in previous conceptual research as leading to high agency costs. [...]... balancesheets Therefore, they can only look to the performance of the project company’s assets to satisfy their outstanding loans Project Finance is the financing of a particular economic unit in which a lender is satisfied to look only to the cash flows and earnings of that economic unit as the source of funds from which the loan will be repaid and to the assets of the economic unit as collateral for the loan... finance is a means of allocating optimal ownership over specific assets The particular financing structure of project finance enables investors to hand control over of project financed assets to ‘redeployers’ in a state of the world where the primary use of the asset has lost value The redeployer is skilled in the alternate use of the asset b Chemmanur and John (1996) analyze project finance through the. .. 72 8 range of assets and industries Project finance has been used to finance theme parks like the Hong Kong Disneyland theme park, undersea telecommunication cable companies like the Australia-Japan Cable project, the Euro-tunnel project, the A2 Motorway in Poland, and Chad-Cameroon Pipeline Project finance loans have been very successfully used in the development of the North Sea oil fields, the Ras... loans) shows that project finance is a different form of financing They measure the impact of loan size, maturity, guarantee, currency risk, country risk and the presence of collateralizable assets 10 on the cost of project finance loans measured as a spread over LIBOR They find that project finance differs from corporate finance in the following manner: a) PF loans have longer average maturities than... (Megginson and Kleimeier (2000), Esty (2003)) shows that project finance is indeed a distinct form of financing with unique characteristics Sections 1.1, 1.2 and 1.3 of the review lays out these characteristics of project finance The use of project finance and its persistence through history and into modern times indicates that project finance indeed serves an economic purpose Theoretical research into the. .. running and therefore future defaults could change the results The next section lays out the theoretical literature explaining the determinants of project finance 14 Chapter 2 : Theories of Project Finance Project Finance as a unique financing structure has received considerable attention in the theoretical literature The main theories are as follows; a Habib and Johnsen (1999) have posited that project finance. .. Lenders are therefore able to obtain possession of aircraft for redeployment without ex-post bargaining with the airlines Habib and Johnsen also cite the case of lending by finance companies secured by receivables and inventories of the firms they finance They hypothesize that finance companies possess special skills at redeploying these assets and thus can loan to riskier borrowers Carey, Post and Sharpe... project finance reduces costs from underinvestment and transaction costs and derives empirically testable hypotheses Hypotheses most important to this dissertation include, “Firms with risky debt outstanding have a high propensity to undertake project finance. ” and “Supplier and Buyer concentration increases the propensity for project finance. ” Chapter 4 describes the data and the methodology of data... economic determinants of project finance reveals at least six distinct theories about the economic problems that project finance solves Project finance has been posited as a means of allocating optimal ownership over specific assets by Habib and Johnsen (1996) This theory is explored in Section 2.1 Analysis of managerial decisions leads Chemmanur and John (1996) to posit that the project finance structure... to look initially to the cash flows…” to “…a lender is satisfied to look only to the cash flows…” Brealey, Cooper and Habib (1996) define the characteristics of project finance as a distinct financing structure These characteristics are; a) The project manager or sponsor establishes a separate company specifically limited to execution and management of the project b) The sponsor/sponsors provide the . The Economics of Large Scale Infrastructure Project Finance: An Empirical Examination of the Propensity to Project Finance A Thesis Presented to the Faculty Of The Fletcher. growth and growing demands of the private sector 4 . The European Union plans to spend €300B up to 2013 on infrastructure assets 5 . An understanding of project finance and its determinants is therefore. Introduction Project Finance 7 1.2 Project Finance Applications 8 1.3 Project Finance loan characteristics 10 Chapter 2 : Theories of Project Finance 15 2.1 Project Finance as an asset specific