3.1 Identifying Project Risks
3.1.3 Risks Found in Both the Pre- and Postcompletion Phases
Risks found in both the construction and operational phases are those that might systematically arise during the life of the project, though with differing intensity depending on the phase in the life cycle of the initiative.
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Many risks common to both phases pertain to key macroeconomic and financial variables (inflation, exchange rate, interest rate); consequently, any division between the categories of industrial and financial risk is actually somewhat arbitrary. For example, the exchange rate risk inherent in a construction contract in dollars with an SPV domiciled in a EMU country can be considered both an industrial risk (since it is linked to a nonfinancial contract) and a financial risk (because it would be covered by recourse to financial derivatives, if need be).
3.1.3.1 Interest Rate Risk
In project finance ventures, there is always the risk of fluctuations in interest rates.
We will see in Chapter 6 that in this context credit is always granted with a variable rate, due to the long life of such projects. In addition, unlike exchange rate risk, interest rate risk indiscriminately strikes both domestic and international projects as well as ventures with multi-currency cash flows. Sponsors and their advisors have to decide whether or not to cover against this risk, a decision that is not exactly identical throughout the life of the project.
During the construction phase, the project does not generate revenues. However, drawdowns begin to produce interest payable, the amount of which depends on the level of interest rates during the years in which the project is under construction. Out of the total value of direct and indirect investments, clearly the interest on drawdowns cannot be precisely defined with certainty ex ante. Only a percentage of total investments consists of definite costs; this percentage certainly includes construction costs, which are defined on the basis of a turnkey contract. In addition, a reasonable estimate can be made of the cost of land; the same may be said for some development costs and for owner’s costs. Interest payable, in contrast, depends on trends in the benchmark rate.
This cost item represents a significant percentage of total costs; in fact, the more intense the recourse to borrowed capital, the greater the weight of the interest component. The risk the SPV runs is that unexpected peaks in the benchmark rate to which the cost of financing is indexed can cause an increase in the value of the investments such as to drain project funds entirely. For this reason, a rather widely used strategy is comprehensive coverage of the variable-rate loan throughout the entire project construction phase.
The most difficult problem for the SPV’s sponsors is to select the best strategy for covering floating-interest-rate loans during the postcompletion phase of the venture.
Often advisors decide on the approach to adopt on a case-by-case basis, depending on the specific features of the project in question. Nonetheless, the key concept advisors focus on is self-protection of cash flows, i.e., valuing whether cash flows from operations are sustainable in the face of negative variations in the value of the debt service. A rise in interest rates impacts debt service value by increasing payouts to lenders. Clearly this effect will abate over time (given the same rate variation) due to the progressive reduction in the outstanding debt. In any case, the main point is to ascertain the capacity of operating cash flows, i.e., to verify how these flows move over time. Naturally, self-protection of cash flows depends on the underlying connection among variables that move industrial cash flows and interest payable.
When this correlation is high and positive, any increase in interest rates is counter- balanced by variables that determine operating cash flows. The project, at least in part, will be ‘‘self-immunized’’ from rate risk. If there is no such correlation, an unexpected increase in the cost of financing would best be avoided because the project would not easily withstand such a contingency.
36 C H A P T E R u 3 Project Characteristics, Risk Analysis, and Risk Management
For example, consider a PPP project in the hospital sector, discussed further in Section 3.2.4.3. The periodic payments by the public administration to the SPV/
concession holder are linked specifically to the Consumer Price Index as a benchmark for the rate of inflation. This is a considerable advantage, because nominal rates move in relation to the inflation rate. As we know, nominal rates are made up of a real component and a premium requested by investors to protect their purchasing power. Ideally, therefore, the SPV would find itself in a situation where a variation in debt service would be compensated by an increase in revenues. The conditional must be used, however, since inflation can be determined with different parameters in terms of revenues and interest rates.
The only risk remaining for the SPV to face would be that the trends in actual interest rates may not be in line with the projections given in the financial model. The ideal strategy, then, would be to draw up a swap contract on the true interest rate or to use contracts that cover inflation risk (Section 3.1.3.4).
In practice, interest rate risk tends to be completely covered during the postcom- pletion phase: Percentages usually run from 70% to 90% of the outstanding debt; this gradually decreases as the outstanding debt diminishes. However, we must keep in mind that this coverage eliminates variability and in so doing prevents the SPV from taking advantage of possible drops in interest rates. Coverage strategies, in fact, are subject to a very considerable opportunity cost.
3.1.3.2 Exchange Rate Risk
Essentially this risk emerges when some financial flows from the project are stated in a different currency than that of the SPV. This often occurs in international projects where costs and revenues are computed in different currencies. However, a similar situation may arise in domestic projects when a counterparty wants to bill the SPV in foreign currency. Various industrial multinational groups, for example, customarily invoice in a hard currency, even if it is not that of the host country.
When possible, the best risk coverage strategy is currency matching. In other words, advisors of an SPV try to state as many flows as possible in the home currency, avoiding any use of foreign currency. If this is not possible (usually because counterparties have strong bargaining power), the following coverage instruments provided by financial intermediaries must be used:
. Forward agreements for buying or selling
. Futures on exchange rates
. Options on exchange rates
. Currency swaps
3.1.3.3 Derivatives Contracts for Managing Interest Rate Risk and Exchange Risk
Covering financial risk in a project finance venture does not differ greatly from policies on corporate treasury management. However, one major difference is clearly that the project life of such ventures is always longer than the time horizon for which these instruments are traded. In particular, this is the case regarding coverage instruments listed on stock exchanges and for some over-the-counter derivatives (such as futures on exchange rates). For this reason, structured finance transactions most often involve specific negotiated forms of coverage earmarked specifically for the project or use rollover strategies on standard contracts as they reach maturity.
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Forward Contracts: A forward contract involves an exchange with a delayed settlement. Traders set down contract conditions (specifically the date of settlement and the price) upon signature of the contract, and the exchange is actually settled at a future, preagreed date. A forward contract might pertain to a currency exchange rate (on maturity, the traders sell each other one form of currency for another on the basis of an exchange rate set when the contract is drawn up), a financial asset, or an interest rate.
If the price is fixed when the contract is made and remains unchanged until settlement, any potential fluctuations in the quotation on exchange rates, interest rates, or the financial asset in question do not affect the two parties, so both are covered. Of course, when listed prices rise above the negotiated price level of the forward contract, the buyer is at an advantage; the reverse will occur if the listing falls below the agreed-on price level. (Naturally, for the seller the opposite is true.)
In project finance ventures, forward contracts are used for the most part as coverage against exchange rate risks. This is true despite the greatest complication, which lies in the fact that the forward exchange market is very liquid only for maturities up to 12 months but is practically nonexistent for time horizons spanning more than 18 months.
Forward Contracts on Interest Rates—The Forward Rate Agreement: Traders can also agree to exchange a future interest rate. The forward rate agreement (or FRA) is one of the most widely used futures written on interest rates. With an FRA, the buyer pledges to pay the seller interest accrued on a principal at a preagreed rate, starting at a future date, and for certain period of time. The seller, on the other hand, commits to paying a fixed interest rate on the principal based on the interest rate at the future date. So, for example, a 6–9 FRA means that for 3 months (the difference between 9 and 6) the buyer and the seller will calculate an interest differential 6 months after the contract term takes effect. Clearly, the contract expires in month 9 (6þ3). The FRA buyer sets the future rate and is covered from interest rate risk. If in fact the future rate is higher than what was agreed on in the contract, the seller of the forward rate agreement pays the difference between the two rates to the buyer. Conversely, the buyer pays if the future rate proves to be lower than the preset rate.
In project finance deals, the SPV would buy forward rate agreements in order to fix the cost of financing. However, the FRA market also shows higher liquidity on maturities that are much shorter than the entire tenor of the loan.
Swaps: Swaps are contracts between two counterparties that stipulate reciprocal disbursement of payment streams at preestablished future dates for a set period of time. We can think of a swap as a combination of several forward transactions. In any case, the payment streams relate to interest calculated on given principal. When interest rates are stated in two different currencies, we refer to currency swaps, and the two streams can be either fixed rate or variable rate. When interest rates pertain to the same currency, obviously one of the flows is calculated at a fixed rate and the other at a variable rate. Contracts known asinterest rate swaps, in their simplest form, are a periodic exchange of fixed-rate streams against variable-rate streams (usually indexed to LIBOR or Euribor) for a given time horizon.
Swaps are used to modify the conditions of a preexisting loan. A swap buyer, who agrees to pay a fixed interest rate (short position) and periodically receive a variable rate (long position), aims to cover against possible future increases in interest rates on the base loan. If a rate increase does in fact occur, then the heavier debt burden is counterbalanced by positive differentials between variable and fixed rates that the swap counterparty will have to pay.
38 C H A P T E R u 3 Project Characteristics, Risk Analysis, and Risk Management
Swaps are over-the-counter contracts handled by intermediaries on the basis of the specific needs of a trader. In this sense, they are contractual structures that are well suited to covering exchange and interest rate risk in project finance deals.
Futures: A future is a forward agreement in which all contractual provisions are standardized (the underlying asset, date of maturity and date of delivery of the instrument in question, minimum contract lot). This is done to facilitate and expedite the trade of these instruments on official exchanges. In futures markets, a clearing house serves to guarantee obligations resulting from futures exchanges. This organization requires traders to pay an initial margin as collateral and daily variation margins until the position closes (the marking to market and variation margins mechanisms). Due to this fact, futures differ from forward contracts in light of their lower risk for counterparties and greater market liquidity.
In project finance ventures,interest rate futurescan be used to curb the negative repercussions of a rise in interest rates on a loan raised by the project company.
However, more difficulties are involved in using this instrument. For example, coverage is comprehensive only if there is a future contract on the market that corresponds to the interest rate paid on the base loan. If this is not the case, the operator is exposed tobasis risk; i.e., the risk that trends in the two interest rates (on the loan and on the future) diverge considerably. Instead, exchange rate risk coverage entails fewer problems: Futures markets, in fact, offer contracts written on the most widely exchanged currencies on an international level. Another drawback regarding the use of futures lies in the difficulty of finding contracts that last as long as the life span of the base transaction, as mentioned earlier. Of course, it may be possible continually to renew the contracts in question as they mature.
Options and Interest Rate Options (Caps, Floors, and Collars): Options, which are either listed on the stock markets or negotiated over the counter, are contracts that allow (but do not oblige) the buyer to purchase (call option) or sell (put option) a commodity or a financial asset at a fixed price (strike price) at a future date in exchange for payment of a premium. Unlike all the contracts described previously, options let the buyer choose whether or not to settle the contract. The cost of this choice is the premium the buyer pays to the seller.
Having this alternative is very important for the buyer, who can minimize the negative effects of keeping a position while maximizing positive effects. So, for example, the buyer of a call will not exercise an option if the listing on the underlying security at the expiry date is lower than the strike price; in doing so he or she will only lose the premium. Instead, the higher the price of the asset on expiry as compared to the strike price, the greater the profits for the buyer will be. The opposite occurs when one buys a put option.
In project finance deals, options are used both for covering exchange rate risk and protecting an SPV’s cash flows from interest rate risk. With regard to the latter case, in practice interest rate caps, floors, and collars are widely used.
With an interest rate cap, a buyer pays a premium in exchange for the right to receive the difference (if positive) between two interest rates: a variable rate (usually the rate stipulated for the base loan raised by the cap buyer) and a preset rate agreed on with the seller (strike rate or cap rate). The buyer and seller also establish relative maturities and time horizons in advance. If the difference between the variable interest rate and the cap rate is negative, the buyer simply pays the premium and receives nothing in return. The underlying asset that is the basis for flow calculations is fixed from the outset. If a cap buyer has already taken out a long-term loan, the reference principal coincides with the residual debt in each period in the amortization schedule.
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An interest rate cap is an attractive instrument for companies who have variable- rate financing and fear an excessive increase in their debt burden. SPVs fall into this category. Coverage by means of a cap allows them to fix a quota on increases, though this instrument also intensifies the debt burden when rates fall.
With an interest rate floor, in contrast, a buyer pays a premium in exchange for the right to receive the difference (if negative) between two interest rates: a variable rate and a preset rate arranged with the seller (strike rate or floor rate).
If the difference between the variable interest rate and the floor rate is positive, the floor buyer in this case simply pays the premium and receives nothing in return.
Interest rate floor buyers are usually investors dealing in variable-rate assets who anticipate a downturn in prices. With a floor, they set a lower limit to this downward trend, though forfeiting part of the yield, given the premium payment, if rates rise or remain stable.
Lastly, aninterest rate collaris a combination of buying (selling) a cap and selling (buying) a floor. More specifically, a collar buyer is in the same position as a cap buyer and a floor seller. If the variable rate exceeds the cap rate, the collar buyer will be paid the difference by the counterparty; if instead the variable rate falls below the floor rate, the buyer will pay the difference to the counterparty. (Note that we are in the position of a floor seller.) If the variable rate lies between the cap rate and the floor rate, no exchange takes place.
Figure 3-2 illustrates how a collar works.
The two horizontal lines indicate the floor rate (lower bound) and the cap rate (upper bound). Consider for example timet2. In this case the current level of interest rates is lower than the floor rate, so the SPV, having sold the floor to the hedging bank, will pay the difference. On the contrary, at time t3 we find the opposite situation. The current level of interest rates is higher than the cap rate, so the SPV is entitled to receive the difference from the hedging counterparty. In this way, the risk of interest rate fluctuations is limited to the corridor represented by the difference between cap and floor rates.
Buying a collar is a common strategy among SPVs in project finance deals. Doing so allows the company to establish a ‘‘band’’ for rate fluctuation without having to bear the higher cost of buying a pure interest rate cap.
Cap rate Floor rate
t1 t2 t3 t4
Cash out Cash in
F I G U R E 3-2 Model of How a Collar Works
40 C H A P T E R u 3 Project Characteristics, Risk Analysis, and Risk Management
3.1.3.4 Inflation Risk
Inflation risk arises when the cost dynamic is subject to a sudden acceleration that cannot be transferred to a corresponding increase in revenues. Inflation risk derives from the fact that most contracts between SPVs and their commercial counterparties are based on revision mechanisms for rates or installments based on the behavior of a given price index.
Both industrial and financial costs and revenues are impacted by inflation risk.
Consider, for instance, the effects of inflation on floating-rate loans. It is only natural that in project finance this point is crucial, considering the long tenor of the relative loans and the multiplicative effect of the capitalization factor applied to real cash flows. When costs grow more rapidly than revenues, cash flows from operations used for debt service slow to a trickle.
Inflation risk is even more difficult to deal with in the framework of ventures in which the buyer is a public entity or a service is offered for public use, such as with public transportation. In this context, in fact, fee readjustments that take the inflation dynamic into account must be approved by means of administrative measures.
Delays in this process can create the conditions for diseconomies in operations for periods of time that are not always predictable.
To cover against this risk, a swap contract is drawn up between a hedging bank and the SPV. ThisConsumer Price Index swap(CPI swap) serves to mitigate the effect that a drop in inflation would have on the capacity of nominal cash flows to service the debt, in any given period.2
When a hedging contract is signed, the benchmark inflation rate is quoted by the hedging bank for the entire tenor of the loan (henceforth Fixed Swapped Index, or FSI). From that time forward the debt service, in terms of capital and interest, is
‘‘immunized’’ from any possible future change in the rate of inflation. Figure 3-3 shows how a CPI works. The SPV receives indexed payments from the users (market) or from the offtaker, and payments are linked to a given Consumer Price Index (CPIt). The CPI swap stipulates that the SPV pays the CPI to the hedging bank, which in turn pays the FSI to the project company. For any future level of CPIt, the SPV bears no inflation risk.
In practice, the exchange of cash flows between the two counterparties coincides with each loan repayment after the scheduled revision of rates or periodic payments collected by the SPV. At this time, after agreeing to a base inflation rate to use for computing the coefficient for revising the payments, one of the two parties gives the other a certain sum of money depending on the differential between the real inflation rate (CPI) and the fixed rate (FSI) negotiated when the hedging contract was signed.
At every loan repayment date, the SPV can face three alternative scenarios:
1. CPIt<FSI: When this occurs, the inflation rate attis less than the rate fixed when the hedging contract was signed. The drop in the nominal value of cash flows and the resulting emergence of inflation risk is counterbalanced by a corresponding amount paid by the hedging bank to the SPV.
2. CPIt>FSI: Here the inflation rate attis higher than the rate fixed when the hedging contract was signed. The increase in the nominal value of cash flows is
2. Inflation risk coverage takes effect when the operational phase begins, because it is normally during this phase that financing is repaid.
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