An introduction to the financing method which provides the cash for new capacities.
Project finance has today emerged as the preferred method of financing large-scale power and water projects - and nowhere more so than in the Middle East.
The concept involves non-recourse or limited recourse financing of the development and construction of a project. Thus, loans from a lender, usually a syndicate of banks, are secured by the project itself and paid entirely from its cash flow. In the case of a project deemed to involve a greater level of risk, the loans might be secured primarily by the project with some additional reassurances from the sponsors, i.e limited recourse financing.
We work in partnership with the developer and help him win, because he has to be competitive in his pricing to win. But at the same time we have to make sure we can sell the deal in the market. Ravi Suri
The lender therefore looks not to the general credit of the project sponsor but to the revenues expected to be generated by the project for the repayment of its loan and to the assets of the project as collateral.
Though project finance is more complicated, and more expensive, than alternative financing methods, and it can take a long time to draw up and finalise the agreements, it also has big advantages. It is most desirable in capital-intensive, long-term projects, so comes into its own for power and water plants.
The sponsors of such projects, who themselves invest some equity, often do not have a sufficient credit rating to obtain traditional financing, or are unwilling to take the risks and assume the debt obligations associated with it. Project financing sees that the risks are allocated among a number of different parties, acting in contract with one another, at reasonable levels - and simultaneously ensures profits for each of them.
"You have to look at many risks," says Ravi Suri, head of project and export finance at Standard Chartered for the Middle East and South Asia. "The construction should be well mitigated. You have to look at the operation and maintenance risk, you look at the offtake risk, how expensive the power is, what the demand for power will be. You look at the country issues...the entire gamut of risk has to be looked at."
"Project finance is primarily about the identification and the allocation of risk," agrees Christopher Clement-Davies, a partner in the London office of law firm Fulbright & Jaworski International who has worked on power projects in the Middle East and around the world. With the deals being so contract-driven, the documentation can become so complex that legal firms are themselves crucial to the success of project finance and act for all the parties involved.
"The key things really would be: where are the stress points? Where are the most difficult risks likely to be found? What approach are the different parties going to take to them? Who will be expected to bear which risks and how will that pan out in the negotiation process as the documents are drafted and finalised?
"There are lots of other threshold questions whenever you are dealing with emerging markets," Clement-Davies continues, "because some of the features that lawyers will often take for granted on project financing structures are not there. You may encounter individual difficulties in some areas: aspects of the security needed to be granted, aspects of government empowerment, aspects of legal capacity and so on, in specific jurisdictions - and that can compound the challenge of making these projects work."
So how does the whole process begin and who would approach the lenders in the first place? "There are two ways," says Suri. "When you do government advisories, the governments approach. Or you can work with the private developers when they bid.
"On the power side, you generally have to team up with the power developer when it is bidding. Some of the projects call for financial bids, so when they call for financial bids then you get associated at an early, pre-bid stage. Some of them do not call for financial bids, so then you are approached by the developer once he has won the mandate."
And what would entice a bank to take part? "We get a structuring fee, we get a front-end fee, we play many roles," Suri continues. "We work in partnership with the developer and help him win, because he has to be competitive in his pricing to win. But at the same time we have to make sure we can sell the deal in the market."
A combined project…will have an added impetus, a momentum that neither has on its own, because you are servicing two needs at once. Christopher Clement-Davies
As for the legal firms, it is typically the governments who first make contact and subsequently the project sponsors, according to Clement-Davies. "Governments and sponsors would appoint their own lawyers," he explains. "They would then bring in the lending banks, and finally you would get to the contractors, although a major contractor might have a role as one of the key sponsors from the outset.
"All those groups, and others too if it is a complex financing structure, would need separate legal advice, though no one firm would act for more than one of those groups on an individual project."
Because of its drive to expand power generation and water capacities - a strategy which calls for huge levels of capital - this region is a prime market for project finance. As Clement-Davies puts it, "The Middle East dominates the horizon more than ever nowadays."
But there are other reasons why it is a sensible choice. "The risks are well mitigated in this region. Fees are well structured, governments have privatised well," explains Suri. And another issue of increasing relevance in this region is the role Islamic finance can play. "Islamic finance is becoming an important source of finance and we work with the Islamic team for syndicating these loans," says Suri.
In June, the Khaleej Times reported the project finance market in the GCC had soared to an estimated US$1 trillion, with an increasing number of companies in the region choosing to finance their projects in accordance with Shariah principles. "The growth in Islamic project financing has been phenomenal," wrote MEED ahead of its conference on the subject earlier this year. "It exemplifies the success of both the burgeoning Islamic finance sector and the booming construction industry in the region," it added.
As a case in point, the massive Marafiq independent water and power project (IWPP), which reached financial close in June, having secured a record US $3.44 billion worth of financing, included a US$600 million Islamic financing facility provided by Riyad Bank, Al Rajhi Banking & Investment Corporation and National Commercial Bank - the largest such facility in the power and water sector to date.
Nonetheless, the Islamic project financing industry remains young, and there is still an air of uncertainty and lack of knowledge about its benefits, and about how it can work in conjunction with conventional finance.
As for sukuks, Suri says their use has been minor in the power market so far because of some construction risk. "Wherever there are issues of no construction risk, sukuks can play a big role," he says.
When examining project finance issues pertaining to power and water in particular, it should be noted that power projects are often seen as a point of reference on how a deal should be structured.
"Power has tended to lead the way in the project finance world for many years now," says Clement-Davies, though he points out that the oil and gas industry is now comparable in size because of some enormous recent LNG projects.
In utility projects, it should be noted that lenders are not paid back through a percentage of the revenues generated from the sale of power and water, rather they lend amounts to the project company at a given rate of interest.
Of course, for the project company to fulfill its obligations and repay the amounts it has borrowed, as well as the interest and other associated charges, the sponsors need to make sure that the tariffs which are charged for the production of power and water are properly structured so as to generate sufficient revenues.
"It is a loan to the project company, which the project company has an obligation to repay," says Clement-Davies. "But everyone knows that the project company's ability to repay is dependent on the revenues it is going to generate over time. If something goes wrong with those revenue levels, the lenders will ensure that they have priority rights to assert their claims against the project company."
On the water side, Clement-Davies believes that water projects, while problematic on their own because of affordability issues and political sensitivities, can become more straightforward when they are combined with power projects, as is often the case today in the Middle East.
"Water is an up-and-coming sector but is has been a very hesitant one around the world," he continues. "The water sector was being referred to a few years ago as the oil of the 21st century. They were anticipating massive new levels of investment in the water sector around the world with hundreds of new projects being implemented. That hasn't really happened. The pattern has been much more hesitant than people expected and it remains a difficult and challenging sector.
"Combining them with power in the Middle East somehow makes them more straightforward to put in place. Affordability becomes less of a problem. The expensive transaction costs associated with projects become relatively insignificant when you are working on a massive deal. A combined project of that kind will have an added impetus, a momentum that neither has on its own, because you are servicing two needs at once."
Joint power and water projects do mean more work for the lawyers, however, since the contract and financing package will inevitably become more complex.
Looking ahead, it seems law firms will be kept busy, as multi-billion dollar project-financed power and water plants become the norm in the Middle East. "There will continue to be huge demand in the next five years," says Suri.
"I think that aggregate volumes of project financing deals are now larger than ever before, particularly in the Middle East," adds Clement-Davies.
With no sign of growth slowing down, continued governmental support, popularity among international banks, high levels of liquidity locally and the question of Islamic finance adding extra interest, project finance in the Middle East, already a focal point for the entire industry, will continue to be a very attractive proposition all round.