Misconceptions about project finance are present not only in groups outside this area but also, among some project participants due to limited exposure to, knowledge of, and
experience in project finance. These misconceptions manifest themselves in errors of judgment, incomplete evaluations, miscalculations, wrong assumptions and decisions, poor negotiation positions and posture, and protracted negotiations and re work of
agreements. Project finance misconceptions account for a good part of lengthy back and forth negotiations and are a cause of project failures. Opinions or beliefs behind
expressed misconceptions include the following:
1. Project finance is nonrecourse finance. True; there is no recourse to the
sponsor(s) balance sheet, but in the event of risks materializing that lead to
discontinuing operations and dissolution of the project company, there is a loss of their investment. No recourse does not equal no loss in any case.
2. Project financing is cheap. True, but it depends. There are cases where subsidies from international development associations or donor organizations, unilateral and multilateral agency enhancements, and government in kind contributions make the financing costs of a project lower than without them. But, corporate or direct financing of a project is less expensive than project financing in the absence of subsidies and the advantage of project financing is that it makes possible to fund a project of credit
impaired customers than otherwise would be the case.
3. Barriers to entry guarantee project success. Because infrastructure projects ordinarily involve the host country government's participation, the issuance of licenses and permits, a monopoly project company status, and substantial upfront investment, these factors usually ensure the economic viability of the project company. Because of the project security package, this thinking does not take into account fluidity of developing country political and economic conditions and industry and market changes and often leads to complacency. Complacency in the quality of the project company's products or services and management of the relationship with the host country's government agencies invites competition that usually come in the form of a second operating license or regulatory regime changes.
4. Build it and they will come. This belief assumes that because there is a need for the project company's products or services and the characteristics of the project will satisfy customer or user needs. Therefore, the project will attract a sufficient number of customers or users and create adequate demand to make the project a success.
However, without market research to establish desire for the product or service and the willingness of customers or users and their ability to pay, such view is baseless.
That is, it does not really understand needs and pricing that would make the products or services affordable, it is plagued with overoptimistic revenue forecasts, and is
prescription of project underperformance and even failure.
5. Project approvals for developing country projects are routine. This misconception has to do with the presence of ECA and multilateral agency
enhancements, support, and project reviews flexibility which make approvals easier to get because of the urgent help needed by developing countries with no public budgets to undertake infrastructure projects. This is not true and comes from ignorance of processes, evaluations, and requirements of these institutions that are accountable for investments to all projects they support and, therefore, they ensure that their
investments or support are in viable projects. Export credit agencies and multilaterals have expertise in scrutinizing projects using well developed processes and
requirements that take time to complete before final board review and approval. That is to say, sponsors or developers should not expect immediate project support
approvals; not even an indication of their interest in participation.
6. If the project passed due diligence, there is no problem. Unlike lenders, other project participants are under the impression that raising funds for the project is forthcoming simply because the due diligence found no glaring major errors,
omissions, discrepancies, technical issues, and objections and that funding is then only a formality. The due diligence is only one hurdle the project must pass to make it bankable. Other hurdles, such as stress testing the validity of assumptions and
financial ratios under less favorable scenarios and validating creditworthiness of parties behind the security package must also be performed.
7. The project advisors know; we do not need to know. This mindset of sponsor or developer project teams is troubling because it assumes that project financing advisors fully understand sponsor and the customer true needs, interests, objectives, and requirements. It also assumes that advisors have the ability to conduct
appropriate analyses and evaluations and their capacity to deliver on all expectations.
This mentality leads to delays, rework, and inefficiencies throughout the process and increase advisor and project costs. Also, it does not ensure that these participants receive the benefits they expect to receive from the project.
8. Any project can be project financed. This view is too nạve to hold true
universally. Projects need to meet the basic criteria of project finance. That is, they must have adequate and stable cash flow and reasonable debt ratios, sufficient sponsor equity and debt funding, credit enhancements, and adequate lender
protection, all of which necessitate development and negotiation of agreements. There is also a project size requirement because of the high cost of project development and preparation and negotiation of contractual agreements: The minimum project size for project financing purposes is in the neighborhood of US$75 to $100 million.
Otherwise, the project costs are overbearing and projects become unprofitable.
CHAPTER 3
The Record of Project Finance Lessons to Avoid Failures
Project finance deals are commonly viewed as sound investments because of the security packages and the web of negotiated contracts. The prevailing view is that failures are limited and losses are minimized when the security package includes a security
agreement, a pledge of assets agreement, a mortgage or a deed of trust, and a direct agreement. Other considerations that limit failures are the following:
1. Sponsor equity investment is usually adequate in the 20% to 40% range of project costs
2. Sufficient risk insurance across all common project risks and strong host government guarantees are pledged
3. Tight engineering, procurement, and construction (EPC), offtake, supply, and operations and management (O&M) contracts are negotiated and signed
4. Interest rate and foreign exchange rate hedging contracts are in place
5. The ECA and/or multilateral agency providing support and help in project approvals is present
6. Lenders always get rights to control project company assets in the event of underperformance
7. Waterfall accounts, covenants, and restrictions are included in the financing documentation
8. Depository account agreements control the flow of cash from the project company For large capital investment projects, it is difficult to measure success or failure for three reasons: Assessment is done along several dimensions, political considerations cloud project performance ratings, and failure grading is usually subjective. For example, Global Infrastructure Basel (2014) grades sustainable infrastructure along a number of
dimensions, most of them being qualitative, such as:
1. Meeting host government financial and social objectives 2. Proactive and effective risk project lifecycle management 3. Equitable and balanced project cost and benefit agreements 4. Transparency of procurement processes and practices
5. Sound and efficient project financing is obtained
6. Sufficient project output to fill consumer or user needs
7. Project economic value creation according to project evaluations and project company
business plan
Project finance success is difficult to measure and the alternative is to define project failure by the default rate of project finance loans. A Moody's Investor Services 10 year study shows that “project finance is a robust class of specialized lending” and that “default rates of project finance loans are consistent with those recovery rates of low grade
corporate issuers and recovery rates of 80.3% as defined by Basel II.” Notice, however, that the number of projects that failed to achieve the expected economic value is greater than the number of bank loan defaults because projects may not create the expected economic value and yet, not have loan defaults.
The definition of Basel II default rates is based on a complex formula, but for practical purposes they are bank losses that include unpaid principal and accumulated interest, discounts, and the costs of collecting on default loans.
In the next section we present findings from different studies of project finance loan
defaults by industry and region. For our purposes, loan defaults constitute project failures that are commonly accepted as a reasonable quantitative way to measure objectively if a project has met financial expectations. Section 3.2 is a discussion of common reasons for project finance failures along major categories and prepares the stage to avoid pitfalls in different project stages. Section 3.3 presents a summary of valuable key lessons learned help avoid failures and increase chances of project success.