SMC Working Papers1
Contents
Contents………..……………...………..……..…………...……………………….…..………..2
Abstract………………………...………..…..……………..………………………..….………..3
Introduction………………………………………………………...………………….…..……..4
The essence of preliminary risk assessment in project finance ……...………………….…..……..4
The typical project risks at start-up and how these risks can be mitigated/….…………………….5
Why is it important to understand the financial and political risks surrounding a project?...... …………………………….………………………. 6
Is negative pledge adequate to protect a lender’s position? If not what else should be considered?...... ……………………………………………. 7
References…………………………….……………………………………………...... 9
Risks of Project Finance
Siskos V. Dimitrios
Swiss Management Center (SMC) University
May 24, 2019
Abstract
All companies need to be considering project finance risks very carefully since it is believed that “it is here to stay for a long time”. This article examines the essence of preliminary risk assessment in project finance; determines the typical project risk at start-up and provides ways to mitigate it; stresses the importance of financial and political risks surrounding a project; and last, explains the reasons why negative pledge is inadequate to protect a lender’s position. The outcomes of the study show that the preliminary assessment of all relative risks in a project life-cycle is imperative to the survival of such projects. Not doing so, it is almost impossible to immunize project form potential risks and, hence, to avoid negative consequences.
Keywords: Project risks, Start-up phase, Financial risks, Political risks, Negative Pledge.
Introduction
Project finance is generally used for large, complex and sizable operations. Due to their complexity, size, and location, these projects often have challenging several types of risks that threaten their creditworthiness. Unlike traditional corporate finance, the creditworthiness of an established business is not the decisive criterion for granting the loan. It is the future cash flow and to that effect the future success, of the investment that will be financed (Esty 2004; Nevitt and Fabozzi, 2000). If not managed properly, risks can result in disrupting or halting project operations and lead to legal complications and reputational impacts that contribute to project’s failure.
However, the majority of factors influencing the cash inflows and outflows are not deterministic but rather stochastic, making project financing an extremely risky business (Backhaus and Schulte, 2006). A negative example of such risk is the Eurotunnel[1] between France and the United Kingdom, while a positive example is the project-financed Athens airport[2].
The essence of preliminary risk assessment in project finance
According to Ruhanita and Nasir (2006), the success of a project finance project will depend on the ability to timely identify risks and transfer them appropriately. However, the risk assessment cycle in project finance begins with Preliminary Risk Assessment (PRA) (Fight, 2006). The objective of the PRA process is to identify and quantify the expected major hazards and risks associated with the completion of the project.
The identification stage enables the sponsor and lenders to analyze the potential of the project ensuring that the project will have sufficient viability to pay debt service, operations and maintenance costs (Farrell, 2002). As such, this stage represents a feasibility study which usually is analyzed by financial and technical experts to establish whether the project is viable or not.
The next phase in PRA is the allocation of risk. This involves the effective transfer of optimum risks to participants such as the project sponsors, the lawyers, the construction companies, the fuel consultants, the market consultants, the insurance consultants, the financial advisers and the environmental consultants (Fight, 2006). Last, the process continues with preliminary qualification and qualitative assessment of risk to provide the potential impact of risk on the project (Mensah, 2013).
The typical project risks at start-up and how these risks can be mitigated
The project is divided into two main phases: The start-up and the implementation phase. The start-up or concept phase is defined as that period prior to identifying that a project exists, and before the allocation of substantial funds, and when all options including the no-go option have been investigated (Hamilton, 2003). Samset (2001) defines the start-up phase as the things done in the project prior to the final kick-off and represents a number of actions to ascertain the necessary steps that are followed.
During the start-up phase, the banks need to be satisfied that the project will operate at the costs and according to the specifications agreed at the outset (Fight, 2006). This fact results in conflict of interest among the parties in the scheme and as such it is one of the major risks in the start-up phase. Indeed, in sponsors’ quest to start commercial activities to generate cash from the project, most of them tend to compromise on the necessary performance and acceptance test (Mensah, 2013). This is why lenders typically require that the engineer verifies and signs off on all testing before releasing the contractor. Such conflict of interest among the project parties might result in the sponsors possibly compelled to generate cash by persuading the engineers to compromise on the reviews (Ghersi & Sabal, 2012).
To mitigate these potential risks associated with the start-up phase, the parties must provide support to the project team to minimize the time required for it to grow into an effective unit (Weaver and Bourne, 2002); they must expand the role of the Project Office [3]to include specific project “Start Up” responsibilities; and last, they must ensure that an architect issues the value of work certified before completion (Kreydieh, 1996).
Why is it important to understand the financial and political risks surrounding a project?
When a firm decides to engage in a project financing activities, it also takes on additional risk as well as opportunities. The main risks that are associated with businesses engaging in project finance include financial and political risk.
Political risk, unlike other forms of risks associated with project finance, threatens project’s success through changes in legislation and changes in governance stands. For example, project finance loans are usually preferred if the economy of a country is poor, the corporate governance system is weak, political risk high and bank influence over the host government is strong (Hainz and Kleimeier, 2012). This comes from the fact that political events can affect the output of projects as a result of wars, ideologies, neighboring countries, political unrest, revolution, high taxes or government regulators (Fight, 2006; Farrell, 2001).
To mitigate political risks, all companies need to be considering political risk very carefully. Particularly, firms should consider the following to better manage political risk (Rajwani, 2011):
- Understand insurance as a powerful way to mitigate political risk (World Bank[4], OPIC[5], etc.)
- Be proactive and avoid situations with overt political risk.
3. Deal with risks on an ongoing basis.
4. Diversify political risks.
5. Understand macro and a micro political risk environment
Project financial risks are another important component of any project management process. These risks usually arise as a result of foreign exchange exposures, interest rates exposures, inflation exposures, liquidity exposures and project pricing exposures (Fight, 2005). Financial risk is a function of many variables, depending on the industry of which the project is a part and the markets that it serves. According to Moody’s report (1998), these variables can include:
- Lack of demand.
- Pricing change.
In order to keep the risk under control, it is often helpful to establish some sort of backup funding that can be called upon to settle debt that is coming due, effectively buying more time for the project to become self-sustaining.
Is negative pledge adequate to protect a lender’s position? If not what else should be considered?
The unique nature of Project Finance, as opposed to corporate debt financing has placed the project lender in a precarious position (Ochieze, 2008). This ‘unsecured’ position is compounded by the liabilities which a project lender is exposed to. One of such provisions is negative pledge (Fight, 2006). A negative pledge clause is lending agreement language designed to prevent borrowers from pledging the same collateral to multiple lenders or otherwise taking actions that might jeopardize the security of existing lenders (Yescombe, 2002).This action does not permit borrower to create charges on its assets in favor of other lenders. As such, the borrowing company cannot use its assets, such as land, buildings and other tangible assets, as collateral for the loan arrangements. Hence, when a borrower breaches a negative pledge covenant, the negative pledge generally has only a cause of action against a party whose assets are, by hypothesis, already encumbered (Bjerre, 1999).
Notwithstanding the restrictions imposed on the borrowers by the provision of negative pledge, it may still not suffice to protect the lender’s position because if the borrower were to create security in favor of a third party, it is quite likely that the security would in most jurisdictions be regarded as valid (Fight, 2005). As such, the lender’s position will be weak if he relies on the project assets as a source of repayment.
To mitigate the adversity of negative pledges, lending must critically analyze such clauses to understand the provisions and definition of security or the debt covered by the clause (Fight, 2006).
For example, the World Bank included the negative pledge clause in loan agreements by ensuring that a developing nation will not give a later creditor priority over its assets (Barth, et al., 2013). In that way, it mitigated its risk of providing unsecured loans.
References
Backhaus K., Werth Schulte H., (2006). Identification of Key Risk Factors in Project Finance: A project type - Based Simulation Approach, Journal of Structured Finance, Winter, 71.
Barth, J.R., Caprio, G., and Levine, R., (2013), “Bank Regulation and Supervision in 180 Countries from 1999 to 2011”, January.
Bjerre, Carl S., Secured Transactions Inside Out: Negative Pledge Covenants, Property and Perfection. Cornell Law Review, Vol. 84, No. 2, January 1999. Available at SSRN:
Bourne, L. and D. H. T. Walker (2003). Tapping into the Power Lines: a Third Dimension of Project Management Beyond Managing and Leading . IPMA World Congress, Moscow
Bjerre, C.S. (1999) ìSecured Transactions Inside Out: Negative Pledge Covenants, Property and Perfectionî,84 Cornell L. Rev. 305.
Esty, B., (2004). Why Study Large Projects? Harvard Business School. Case #203-031.
Farrel L.M. (2002). Principal-agency risks in project finance. International Journal of Project Management.
Farrel L.M. (2001). Financial Issues in Mortgage underwriting and real estate valuation. Journal of Financial Management of property and Construction.
Fight, A. (2006). Introduction to Project Finance. Essential Capital Markets. Elsvier 1st Edition.
Ghersi H., & Sabal J., (2012). Introduction to Project Finance in Emerging Markets. Retrived (11/05/14) from: Project _Finance_in_Em.html?id=Jl8UPAAACAAJ&redir_esc=y
Hainz, C. and S. Kleimeier, (2012), Political Risk, Project Finance, and the Participation of Development Banks in Syndicated Lending, Journal of Financial Intermediation, 21(2), 287–314.
Hamilton A. (2003). Project start-up phase: the weakest link. Proceedings of the Institution of Civil Engineers, Municipal Engineer, 156(4), pp. 263–271.
Kreydieh A., (1996). Risk Management and BOT Project Financing. Retrieved (23/1/13) from: este%20%26%20Walker.pdf
Marshella, T., Cahill, B., and Atkinson, S., (1998), "Key Credit Risks of Project Finance", Moody’s Investor Service, April.
Mensah, J. (2013), Project Finance and Preliminary Risk Assessment. Available at SSRN: or
Nevitt, P.K., and F.J. Fabozzi, (2000). Project Financing, 7th edition, Euromoney Books (London, U.K.).
Ochieze, C., (2007) Fiscal Stability: To What Extent Can Flexibility Mitigate Changing Circumstances in a Petroleum Production Tax Regime? , 5 (2) Oil, Gas & Energy Law Intelligence
Rajwani, (2011). How Should Firms Deal With Political Risk? Retrieved on 12/05/2014 from:
Ruhanita M, Daing Nasir I. (2006). Activity Based Costing (ABC) Adoption Among Manufacturing Organizations - The Case Of Malaysia. Inter. J. Bus. Soc., 7(1): 70-101.
Samset, K. (2001). Konseptvurdering i tidligfasen, Tapir, Norway.
Yescombe, E.R. (2002). Principles of Project Finance. Academic Press, New York, USA.
May 24, 2019Dimitrios V. Siskos
[1] The Channel Tunnel is the longest undersea tunnel in the world.
[2] Greece's first major greenfield airport project
[3] The Project Management Office (PMO) is the department that defines the processes related to project management within an organization.
[4] The World Bank is comprised of a group of development institutions that provide loans and grants to developing countries with the stated goal of alleviating poverty by creating the conditions for sustained development.
[5] OPIC mobilizes private capital to help solve critical development challenges and in doing so, advances U.S. foreign policy.