A COMPARATIVE ANALYSIS OF

MUTUAL FUNDS WITH SPECIAL

EMPHASIS ON SIP AND LUMPSUM
INVESTMENTS

A PROJECT REPORT

Submitted by

SAKET AGARWAL

in partial fulfillment for the award of the degree

of

BACHELOR OF COMMERCE

1
 In

FINANCE

ST. XAVIERS COLLEGE (AUTONOMOUS),KOLKATA

MARCH, 2010

ST. XAVIER’S COLLEGE(AUTONOMOUS),

KOLKATA

BONAFIDE CERTIFICATE

Certified that this project report “A COMPARATIVE ANALYSIS OF MUTUAL

FUNDS WITH SPECIAL EMPHASIS ON SIP & LUMPSUM INVESTMENTS”
is the bonafide work of “SAKET AGARWAL” who carried out the project work
under my supervision.

2
SIGNATURE SIGNATURE

HEAD OF THE DEPARTMENT SUPERVISOR

DEPT. OF COMMERCE (EVE.) DEPT. OF COMMERCE (EVE.)

30 MOTHER TERESA SARANI 30 MOTHER TERESA SARANI

KOLKATA 700 016 KOLKATA 700 016

3
ACKNOWLEDGEMENT

First and foremost, I would like to extend my deepest gratitude to my

guide Professor Kaushik Chatterjee for his support. His constant
encouragement motivated me to perform to the best of my ability.

I am sincerely thankful to my teachers, without whose supervision and

guidance this project would not have been completed.

Also, I would like to convey my gratitude to Mr. Sanjay Saraf of SSEI

Ltd. Who gave me valuable knowledge on the subject.

Also, I would like to speacially thank Mr. Basant Maheshwari, Director

of www.theequitydesk.com for providing and guiding me on the various
regulations governing the stock market.

4
ABSTRACT

Finance is the lifeblood of business. Finance is indispensable, it is rightly

said that finance is the lifeblood of an enterprise. This is because in modern
money oriented economy, finance is one of the basic foundations of all kinds
of economic activities. It is needed to convert ideas into reality.

It may be arranged in many ways – and project finance is one such way. It is
the raising of funds on a limited recourse or non-recourse basis to finance an
economically separable capital investment project in which the providers of
the funds look primarily to the cash flow from the project as the source of
funds to service their loans and provide a return on their equity invested in
the project.

As an effective alternative to conventional direct financing, project financing

has become one of the hottest topics in corporate financing. It’s being used
more and more frequently on a wide variety of high profile corporate
projects.

Through this project I have highlighted on the rationale of project finance,

the characteristics and scheme of project finance, and the security
arrangements, project structure, project risks and its mitigation. Financial
modelling calculations are also shown and the various sources of project
funds have also been highlighted.

5
The presented case study involves a peep into Enron scandal and the way it
has impacted project finance, as after Enron project finance was widely
criticized.

Table of Contents

PAGE NO.

1. INTRODUCTION
1.1 Rationale of Project Finance
1-2
1.2 Characteristics of Project Finance
3
1.3 Basic Scheme of Project Finance
4-5

2. LITERATURE REVIEW
2.1 Definition of Project Finance
6-7
2.2 Project Financing Arrangements
8-9
2.2.1 Build Own Operate Transfer
2.2.2 Build Own Operate Structure
2.2.3 Build Lease Transfer Structure
2.3 Project Viability and Financial Modelling
10-23
2.3.1 Technical Feasibility
2.3.2 Project Construction Cost
6
 2.3.3 Economic Viability
2.3.4 Adequacy of Raw Material Supplies
2.3.5 Creditworthiness
2.3.6 Financial Modelling
2.4 Project Finance Risk
24-34
2.4.1 Risk Minimization Review
2.4.2 Types Of Risks
2.5 Security Arrangements
35-39
2.5.1 Security Arrangements Covering Completion of Project
2.5.2 Direct Security Interest in Project’s Facilities
2.5.3 Security Covering Debt Service
2.5.4 Purchase And Sale Contract
2.5.5 Raw Material Supply Agreement
2.5.6 Supplemental Credit Support
2.5.7 Financial Support Agreement
2.5.8 Cash Deficiency Agreement
2.5.9 Escrow Fund
2.5.10 Insurance
2.6 Legal Structure
40-44
2.6.1 Undivided Joint Interest
2.6.2 Corporations
2.6.3 Partnerships
2.7 Sources Of Funds
45-49

3. CASE STUDY: HOW ENRON HAS AFFECTED PROJECT FINANCE

3.1 The Enron Story
50-51

7
 3.2 Caution among Lenders and Investors
52-53
3.3 Project Finance And Enron Factor
53-64
3.3.1 Effect on Traditional Project Finance
3.3.2 Effect in Structured Project Finance
3.3.3 Sources of Free Cash Flow
3.3.4 Security Interests
3.3.5 How Companies Have Responded
3.3.6 Increased Transparency and Disclosure
3.3.7 Regulatory Issues
3.4 Other Lessons Learned
65-66

4. CONCLUSION
67

BIBLIOGRAPHY
68

8
9
10
11
CONTENTS

PARTICULARS PAGE NO.

1. INTRODUCTION 4

2. LITERATURE REVIEW 6

3. METHODOLOGY 17

4. HYPOTHESIS 26

5. RESULTS 27

6. CONCLUSION 28

7. EXECUTIVE SUMMARY 30

ANNEXURE

BIBLIOGRAPHY

12
 1. INTRODUCTION

1.1 Rationale of Project Financing

13
There is a growing realization in many developing countries of the
limitations of governments in managing and financing economic activities,
particularly large infrastructure projects, Provision of infrastructure
facilities, traditionally in the government domain, is now being offered for
private sectors investments and management. This trend has been
reinforced by the resource crunch faced by many governments.
Infrastructure projects are usually characterized by large investments, long
gestation periods, and very specific domestic markets.

In project financing the project, its assets, contracts, inherent economic and
cash flows are separated from their promoters or sponsors in order to permit
credit appraisal and loan to the project, independent of the sponsors. The
assets of the specific project serve as a collateral for the loan, and all loan
repayments are made out of the cash of the project. In this sense, the loan
is said to be of non-resource to the sponsor.

14
Thus, project financing may be defined as the scheme of ‘financing of a
particular economic unit in which l lender is satisfied in looking at the cash
flows and the earnings of that economic unit as a source of funds, from
which a loan can be repaid, and to the assets of the economic unit as a
collateral for the loan. In the past, project financing was mostly used in oil
exploration and other mineral extraction through joint ventures with foreign
firms. The most recent use of project financing can be found in
infrastructure projects, particularly in power and telecommunication
projects. Project financing is made possible by combining undertakings and
various kinds of guarantees by parties who are interested in a project. It is
built in such a way that no one party alone has to assume the full credit
responsibility of the project. When all the undertakings are combined and
reviewed together, it results in an equivalent of the satisfactory credit risk
for the lenders. It is often suggested that the project financing enables a
parent company to obtain inexpensive loans without having to bear all the
risks of the project. This is not true, in practice, the parent company is
affected by the actual plight of the project, and the interests on the project
loan depend on the parents stake in the project. The traditional form of
financing is the corporate financing or the balance sheet financing. In this
case, although financing is apparently for a project, the lender looks at the
cash flows and assets of the whole company in order to service the debt and
provide security.

15
1.2 Characteristics of Project Finance

The following are the characteristics of project financing:

• A separate project entity is created that receives loans from lenders and
equity from sponsors.

• The component of debt is very high in project financing. Thus, project

financing is a highly leveraged financing.

• The project funding and all it’s other cash flows are separated from the
parent company’s balance sheet.

• Debt services and repayments entirely depend on the project’s cash flows.
Project assets are used as collateral for loan repayments.

• Project financers’ risks are not entirely covered by the sponsor’s

guarantees.

• Third parties like suppliers, customers, government and sponsors commit

to share the risk of the project.

16
Project financing is most appropriate for those projects, which require large
amount of capital expenditure and involve high risk. It is used by
companies to reduce their own risk by allocating the risk to a number of
parties.

It allows sponsors to:

• Finance large projects than the company’s credit and financial capability
would permit.

• Insulate the company’s balance sheet from the impact of the project.

• Use high degree of leverage to benefit the equity owners.

1.3 Basic Scheme of Project Finance

The basic scheme of project finance has been explained with an example:

Acme Coal Co. imports coal. Energen Inc. supplies energy to consumers.
The two companies agree to build a power plant to accomplish their
respective goals. Typically, the first step would be to sign a memorandum of
understanding to set out the intentions of the two parties. This would be
followed by an agreement to form a joint venture.

17
Acme Coal and Energen form an SPV (Special Purpose Vehicle) called
Power Holdings Inc. and divide the shares between them according to their
contributions. Acme Coal, being more established, contributes more capital
and takes 70% of the shares. Energen is a smaller company and takes the
remaining 30%. The new company has no assets.

Power Holdings then signs a construction contract with Acme Construction

to build a power plant. Acme Construction is an affiliate of Acme Coal and
the only company with the know-how to construct a power plant in
accordance with Acme's delivery specification.

A power plant can cost hundreds of millions of dollars. To pay Acme

Construction, Power Holdings receives financing from a development bank
and a commercial bank. These banks provide a guarantee to Acme
Construction's financier that the company can pay for the completion of
construction. Payment for construction is generally paid as such: 10% up
front, 10% midway through construction, 10% shortly before completion,
and 70% upon transfer of title to Power Holdings, which becomes the owner
of the power plant.

Acme Coal and Energen form Power Manage Inc., another SPV, to manage
the facility. The ultimate purpose of the two SPVs (Power Holding and
Power Manage) is primarily to protect Acme Coal and Energen. If a disaster
happens at the plant, prospective plaintiffs cannot sue Acme Coal or Energen
and target their assets because neither company owns or operates the plant.

A Sale and Purchase Agreement (SPA) between Power Manage and Acme
Coal supplies raw materials to the power plant. Electricity is then delivered
to Energen using a wholesale delivery contract. The cash flow of both Acme
Coal and Energen from this transaction will be used to repay the financiers.

18
FIGURE - I

2. LITERATURE REVIEW

19
2.1 Definition of Project Finance

There is no single agreed upon definition for project finance.

For example, Finnerty defines project finance as:

The raising of funds to finance an economically separable

capital investment project in which the providers of the
funds look primarily to the cash flow from the project as the
source of funds to service their loans and provide the return
of and a return on their equity invested in the project.

While Nevitt and Fabozzi defines it as:

A financing of a particular economic unit in which a lender

is satisfied to look initially to the cash flow and earnings of
that economic unit as the source of funds from which a loan
will be repaid and to the assets of the economic unit as
collateral for the loan.

And the International Project Finance Association (IPFA) defines project

finance as:

The financing of long-term infrastructure, industrial

projects and public services based upon a non-recourse or
limited recourse financial structure where project debt and
equity used to finance the project are paid back from the
cash flow generated by the project.

Although none of these definitions uses the term “nonrecourse debt”

explicitly (i.e., debt repayment comes from the project company only rather
than from any other entity), they all recognize that it is an essential feature of
project finance.[1]
20
The following definition, albeit slightly more cumbersome, allows one to
distinguish project finance from other financing vehicles, something the
previous two definitions cannot do:

Project finance involves the creation of a legally and

economically independent project company financed with
nonrecourse debt (and equity from one or more corporate
sponsors) for the purpose of financing a single purpose,
capital asset usually with a limited life.

--------------------------------------------------------------------------------------------

[1] Limited recourse debt—debt that carries a repayment guarantee for a

defined period of time, for a fraction of the total principal, or until a certain
milestone is achieved (e.g., until construction is complete or the project
achieves a minimum level of output)—is a subset of nonrecourse debt. The
distinguishing feature is that at least some portion of the debt becomes
nonrecourse at some point in time.

21
2.2 Project Financing Arrangements

The project financing arrangements may range from simple conventional

type of loans to more complex arrangements like the build-own-operate-
transfer (BOOT).

The typical arrangements include:

2.2.1 ‘The build-own-operate-transfer (BOOT) structure

2.2.2 The build-own-operate (BOO) structure

2.2.3 The build-lease-transfer (BLT) structure

2.2.1 ‘The build-own-operate-transfer (BOOT) structure

22
It is a special financing scheme, which is designed to attract private
participation in financing constructing and operating infrastructure projects.
In BOOT scheme, a private project company builds a project, operates it for
a sufficient period of time to earn an adequate return on investment, and then
transfers it to the host government or its agency. Quite often, the value of
efficiency gain from private participation can outweigh the extra cost of
borrowing through a BOOT project, relative to direct government borrowing.
The private group usually consists of international construction contractors,
heavy equipment suppliers, and plant and system operators along with local
partners.

2.2.2 The Build-Own-Operate (BOO) Arrangement

The issue of “transfer”(the T in BOOT projects) is ambiguous because most

of the BOOT projects under operation or consideration have the transfer
dates quite far away and, therefore, they are not a real concern as yet. One
problem with the transfer provision is the likelihood of the capital stock of
the project being run down as the date of transfer draws bearer.

23
2.2.3 Build-Lease-Transfer arrangement

In the build lease transfer arrangement, the control of the project is

transferred from the project owners to a lease. The shareholders retain the
full ownership of the project, but, for operation purposes, they lease it to a
lessee. The host government agrees with the lessee to buy the output or
service of the project. The lesser receives the lease rental guaranteed by the
host government.

2.3 PROJECT VIABILITY AND FINANCIAL MODELLING

24
Investors are concerned about all the risks a project involves, who will bear
each of them, and whether their returns will be adequate to compensate them
for the risks they are being asked to bear. Both the sponsors and their adviser
must be thoroughly familiar with the technical aspects of the project and the
risks involved, and they must independently evaluate a projects economics
and its ability to service project related borrowings.

2.3.1.Technical Feasibility:

Prior to the start of construction, the project sponsors must undertake

extensive engineering work to verify the technological processes and design
of the proposed facility. If the project requires new or unproven technology,
test facilities or a pilot plant will normally have to be constructed to test the
feasibility of the process involved and to optimize the design of full scale
facilities. A well-executed design will accommodate future expansion of the
project; often, expansion beyond the initial operating capacity is planned at
the outset. The impact of project expansion on operating efficiency is then
reflected in the original design specifications and financial projections.

25
2.3.2 Project Construction Cost:

The detailed engineering and design work provides the basis for estimating
the construction costs for the project. Construction costs should include the
cost of all facilities necessary for the project’s operation as a freestanding
entity. Construction costs should include contingency factor adequate to
cover possible design errors or unforeseen costs. Project sponsors or their
advisers generally prepare a time schedule detailing the activities that must
be accomplished before and during the construction period. A quarterly
breakdown of capital expenditures normally accompanies the time schedule.

The time schedule specifies

(1) Time expected to be required to obtain regulatory or environmental

approvals and permits for construction.

(2) The procurement lead time anticipated for major pieces of equipment and

(3) The time expected to be required from pre-construction activities-

performing detailed design work, ordering the equipment and building
materials, preparing the site and hiring the necessary manpower.

26
The project sponsor examines the critical path of the construction schedule to
determine where the risk of delay is greatest and then assesses the potential
financial impact of any projected delay.

2.3.3 Economic Viability:

27
 The critical issue concerning economic viability is whether the project’s
expected net present value is positive. It will be positive only if the expected
present value of the future free cash flows exceeds the expected present
value of the project’s construction costs. All the factors that can affect
project cash flows are important in making this determination. Assuming that
the project is completed on schedule and within budget, its economic
viability will depend primarily on the marketability of the projects output
(price and volume). To evaluate marketability, the sponsors arrange for a
study of projected supply and demand conditions over the expected life of
the project. The marketing study is designed to confirm that, under a
reasonable set of economic assumptions, demand will be sufficient to absorb
the planned output of the project at a price that will cover the full cost of
production, enable the project to service its debt, and provide an acceptable
rate of return to equity investors.

The marketing study generally includes:

1) A review of competitive products and their relative cost of production;

2) An analysis of the expected life cycle for project output, expected sales
volume, and projected prices; and

3) An analysis of the potential impact of technological obsolescence.

28
An independent firm of experts usually performs the study. If the project
will operate within a regulated industry, the potential impact of regulatory
decisions on production levels and prices—and, ultimately, on the
profitability of the project –must also be considered. The cost of production
will affect the pricing of the project output. Projections of operating costs are
prepared after project design work has been completed. Each cost element,
such as raw materials, labor, overhead, taxes, royalties, and maintenance
expense, must be identified and quantified. Typically, this estimation is
accomplished by dividing the cost element into fixed and variable cost
components and estimating each category separately. Each operating cost
element should be escalated over the term of the projections at a rate that
reflects the anticipated rate of inflation. From a financing standpoint, it is
important to assess the reasonableness of the cost estimates and the extent to
which the pricing, and hence the marketability, of the project output is likely
to be affected by estimated cost inflation rates. In addition to operating costs,
the project’s cost of capital must be determined. The financial adviser
typically is responsible for this task. He develops and tests various financing
plans for the project in order to arrive at an optimal financing plan that is
consistent with the business objectives of the project sponsor.

2.3.4 Adequacy of raw material supplies:

29
The project should have sufficient supplies of raw materials to enable it to
operate at design capacity over the term of the debt. Independent consultants
may be summoned to evaluate the quantity, grade, and rate of extraction that
the mineral reserves available to the project are capable of supporting. The
project should have the ability to access the raw materials through
contractual agreements like direct ownership, lease, purchase agreement etc.

2.3.5 Creditworthiness:

A project has no operating history at the time of its initial debt financing.
Consequently, the amount of debt the project can raise is a function of the
project’s expected capacity to service debt from project cash flow- or more
simply, its credit strength.

A project’s credit strength derives from

(1) The inherent value of the assets included in the project,

(2) The expected profitability of the project,

(3) The amount of equity project sponsors have at risk,

(4) The pledges of creditworthy third parties or sponsors involved in the

project.

30
Thus,

To arrange financing for a stand-alone project, prospective lenders must be

convinced that the project is technically feasible and economically viable and
that the project will be sufficiently creditworthy if financed. Establishing
technical feasibility requires demonstrating that the construction can be
completed on schedule and within budget and that the project will be able to
operate at its design capacity following completion. Establishing economic
viability requires demonstrating that the project will be able to generate
sufficient cash flow so as to cover its overall cost of capital.
Creditworthiness will be established by demonstrating that even under
reasonably pessimistic circumstances, the project will be able to generate
sufficient revenue to cover all operating costs and to service project debt in a
timely manner. The loan terms have an impact on how much debt the project
can incur and still remain creditworthy.

2.3.6 Financial Modelling

EXAMPLE: To illustrate how financial modeling is done a 50MW power

plants calculation is shown below:

31
2.4 PROJECT FINANCE RISK

2.4.1 Risk Minimization Process

Financiers are concerned with minimizing the dangers of any events that
could have a negative impact on the financial performance of the project, in
particular, events that could result in:
32
(1) The project not being completed on time, on budget, or at all;

(2) The project not operating at its full capacity;

(3) The project failing to generate sufficient revenue to service the debt; or

(4) The project prematurely coming to an end.

The minimization of such risks involves a three-step process. The first step
requires the identification and analysis of all the risks that may bear upon the
project. The second step is the allocation of those risks among the parties.
The last step involves the creation of mechanisms to manage the risks.

If a risk to the financiers cannot be minimized, the financiers will need to

build it into the interest rate margin for the loan.

STEP 1 - Risk identification and analysis

33
The project sponsors will usually prepare a feasibility study, e.g. as to the
construction and operation of a mine or pipeline. The financiers will
carefully review the study and may engage independent expert consultants to
supplement it. The matters of particular focus will be whether the costs of the
project have been properly assessed and whether the cash-flow streams from
the project are properly calculated. Some risks are analyzed using financial
models to determine the project's cash flow and hence the ability of the
project to meet repayment schedules. Different scenarios will be examined
by adjusting economic variables such as inflation, interest rates, exchange
rates and prices for the inputs and output of the project. Various classes of
risk that may be identified in a project financing will be discussed below.

STEP 2 - Risk allocation

Once the risks are identified and analyzed, they are allocated by the parties
through negotiation of the contractual framework. Ideally a risk should be
allocated to the party who is the most appropriate to bear it (i.e. who is in the
best position to manage, control and insure against it) and who has the
financial capacity to bear it. It has been observed that financiers attempt to
allocate uncontrollable risks widely and to ensure that each party has an
interest in fixing such risks. Generally, commercial risks are sought to be
allocated to the private sector and political risks to the state sector.

34
STEP 3 - Risk management

Risks must be also managed in order to minimize the possibility of the risk
event occurring and to minimize its consequences if it does occur. Financiers
need to ensure that the greater the risks that they bear, the more informed
they are and the greater their control over the project. Since they take
security over the entire project and must be prepared to step in and take it
over if the borrower defaults. This requires the financiers to be involved in
and monitor the project closely. Such risk management is facilitated by
imposing reporting obligations on the borrower and controls over project
accounts. Such measures may lead to tension between the flexibility desired
by borrower and risk management mechanisms required by the financier.

2.4.2 TYPES OF RISKS

Of course, every project is different and it is not possible to compile an

exhaustive list of risks or to rank them in order of priority. What is a major
risk for one project may be quite minor for another. In a vacuum, one can
just discuss the risks that are common to most projects and possible avenues
for minimizing them.

However, it is helpful to categorize the risks according to the phases of the

project within which they may arise:

(i) The design and construction phase;

35
(ii) The operation phase; or

(iii) Risks common to both construction and operational phases.

It is useful to divide the project in this way when looking at risks because the
nature and the allocation of risks usually change between the construction
phase and the operation phase.

(i) Construction phase risk –

36
Completion risk:

Completion risk allocation is a vital part of the risk allocation of any project.
This phase carries the greatest risk for the financier. Construction carries the
danger that the project will not be completed on time, on budget or at all
because of technical, labour, and other construction difficulties. Such delays
or cost increases may delay loan repayments and cause interest and debt to
accumulate. They may also jeopardize contracts for the sale of the project's
output and supply contacts for raw materials.

Commonly employed mechanisms for minimizing completion risk before

lending takes place include:

(a) Obtaining completion guarantees requiring the sponsors to pay all debts
and liquidated damages if completion does not occur by the required date;

(b) Ensuring that sponsors have a significant financial interest in the success
of the project so that they remain committed to it by insisting that sponsors
inject equity into the project;

(c) Requiring the project to be developed under fixed-price, fixed-time

turnkey contracts by reputable and financially sound contractors whose
performance is secured by performance bonds or guaranteed by third parties;

(d) Obtaining independent experts' reports on the design and construction of

the project.

37
Completion risk is managed during the loan period by methods such as
making pre-completion phase drawdown’s of further funds conditional on
certificates being issued by independent experts to confirm that the
construction is progressing as planned.

(ii) Operation phase risk

Resource / reserve risk

This is the risk that for a mining project, rail project, power station or toll
road there are inadequate inputs that can be processed or serviced to produce
an adequate return.

For example, this is the risk that there are insufficient reserves for a mine,
passengers for a railway, fuel for a power station or vehicles for a toll road.
Such resource risks are usually minimized by:

(a) Experts’ reports as to the existence of the inputs (e.g. detailed reservoir
and engineering reports which classify and quantify the reserves for a mining
project) or estimates of public users of the project based on surveys and other
empirical evidence (e.g. the number of passengers who will use a railway);

38
(b) Requiring long term supply contracts for inputs to be entered into as
protection against shortages or price fluctuations (e.g. fuel supply
agreements for a power station);

(c) Obtaining guarantees that there will be a minimum level of inputs (e.g.
from a government that a certain number of vehicles will use a toll road); and

(d) "Take or pay" off-take contacts, which require the purchaser to make
minimum payments even if the product cannot be delivered.

Operating risk

These are general risks that may affect the cash flow of the project by
increasing the operating costs or affecting the project's capacity to continue
to generate the quantity and quality of the planned output over the life of the
project. The usual way for minimizing operating risks before lending takes
place is to require the project to be operated by a reputable and financially
sound operator whose performance is secured by performance bonds.
Operating risks are managed during the loan period by requiring the
provision of detailed reports on the operations of the project and by
controlling cash-flows by requiring the proceeds of the sale of product to be
paid into a tightly regulated proceeds account to ensure that funds are used
for approved operating costs only.

39
Market / off-take risk

Obviously, the loan can only be repaid if the product that is generated can be
turned into cash. Market risk is the risk that a buyer cannot be found for the
product at a price sufficient to provide adequate cash flow to service the
debt. The best mechanism for minimizing market risk before lending takes
place is an acceptable forward sales contact entered into with a financially
sound purchaser.

(iii) Risks common to both construction and operational phases

Participant / credit risk

These are the risks associated with the sponsors or the borrowers themselves.
The question is whether they have sufficient resources to manage the
construction and operation of the project and to efficiently resolve any
problems that may arise. Of course, credit risk is also important for the
sponsors' completion guarantees. To minimize these risks, the financiers
need to satisfy themselves that the participants in the project have the
necessary human resources, experience in past projects of this nature and are
financially strong.

40
Technical risk

This is the risk of technical difficulties in the construction and operation of

the project's plant and equipment, including latent defects. Financiers usually
minimize this risk by preferring tried and tested technologies to new
unproven technologies. Technical risk is also minimized before lending takes
place by obtaining experts reports as to the proposed technology. Technical
risks are managed during the loan period by requiring a maintenance
retention account to be maintained to receive a proportion of cash flows to
cover future maintenance expenditure.

Currency risk

Currency risks include the risks that:

(a) A depreciation in loan currencies may increase the costs of construction

where significant construction items are sourced offshore; or

(b) A depreciation in the revenue currencies may cause a cash-flow problem

in the operating phase.

Mechanisms for minimizing currency risk include:

41
(a) Matching the currencies of the sales contracts with the currencies of
supply contracts as far as possible;

(b) Denominating the loan in the most relevant foreign currency; and

(c) Requiring suitable foreign currency hedging contracts to be entered into.

Regulatory / approvals risk

These are risks that government licenses and approvals required to construct
or operate the project will not be issued (or will only be issued subject to
onerous conditions), or that the project will be subject to excessive taxation,
royalty payments, or rigid requirements as to local supply or distribution.
Such risks may be reduced by obtaining legal opinions confirming
compliance with applicable laws and ensuring that any necessary approvals
are a condition precedent to the drawdown of funds.

Political risk

42
This is the danger of political or financial instability in the host country
caused by events such as insurrections, strikes, and suspension of foreign
exchange, creeping expropriation and outright nationalization. It also
includes the risk that a government may be able to avoid its contractual
obligations through sovereign immunity doctrines. Common mechanisms for
minimizing political risk include: (a) requiring host country agreements and
assurances that project will not be interfered with;

(b) Obtaining legal opinions as to the applicable laws and the enforceability
of contracts with government entities;

(c) Requiring political risk insurance to be obtained from bodies which

provide such insurance (traditionally government agencies);

(d) Involving financiers from a number of different countries, national export

credit agencies and multilateral lending institutions such as a development
bank; and

(e) Establishing accounts in stable countries for the receipt of sale proceeds
from purchasers.

Force majeure risk

43
This is the risk of events which render the construction or operation of the
project impossible, either temporarily (e.g. minor floods) or permanently
(e.g. complete destruction by fire). Mechanisms for minimizing such risks
include:

(a) Conducting due diligence as to the possibility of the relevant risks;

(b) Allocating such risks to other parties as far as possible (e.g. to the builder
under the construction contract); and

(c) Requiring adequate insurances which note the financiers' interests to be

put in place.

Country Risk

Country risk includes risks of currency transfer, expropriation, war and civil
disturbances, and breach of contract by the host government. The multilateral
Investment guarantee Agency (MIGA) of the World Bank provides
guarantee against country risk for an appropriate premium. Export credit
agencies also provide such guarantees but they usually seek counter-
guarantees from the host government.

Sector Risk

44
Sector risk refers to the risk in certain sectors because of the role of
government agencies in those sectors. For example, in the power sector, the
buyer is usually a government utility agency that transmits and distributes
power. The solvency of the utility is critical for the ‘take or pay’ power
purchase agreement to have any value. For selected power projects, the
Indian government has agreed in principle to give counter guarantees to back
up state guarantees for the State Electricity Boards (SEBs), payment
obligations to private generating companies, on a specific request to the state
government concerned and subject to the state government agreeing to
certain terms and conditions. For toll roads, government support may be
necessary to enforce toll collections. Similarly, in the case of municipal
services such as water supply and solid-state disposal, the support of
municipal authorities is important. In each case, the government may
guarantee contract compliance of the respective agencies.

FIGURE 2: TYPES OF RISK

45
2.5 Security Arrangements

46
Arranging sufficient credit support for project debt securities is a necessary
precondition to arranging debt financing for any project. Lenders to a project
will require that security arrangements be put in place to protect them from
various risks. The contractual security arrangements apportion the risks
among the project sponsors, the purchasers of the project output, and the
other parties involved in the project. They represent a means of conveying
the credit strength of going-concern entities to support project debt.

2.5.1 Security arrangements covering completion of project:

The security arrangements covering completion typically involves an

obligation to bring the project to completion or else repay all project debt.
Lenders normally require that the sponsors or creditworthy parties provide an
unconditional undertaking to furnish any funds needed to complete the
project in accordance with the design specifications and place it into service
by a specified date. The specified completion date normally allows for
reasonable delays. If the project is not completed by the specified date, or if
the project is abandoned prior to completion, the completion agreement
typically requires the sponsors or other designated parties to repay all project
debt. The obligations of the parties providing the completion undertaking
terminates when completion of the project is achieved.

47
2.5.2 Direct security interest in project facilities:

Lenders require a direct security interest in project facilities, usually in the

form of a first mortgage lien on all project facilities. This security interest is
often of limited value prior to project completion. Following completion of
the project, the first lien provides added security for project loans. The lien
gives lenders the ability to seize the assets and sell them if the project
defaults on its debt obligations. It thus affords a second possible source of
debt repayment apart from cash flows of the project.

2.5.3 Security covering debt service:

After the project commences operations, contracts for the purchase and sale
of the project’s output or utilization of the project’s services normally
constitute the principal security arrangements for project debt. Such contracts
are intended ensure that the project will receive revenues that are sufficient
to cover operating costs fully and meet debt service obligations in a timely
manner.

48
2.5.4 Purchase and Sale Contracts:

It is of the following types:

(a)Take-if-offered contract:

Such a contract obligates the purchaser of the project’s output or services to

accept delivery and pay for the output and services that the project is able to
deliver. It does not require the purchaser to pay if the project is unable to
deliver the product. That is the contract protects the lenders only if the
project is operating at a level that enables it to service its debt. Lenders
would therefore require additional credit support or security arrangements in
order to provide against unforeseen events.

(b) Take-or-pay contract:

49
A Take-or-pay contract is similar to a Take-if-offered contract; it gives the
buyer the option to make cash payment in lieu of taking delivery, whereas
the take-if-offered contract requires the buyer to accept deliveries. Cash
payments are usually credited against charges for future deliveries. Like the
take-if-offered contract, a take-or-pay contract does not require the purchaser
to pay if the project is unable to deliver the output or services.

(c) Hell-or-high water contract:

This is similar to a take-or-pay contract except that there are no ‘outs’ even
when adverse circumstances are beyond the control of the purchaser. The
purchaser must pay in all events, regardless of whether any output is
delivered. It therefore provides lenders with tighter security than other
contracts.

Step-up provisions:

The strength of these various agreements can be enhanced in situations

where there are multiple purchasers of the output. A step-up provision is
often included in the purchase and sale contracts. It obligates all the other
purchasers to increase their respective participation in case one of the
purchasers goes into default.

2.5.5 Raw material supply agreements:

50
A raw material supply agreement represents a contract to fulfill the project’s
raw material requirements. The contract specifies certain remedies when
deliveries are not made. Often both purchase and supply contracts are made
to provide credit support for a project. A supply-or-pay contract obligates the
raw material supplier to furnish the requisite amounts of the raw material
specified in the contract or else make payments to the project entity that are
sufficient to cover the project’s debt service.

2.5.6 Supplemental credit support:

Depending on the structure of a project’s completion agreement and the

purchase and sale contracts, it may be necessary to provide supplemental
credit support through additional security arrangements. These arrangements
will operate in the event the completion undertaking or the purchase and sale
contracts fail to provide the cash to enable the project entity to meet its debt
service obligations.

2.5.7 Financial support agreement:

51
A financial support agreement can take the form of a letter of credit or
similar guarantee provided by the project sponsors. Payments made under
the letter of credit or similar guarantee are treated as subordinated loans to
the project company. In some cases it is advantageous to purchase the
guarantee of a financially able party to provide credit support for the
obligations of a project company

2.5.8 Cash deficiency agreement:

It is designed to cover any cash shortfalls that would impair the project
company’s ability to meet its debt service requirements. The obligor makes a
cash payment sufficient t cover the cash deficiency. Payments made under a
cash deficiency agreement are usually credited as cash advances toward
payment for future services or product from the project.

2.5.9 Escrow Fund

In certain instances lenders may require the project to establish an escrow

fund that typically contains between 12 and 18 month’s debt service. A
trustee can draw money from the escrow fund if the project’s cash flow from
operations proves insufficient to cover the project’s debt service obligations.

52
2.5.10 Insurance:

Lenders typically require that insurance betaken out to protect against certain
risks of force majeure. The insurance will provide funds to restore the project
in the event of force majeure, thereby ensuring that the project remains a
viable entity. The project sponsors normally purchase commercial insurance
to cover the cost of damage caused by natural disasters. They may also
secure business interruption insurance to cover certain other risks. In
addition lenders may require the sponsors to agree contractually to provide
additional funds to the project to the extent insurance proceeds are
insufficient to restore the operations.

53
2.6 LEGAL STRUCTURE

Sponsors of projects adopt many different legal forms for the ownership of
the project. The specific form adopted for any particular project will depend
upon many factors, including:

• The amount of equity required for the project

• The concern with management of the project
• The availability of tax benefits associated with the project
• The need to allocate tax benefits in a specific manner among the
project company investors.

One of the most critical questions project sponsors need to address is

whether a legally distinct “ project financing entity” should be employed and
how it should be organized.

2.6.1 Undivided Joint interest:

Projects are often owned directly by the participants as tenants in common.

Under the undivided joint interest ownership, each participant owns an

54
undivided interest in the real and personal property constituting the project
and shares in the benefits and risks of the project in direct proportion to the
ownership percentage. The ownership interests relate to the entire assets of
the project; no participant is entitled to any particular portion of the property.
When the project is organized, the participants choose someone in their ranks
to serve as the project operator. This arrangement is particularly suitable
when one of the owners already has operations in the same industry that are
of a similar nature, or otherwise has qualified employees available. The
duties of the operator and obligations of all other parties are specified in an
operating statement. The joint venture will require each participant to
assume responsibility for raising its share of the project’s external financing
requirements. Each sponsor will be free to do so by whatever means are most
appropriate to its circumstances.

Thus for example,

if a sponsor owns 25 percent of the project, it will be required to provide,

from its resources, 25 percent of the funds necessary to construct the project.
The undivided joint interest has particular appeal when firms of widely
differing credit strength are sponsoring the project. By financing
independently, the higher-rated credits can borrow at a cost that is lower than
the cost at which the project entity can borrow based on its composite credit.
Depending on the sponsor’s ability to take immediate advantage of the tax
benefits of ownership arising out of the project, direct co-ownership may

55
also provide the project sponsors with immediate cash flow to fund their
equity investments.

2.6.2 Corporation

The form of organization most frequently chosen for a project is the

corporation. A new corporation is formed to construct, own, and operate the
project. This corporation, which is typically owned by the project sponsors,
raises funds through the sponsors’ equity contributions and through the sale
of senior debt securities issued by the corporation. The senior debt
securities typically take the form of either first mortgage bonds or debentures
containing a negative pledge covenant that protects their senior status. The
negative pledge prohibits the project corporation from granting a lien on
project assets in favour of other lenders unless the debentures are secured
rate able. The corporate form permits creation of other types of securities,
such as junior debt (second mortgage, unsecured, or subordinated debt),
preferred stock, or convertible securities. The corporate form of organization
offers the advantages of limited liability and an issuing vehicle.
Nevertheless, the corporate form has disadvantages that must be considered.
The sponsors usually do not receive immediate tax benefits from any
Investment Tax Credit (ITC) the project entity can claim or from
construction period losses of the project. Also, the ability of a sponsor to
56
invest in the project corporation may be limited by provisions contained in
the sponsor’s bond indentures or loan agreements. In particular, the
provisions restricting “investments” either by amount or by type may impose
such limitations.

2.6.3 Partnership:

The partnership of organization is frequently used in structuring joint venture

projects. Each project sponsor, either directly or through a subsidiary,
becomes a partner in a partnership that is formed to own and operate the
project. The partnership issues securities (either directly or through a
corporate borrowing vehicle) to finance construction. Under the terms of a
partnership agreement, the partnership hires its own operating personnel and
provides for a management structure and decision-making process. A
partnership is particularly attractive for so-called “cost companies”; a profit
is not realized at the project level but instead is earned further downstream in
the sale of the project’s output. The Uniform Partnership Act imposes joint
and several liabilities on all the general partners for all obligations of the
partnership. They are also jointly and severally liable for certain other
project-related obligations any of the general partners incurs in the ordinary
course of business or within the scope of a general partner’s apparent
authority. A partnership can also have any number of limited partners.

57
They are not exposed to unlimited liability. However, there must be at least
one general partner who does have such exposure.

FIGURE 3: A PARTNERSHIP STRUCTURE IN PROJECT FINANCE

58
100% OWNERSHIP 100% OWNERSHIP 100% OWNERSHIP

AND AND AND

PERFORMANCE PERFORMANCE PERFORMANCE

X Y Z

OWNER OWNER OWNER

SHIP SHIP SHIP

100%

OWNER

59
2.7 SOURCES OF FUNDS

Financing options i.e the various sources of finance are equity, debt, Indian
and international financial institutions, multilateral institutions, export credit
agencies, GDR’s and external commercial borrowings.

(a) Equity finance

Government policy allow a debt equity ratio of 8:2, however lending

institutions advocate a gearing ratio up to 7:3 as a prudent measure of
lending. Specialized infrastructure and mutual funds have come up to bridge
the equity gap in mega projects such as Global Power investment of GE
Caps, the AIG Asian Infrastructure Fund, and the Asian Infrastructure Fund
of Peregrine Capital Ltd. And ICICI.

(b) Debt Financing

In raising debt or financing the power sector projects the list of funds should
be the lowest so that the ultimate cost of electricity will be the lowest for the
end consumer. The decision of the promoter to go in for equity or debt
financing depends on various factors like go guidelines for power projects,
incentives available and return on equity as also the cost of debt vis-a vis
equity.

60
Domestic Capital market Bonds are issued by the Central / State Government
and Publish/private Ltd. Companies t augment the resources of the power
sector in the capital market. Presently, internal rates are regulated and credit
rating is mandatory if the maturity of the instruments exceeds 18 months.
NCDs with an option of buy back, debentures with equity warrants, floating
rate bonds and deep discount bonds are some of the innovative instruments
offered in the market.

(c) Indian Financial Institutions

The area of project financing in the Indian context is mainly limited to the
Indian Term Lending Institutions. In addition a large number of state level
institutions, finance projects of smaller size commercial banks also
participate in the term loans to a limited extent, besides meeting the working
capital requirements. As no individual FI can feed to the power sector
because of the huge funds requirements and the long gestation period of the
projects. The concept of loan syndication amongst the FIs is gaining
momentum. This also helps in sharing the risk among the FIs apart from
saving o the efforts and the cost because of the appraisal done by the leading
institution.

61
(d) Sources of international finance

Due to the domestic finance viable for the power projects, the need to tap
international markets has become inevitable which is characterized by the
long tenure of maturities and availability of various modes of finance.

(e) Multilateral Institutions

Institutions like the World Bank, IFC, and ADB etc. Have traditionallybeen
financing infrastructure in developing countries. The financing comer with
restrictive covenants affordable costs, long tenure and in an assured manner.
The co-financing facility extended by some of the multilateral institutions is
gaining popularity. In many of these loans, sovereign guarantee is required.

(f) Export Credit Agencies

ECAs are a common source of bilateral funding. Credit is provided by ECAs

such as the US Exim Bank, Exim Japan, etc. ECAs have a long history of
providing finance for all types of power generation equipment. There are
certain limitations in ECA financing like exposure limits, exchange risk,
transfer to IPP guarantee requirements and cost of insurance etc.

62
(g) External commercial borrowings

These include Yankee bonds, Dragon bonds, Euro Currencysyndicated loans,

US144A private placements, Global Registered Notes, Global Bonds etc. (J)
Syndicated loans The special features of syndicated loans are that they are
for medium to longer period; specific to the requirements of the borrowers to
suite their projects and availability of floating rate of interest. Most of the
investors are Asian/European Banks, FIs, Insurance Companies and pension
funds.

(h) Global Depository receipts (GDRs)

GDRs present an attractive avenue of funds for the Indian companies. Indian
Companies can collect a large volume of funds in foreign currency in Euro
issues. GDRs are usually listed in Luxembourg and are traded in London in
the OTC market or among a restricted group such as Qualified Institutional
Buyers (QIBs) in the USA. The GDRs do not have a voting right; there is no
fear of management control.

63
FIGURE4: SOURCES OF FUNDS

64
 3. CASE STUDY :

HOW ENRON HAS AFFECTED PROJECT FINANCE

3.1 The Enron Story

Enron Corporation (former NYSE ticker symbol ENE) was an American

energy company based in Houston, Texas. Before its bankruptcy in late

2001, Enron employed approximately 22,000 staff and was one of the

world's leading electricity, natural gas, communications and pulp and paper

companies, with claimed revenues of nearly $101 billion in 2000. Fortune

named Enron "America's Most Innovative Company" for six consecutive

years.

Enron traded in more than 30 different products, including the following:

Products traded on Enron Online
Petrochemicals
Plastics
Power
Pulp and paper
Steel
Weather Risk Management
Oil& LNG Transportation
Broadband
Principal Investments
65
Risk Management for Commodities
Shipping / Freight
Streaming Media
Water and Wastewater

At the end of 2001 it was revealed that its reported financial condition was
sustained substantially by institutionalized, systematic, and creatively
planned accounting fraud, known as the "Enron scandal". Enron has since
become a popular symbol of willful corporate fraud and corruption. The
scandal also brought into question the accounting practices of many
corporations throughout the United States and was a factor in the creation
of the Sarbanes–Oxley Act of 2002. The scandal also caused the
dissolution of the Arthur Andersen accounting firm, affecting the wider
business world.
Enron filed for bankruptcy protection in the Southern District of New York in
late 2001 and selected Weil, Gotshal & Manges as its bankruptcy counsel.
It emerged from bankruptcy in November 2004, pursuant to a court-
approved plan of reorganization, after one of the biggest and most complex
bankruptcy cases in U.S. history. A new board of directors changed the
name of Enron to Enron Creditors Recovery Corp and focused on
reorganizing and liquidating certain operations and assets of the pre-
bankruptcy Enron. On September 7, 2006, Enron sold Prisma Energy
International Inc., its last remaining business, to Ashmore Energy
International Ltd. (now AEI).

66
3.2 CAUTION AMONG LENDERS AND INVESTORS

Because lenders may have been stung by PG&E or Enron an because of

other recent market factors such as declining power prices and emerging-
market problems, lenders and investors in early 2002 were approaching all
energy and power companies with increased caution. They were scrutinizing
merchant power and trading businesses with particular care. They were doing
deals mainly with prime names that have proven staying power.

At the same time, rating agencies were downgrading hitherto fast-growing

independent power companies or requiring them to reduce their leverage to
maintain a given rating. Among the agencies’ concerned in the current
market environment are the exposure of these companies’ merchant plants to
fluctuating fuel and electricity prices and the companies’ reduced access to
equity capital. Of course, having been criticized for not downgrading Enron
soon enough, the rating agencies are particularly sensitive toward the energy
and power sectors. But, it is important to remember that the fast-growing
power companies using innovative revolving credits to finance the
construction of new power plants are single sponsors with fully disclosed on-
balance- sheet debt. Even though Enron is one of the factors that have
discouraged banks from increasing their industry exposure, most of the
restrictions the markets are placing on the growth of independent power
companies are related to other market factors discussed above that were
evident before the Enron bankruptcy.

67
Similar to lenders and investors, companies that trade with each other are
becoming more concerned with counterparty credit risk. In evaluating the
creditworthiness of a given counterparty, they are looking at the whole
portfolio to see if one risky business such as merchant power or energy
trading—diversification benefits aside— could drag down the others.

For example, a company with primarily merchant plants is more vulnerable

to an overbuild scenario than one with mainly power purchase agreements.

3.3 PROJECT FINANCE AND ENRON FACTOR

68
The Enron bankruptcy and related events have changed neither the nature nor
the usefulness of traditional project finance, but they have led to a slowing
down of some of the more innovative forms of structured project finance.
Among the other direct and indirect effects of Enron have been increased
caution among lenders and investors toward the energy and power sectors;
increased scrutiny of off-balance sheet transactions, increased emphasis on
counterparty credit risk particularly with regard to companies involved in
merchant power and trading and deeper analysis of how companies generate
cash flow. There is increased emphasis on transparency and disclosure even
tough disclosure in traditional project finance has been more robust than in
most types of corporate finance. In the current market environment, for
reasons that extend beyond Enron, some power companies have been
cancelling projects and selling assets to reduce leverage and resorting to on
balance financing to fortify liquidity.

The immediate cause of the Enron bankruptcy was a loss of confidence

among investors caused by the company’s restatement of earnings and
inadequate, misleading disclosure of off-balance-sheet entities and related
debt. However, because Enron was a highly visible power and gas marketer
(not to mention far-flung activities from overseas power plants to making a
market in broadband capacity), its failure brought more scrutiny to all
aspects of the energy and power business, particularly the growing sectors of
merchant power and trading.
69
Even before the Enron bankruptcy, the confidence of many power and gas
companies was shaken by other devastating events during 2001 including the
California power crisis, the related Pacific Gas and Electric Company
bankruptcy, failing spot power prices in U.S. markets, and the collapse of
Argentina Economy and financial system. The California power crisis is
evidence of a flawed deregulation structure, which caused a global setback to
power deregulation and paralyzed U.S. BANK, markets for much of the first
half of 2001. The falling spot power prices were caused primarily by
overbuilding of new projects for the near term (though probably not for the
longer term), mild weather is most of the United States, and overdependence
on the spot market

The combination of these events in 2001, accentuated at the end of the year
by the Enron bankruptcy, caused a dramatic change in the perception of risk
among investors, lenders, and rating agencies. In particular, these parties
began to perceive independent power producers (IPPs) riskier than they ever
had before.

70
They considered trading businesses difficult to evaluate; they suspected
earnings manipulation through the marking to market of power contracts and
off-balance-sheet vehicles; they feared sustained low power prices in the
U.S. market. After problems in countries such as Argentina, Brazil, India and
Indonesia, emerging market IPP projects began to seem more like a danger
than an opportunity. Investors and lenders began to perceive earnings in the
IPP and trading business to be less predictable and sustainable than they had
thought before. They discounted the growth prospects of these companies
and focused on liquidity and leverage in light of higher perceived risk.

They have bad exposures in foreign markets that have collapsed; they have
had to cancel advance purchase orders for turbines because of a slowing U.S.
power market; their stock prices are tumbling as a result of reduced growth
prospects; and they are facing a credit crunch from lenders, some of which
are gun-shy from recent losses related to PG&E or Enron. So, as we look at
today’s energy and power market, we see some direct effects of the Enron
bankruptcy and other situations caused by a combination of all the factors
discussed above.

But before going further, let’s look at how Enron has affected pure,
traditional project finance.

71
3.3.1 EFFECT ON TRADITIONAL PROJECT FINANCE

“Traditional” project finance is cash flow based; asset-based finance that has
little in common with Enron’s heavily criticized off- balance-sheet
partnerships. The historic elements of project finance are firmness of cash
flow, counterparty creditworthiness, ability to deal over a long time frame,
and confidence in the legal system. It is a method for monetizing cash flows,
enhancing security, and sharing or transferring risks. The Enron transactions
in question generally did not have these characteristics. They were an
attempt to unduly benefit from accounting, tax, and disclosure requirements
and definitions.

Traditional project finance is based on transparency, as opposed to the Enron

partnerships, where outside investors did not have the opportunity to do the
due diligence upon which any competent project finance investor or lender
would have insisted. Those parties are interested in all the details that give
rise to cash flows. As a result, there is a lot more disclosure in project
finance than there is in most corporate deals.

In traditional project finance, investors and rating agencies do not have a

problem with current disclosure standards; it is not hidden and it never has
been. First, they know project financing is either with or without recourse
and either on or off the balance sheet.

72
For example, in the case of Joint venture where a company owns 50% of a
project or less, the equity method of accounting is used for off balance-sheet
treatment. On the income statement, the company’s share of earnings from
the project is included below the line in the equity investment in
unconsolidated subsidiaries.

When a company owns more than 50% of a project, its debt is consolidated
on the balance sheet and its dividends are included in income. The minority
interest is backed out. The point to remember is that whether a project is
financed on or off the balance sheet, analysts know where to look.

Also off-balance-sheet treatment may not be the principal reason for most
project financing. It usually is motivated more by considerations such as risk
transfer or providing a way for parties with different credit rating to jointly
finance a project – whereas if all of those parties providing the financing on
their own balance sheets, they would be providing unequal amounts of
capital by virtue of their different borrowing costs. None of these
considerations have anything to do with the Enron partnerships, where 3 %
equity participation from a financial player with nothing at risk was used as a
gimmick to get assets and related debt off the balance sheet.

3.3.2 EFFECT ON STRUCTURED PROJECT FINANCE

73
Even though traditional project finance has not been affected very much by
Enron, there certainly has been a slowing of activity in the more innovative
types of structured finance such as synthetic leasing, structured partnerships,
and equity share trusts – at least for the time being.

Synthetic leases are a mature product, understood by rating agencies and

accountants, in which billions of dollars of deals have been done.

Even though synthetic lease are transparent and well understood, they have
an off-balance sheet element that creates headlines in today’s environment,
more of them maybe done in a year or two.

The investor market has overreacted to anything that sounds “like Enron”.
Structured and project financing techniques have been developed for sound
risk management reasons and, in my opinion, must be defended vigorously
on those grounds. I believe a prejudice against such financial structures could
have a real economic and financial cost. However if sponsors fear that the
wider market will punish them for using complex structures, they will stop
using them.

At the time of Enron scandal several companies had already made public
vows not to use any off – balance sheet structures.

74
But, rather than pandering to uninformed sentiment, one should make greater
efforts to clearly delineate the difference between legitimate non-recourse
debt and the Enron structures.

3.3.3 SOURCES OF FREE CASH FLOW

75
Immediately after Enron filed for bankruptcy protection, some questioned
whether project and structured finance would survive in its form. And
indeed, some corporations with large amounts of off- balance sheet financing
were subjected to increased scrutiny and sharply red valuations for both their
equity and their debt. In response those companies have expanded their
liquidity and reduced their debt to the extent possible. But, as time
progresses, the main fallout from Enron and the other recent market shocks
have not been so much of a turning away from project finance but rather a
greater stress on bottom-up evaluation of how companies generate recurring
free cash flow and what might affect it over time. In this process, project as
well as structured finance probably will continue to play an important role.
The change, has been that the focus has shifted from not only the project
structures, but also on how they may affect corporate level cash flow and
credit profiles, for example through springing guarantees and potential debt
acceleration, through contingent indemnification and performance
guarantees, and through the potential for joint-venture and partnership
dissolutions to create sudden changes in cash flows.

3.3.4 SECURITY INTERESTS

76
Power business, in part, has shifted from a contract-based business to a
trading, cash flow- based kind of business where the counterparty becomes
critical to the viability of a transaction. The security in the transaction is less
than the asset itself and more what the trading counterparty does with the
asset. That asset has an option value in the hands of a counterparty, but a far
different value if a bask has to foreclose on it—a value you would rather not
find out.

Enron’s alleged tendency to set its own rules for marking gas, electricity and
various other newer, thinly traded derivative contacts to market raises some
questions about collateral and security. Historically, the security in a power
plant financing has consisted of contracts, counterparty arrangements and
assets. But if a lender’s security depends on marking certain contracts to
market and there is some question as to the objectivity of the counterparty
that is marking them to market, that raises additional questions as to what is
an adequate sale, what is adequate collateral, how a lender takes an adequate
security interest, how a lender monitors the value of its security interest, and
what needs to be done to establish a sufficient prior lien in the cash flow
associated with the transaction. In the case of a structured project finance
transaction, the key question remains just as it always has been: whether the
security is real and whether you can get rely on it.

77
3.3.5 HOW COMPANIES HAVE RESPONDED

Affected companies respond to the current market environment rapidly and

decisively to strengthen their liquidity through issuing new equity, canceling
projects, selling assets, either unwinding structured finance deals or putting
them on the balance sheet, and increased transparency and disclosure
(discussed further below). During this past December and J alone five power
companies raised $4 billion in equity. During the first quarter of 2002, power
projects adding up to 58,000 megawatts of capacity were either deferred or
canceled.

Some power companies have set up massive credit facilities for doing so
based on their overall corporate cash flow and creditworthiness. Another
option for a company is to borrow against a basket of power projects,
allowing the lenders to diversify their risks, but such a facility is still largely
based on the credit fundamentals of the corporation. But project financing on
an individual plant basis can be preferable to either of these approaches for
both project sponsors and lenders.

78
For example, say a company is financing ten projects and three run into
trouble. The company can make a rational economic decision as to which of
those projects are salvageable and which ones do not merit throwing in good
money after bad. It might let one go into foreclosure and be restructured and
sold. But if a company is financing ten projects together, its management
may feel compelled to artificially bolster some of its projects so that the
failure of one project does not bring the entire credit facility down. Making
such an uneconomic decision for the near term would not be in the
company’s long-term interests.

3.3.6 INCREASED TRANSPARENCY AND DISCLOSURE

79
The major players generally are releasing much more information than
before about their businesses and financing arrangements. Similarly, an
overriding aura of conservatism in disclosure has been seen, for example, in
conference room discussions while drafting prospectuses for project finance
deals. Bankers are making extra efforts to confirm that details are being
disclosed and explained the right way. Given the current tarnishing of the
merchant power sector, they might explain further than in the past that a
company’s trading is not speculative and that it is using accepted risk
management measures such as value-at-risk (VAR). They also might break
out the percentage of sales from power sales and from “marketing”—a team
that sounds better than trading in today’ environment

Also strong management actions are needed to restore belief in honesty of

numbers. A company’s management needs to demonstrate the same passion
for integrity as it had for growth in the past. It needs to get rid of gimmicks
and consistently communicate and execute a simple, clear strategic vision.
This involves cleaning up the balance sheet. Transactions that have
significant recourse to the sponsor should be put back on the balance sheet.
Only true non-recourse deals should be left off the balance sheet. To convey
an accurate, fair picture of the business, companies need to communicate—to
the point of obsession —information and assumptions about how earnings
are recognized, including mark-to-market transactions.

Managing earnings is out and managing cash flow is in—and, that’s what the
rating agencies are looking at anyway.
80
Companies may need to reexamine their strengths and weaknesses and
refocus and simplify their basic business strategies. Their boards of directors
might become more helpful in this process with the addition of non-
executive members who understand the business.

3.3.7 REGULATORY ISSUES

One of the reasons Enron was left to its own devices in valuing gas,
electricity, and other types of contracts was that it became, in effect the
largest unregulated bank in the world. It was able to avoid regulation of its
activities by the Commodity Futures Trading Commission (CFTC). Partly as
a result of its own lobbying efforts, and the Federal Energy Regulation
Commission (FERC) declined to get involved as well. Therefore, it was able
to duck some of the scrutiny that regulators have directed toward commercial
and investment banks dealing in derivatives. Of course, securities analysis
had long complained about Enron’s opaque financial reporting, only to be
told in return that they just didn’t understand the business.

81
FERC will have to become more involved in trading than it has in the past.
FERC’s current emphasis is to avoid the abuse of market power in the
electricity business But today, a power company might have market power in
trading completely unrelated to market power in asset ownership. Enron
proved that they are two different things. A company can dominate trading
market without dominating the asset-ownership market. So regulatory lesson
to be learned from Enron is that today’s electricity market needs more
sophisticated oversight of both the trading function and market power.

Also Sarbanes-Oxley Act was implemented to protect investors by

improving the accuracy and reliability of corporate disclosures made
pursuant to the securities laws, and for other purposes. The Sarbanes-Oxley
Act created new standards for corporate accountability as well as new
penalties for acts of wrongdoing. It changes how corporate boards and
executives must interact with each other and with corporate auditors. It
removes the defense of "I wasn't aware of financial issues" from CEOs and
CFOs, holding them accountable for the accuracy of financial statements.
The Act specifies new financial reporting responsibilities, including
adherence to new internal controls and procedures designed to ensure the
validity of their financial records.

82
3.4 OTHER LESSONS LEARNED

Among the more general lessonsfrom Enron that go beyond the realm of
structured and project finance are:

• It is risky to over-invest in businesses sectors such as broadband and water

• A power trading business, though potentially profitable, is highly

vulnerable to liquidity crisis and has a low liquidation value.

•Trading to hedge a power company’s inherent physical position in power or

gas should not be regarded as a suspect business per se, but it can involve the
risk of sudden liquidity crisis—especially for triple-B-minus- rated
companies that don’t want to slip below investment-grade status.

83
• Mark-to-market accounting rules can mislead investors, lenders, and
analysts as to the extent of non-recurring earnings, even in the absence of
fraud.

Among the lessons more directly related to project and structured finance are
the following:

• The transfer of assets, intangible and otherwise, into non-consolidating

vehicles controlled by a sponsor may mislead investors as to the extent of
non-recurring earnings or deferred losses even in the absence of fraud.

• There is a risk of low recovery rates on structured transactions secured by

intangible assets (investments, contracts, company stock) or by tangible
assets whose values are net established on an arm’s length basis.

• Having been badly burned by the Enron bankruptcy, banks and investors in
its structured and project financings, and in the energy sector generally, will
be especially conservative, and this will limit credit and capital access for
many clients in the sector, creating a genera liquidity issue for these
customers.

Several recommendations concerning accounting treatment and disclosure:

84
• An effort must be made by all in the project finance industry (and investor
relations) to underscore the distinction between true non-recourse structures
and Enron’s activities

• The terms “non-recourse” and “off balance sheet should remain synonyms.
Liabilities that truly have no recourse to a company’s shareholders can justly
be treated as off balance sheet. Enron appears to have violated this principle
since the undisclosed liabilities in the off- balance sheet partnerships actually
had significant recourse to Enron shareholders through share marketing
mechanisms.

• Many project finance structures are “limited” rather than “non” recourse,
and thus there is a potential grey area in which accounting rules allow off-
balance sheet treatment but there is nonetheless some contingent liability to
the parent company shareholders. Full disclosure of any potential
shareholder recourse was advisable pre-Enron and is absolutely necessary
now.

4. CONCLUSION

85
Two basic tenets of project finance:

I) The financing of hard assets that have ongoing value through economic
cycles and

2) The high level of sponsor expertise and commitment required.

As Enron grew and expanded, it seemed more interested in businesses or

transactions that would generate a certain return than it was in whether or not
those ventures would complement its core businesses. As such, Enron got
into a number of businesses in which it did not have any expertise and then
was not committed to those businesses when expectations were not met.

To conclude, project finance is alive and well. We just need to remind a few
people of its basic fundamentals. Neither project finance nor sensible in
innovations in structured finance with sound, well explained business
reasons have been shaken by Enron.

The principle lessons learned from the Enron debacle have to do with
transparency and disclosure. When some of your businesses or your finance
structures become hard to explain, you may begin to question whether they
make sense in the first place.

86
BIBLIOGRAPHY

• Finnerty, J.D., 1996, Project Financing: Asset-Based Financial

Engineering. New York, NY: John Wiley & Sons.

• Hoffman, Scott L., The Law and Business Of International Project

Finance, Kluwer Law International, 2008.

• Nevitt, P.K., and F.J. Fabozzi, 2000, Project Financing, 7th edition,
Euromoney Books (London, U.K.).

• Brealey, R., and S.Myers, Principles of Corporate Finance, McGraw

Hill

• Standard & Poor's Corporation, 2003, Project Finance Summary Debt

Rating Criteria, by P. Rigby and J. Penrose, in 2003-2004 Project &
Infrastructure Finance Review: Criteria and Commentary, October.

• Wikepedia.com - (http://en.wikipedia.org/wiki/Project_finance)

(en.wikipedia.org/wiki/Enron)

87
• www.projectfinancemagazine.com/

• www.people.hbs.edu/besty/projfinportal/

• www.pfie.com

• www.projectfinancereview .com

• www.time.com/time/2002/enron

• www.enronfraud.com/

• www.uow.edu.au/~bmartin/dissent/documents/.../citienron.html

88