Project Finance: Lender Perspectives and Development Trends

The current credit crisis creates an inflated perception of credit risk when contemplating project financing in the biomass industry. This perception, however, is often inaccurate.

Project finance lenders employ rigorous credit analysis methods to minimize risk when dealing with issues including stringent financial regulatory requirements, new biomass-to-energy power project sponsors, new independent power producer rules, and new biomass technologies and fuel sources.

Lenders' ability to conduct thorough due diligence and credit analysis with the assistance of expert consultants makes project finance transactions, particularly in the power and energy sector, one of the safest asset classes today.

This article outlines the credit analysis process and provides insight into a typical lender's credit rating methodology, with a focus on biomass-to-energy projects. The article identifies key factors attracting lenders to a project and offers insight into lenders' credit analysis methodology and loan covenants. Finally, the article discusses project development trends relative to power infrastructure in emerging economies and specific efforts by leading banks and investors, particularly in the Asia-Pacific region.

Lender Perspectives
Corporate finance quantitative analysis commonly uses internal rate of return and net present value as evaluation methods. These methods are useful in evaluating mutually exclusive projects-projects whose costs and economics are independent from one another-from the perspective of the project sponsor.

Both internal rate of return and net present value evaluation techniques require a basic understanding of the cost of capital, which is the opportunity cost of future cash flows made by the firm. For example, if the cost of capital to a firm is 10 percent, the firm can either reinvest future cash flows in other projects that yield a 10 percent return, or it can repay capital originally borrowed at 10 percent interest. Cost of capital is also known as opportunity cost of capital or investment hurdle rate.

Companies typically determine their cost of capital by calculating the company's weighted average cost of capital, which establishes a blended opportunity cost of capital based on equity holders' expected return and the cost of borrowed capital.

For a corporation with available financial metrics, weighted average cost of capital is typically calculated in several sequential steps. The first step is determining the project firm's unlevered equity beta: Bunlevered = Blevered / [1 + (1-T) D/E], where T is the corporate tax rate, D is the value of corporate debt and E is the value of corporate equity.

In many cases, the weighted average cost of capital method benchmarks unlevered equity betas from similar companies in the same business sector as an average sector weighted average cost of capital, then applies this average to the project company's corporate structure: Bproject company = Bsector average * [1 + (1-T) D/E] project company .

The cost of equity is determined by adjusting normal equity capital markets' expected returns for the project company's equity beta: CE = Bproject company *(market risk premium) + (risk-free rate), where CE is the cost of equity, the risk-free rate is the return on a guaranteed instrument such as a U.S. Treasury bond, and market risk premium is the average return performance over the risk-free rate from the capital markets (e.g., Standard & Poor's 500 20-year return over U.S. government bond).

Weighted average cost of capital is then calculated as a weighted average of the cost of equity sources of capital and debt sources of capital: Weighted average cost of capital = , where CD is the cost of debt (ordinary borrowing rate on a similar bond rating class).

Weighted average cost of capital reflects an expected return for future cash flows, assuming repayment of borrowed sources of capital and investment in projects with a return commensurate with the level of risk. However, the flaw in using weighted average cost of capital as a project hurdle rate is that it applies a corporate debt and equity structure, as well as an implicit risk factor, to a project that might have a much different debt, equity and risk profile.

Firms wishing to maximize their leveraging may instead establish a project special purpose vehicle, which is a separate corporate entity held off balance sheet of the parent company. A special purpose vehicle may have a limited amount of equity capital contributed by the parent company but may raise a relatively large amount of debt capital by guaranteeing repayment from the project's future cash flows and limiting recourse to the parent company. In this case, because debt is substantially higher than equity, calculated weighted average cost of capital would more closely approach the cost of borrowing rather than the cost of the parent corporation's equity. Normally, though, weighted average cost of capital may not be calculated for a project special purpose vehicle because of the lack of prior performance data required for computing the equity beta.

Weighted average cost of capital is commonly used as a reference return when corporations perform internal rate of return and net present value calculations to evaluate a project. Net present value, which is the sum of future discounted cash flows from a project minus the capital outlay, may use weighted average cost of capital as the discount rate: Net present value = - outlay.

If a project's net present value is greater than zero, the project's future cash flows minus its capital outlay exceeds the weighted average cost of capital return rate. Typically, the project should therefore be approved. However, managers making decisions based on a project's net present value should consider the differences in the debt and equity structures of the project versus the corporation. This is particularly true in the case of borrowing capital specifically for the project under a project finance transaction.

Although net present value and internal rate of return are useful for project sponsors when selecting project investments, banks use a different set of metrics when evaluating the attractiveness of lending capital to projects. The benefits implied by net present value are relative to the project sponsor and its equity holders. The benefits relative to a bank or debt issuer, however, are defined by the risk-adjusted return on capital. The risk-adjusted return on capital is a method developed by Bankers' Trust in the 1970s to measure the anticipated return on capital considering the cost of regulatory capital (reserve requirement for loan loss coverage) and the fees earned by the lender on issuing the loan.

Regulatory capital is cash and equity the bank must keep in reserve to cover loan defaults and losses. It is therefore the opportunity cost of lending new capital. The risk-adjusted return on capital calculation enables banks to compute returns on regulatory capital by considering the borrower's creditworthiness. This is usually determined by credit ratings and by historical default and recovery rates of similar entities.

Because risk-adjusted return on capital bases return on the amount of regulatory capital held in reserve, how does a bank determine the amount of the reserve? This amount is related to the risk profile of the project, as explained in the following section.

Project Finance Credit
The elements of determining credit risk for a project finance transaction can be used to attract favorable lending to projects, particularly in the biomass-to-energy power sector.

Credit that makes sense to project sponsors can be difficult to obtain. Insufficient experience and an incompletely defined project may attract loans only from local banks with expensive interest rate terms. A properly defined project that can pass rigorous due diligence, however, can attract more favorable lending terms from international banks.

Credit risk assessment of a project special purpose vehicle is addressed by the Bank for International Settlements Basel Committee on Banking Supervision Publication 118. The publication is the guideline for the Basel II accord, the principles that govern overall capital markets regulation. Annex 6 of the document addresses evaluation criteria for specialized lending, including project finance.

A project feasibility study performed by a consultant specializing in biomass-to-energy projects typically identifies basic transaction characteristics. A more advanced consulting approach is usually required to identify other supervisory criteria.In addition, legal counsel is commonly engaged to draft basic security terms, and supply and offtake contract terms.

Challenges to financing biomass-to-energy projects include providing evidence of sponsor strength and comprehensive offtake contract terms. Sponsor strength with common fossil fuel power plants is readily obtainable in most cases: legacy utility companies usually have an established regional presence and a deep management structure with relationships in the region. Biomass-to-energy power plants, on the other hand, are usually smaller, more entrepreneurial ventures whose sponsors may have little or no experience in running a small-scale utility business. Two factors are paramount for seeking biomass project finance. The first is transparent ownership. The project sponsor must have a corporate structure with registered capital that can be readily reported to lenders. The project sponsor must also clearly identify board members, equity contributors and key management to satisfy banks' Know Your Customer rules.

The second factor is a reputable management team. The feasibility study or project finance documents must outline a management organizational chart to address project commissioning, operations and maintenance. The organization chart should include detailed position descriptions and identify individual managers with established experience in the biomass-to-energy and power sectors.

Project Development Trends
Two key trends pertinent to biomass-to-energy project development are discussed below. The first is power infrastructure in emerging economies. Emerging economies, particularly in Asia-Pacific nations, are continually challenged by insufficient power supply to meet demand. The problem is magnified in nations where rural electricity is limited by physical barriers or political challenges.

Accordingly, many nations have established independent power producer frameworks that promote smaller, private-sector-owned power plant development while guaranteeing a connection to the national power transmission grid. These applications, typically limited in size to approximately 10 to 50 megawatts, create many opportunities for small power producers. In heavy agricultural regions or in countries with national biofuels policies, the availability of biomass fuel sources and the promise of independent power producer policy may create the ideal climate for investing in biomass-to-energy projects.

The second key trend is in project finance markets. The first quarter of 2008 saw the highest-ever volume of project finance transactions worldwide, with more than 125 transactions totaling $56.4 billion, according to the Thomson Financial First Quarter 2008 Global Project Finance Review. Recently, two subsets of the global project finance market have demonstrated consistent strength: the Asia-Pacific region and the power sector. Although Europe, the Middle East and Africa lead the world in volume (67 issues, $26.7 billion in loans), the Asia-Pacific region, with $23.3 billion in volume, has been beating its own quarter-by-quarter records. In fact, the region's rate of increase in project finance transactions is the highest in the world.

In contrast, the Americas trail the global project finance market, with only $6.4 billion in loans. The important conclusion is to recognize that developing nations with relatively stable political climates, as in much of East Asia, are leading the deployment of project finance capital.

The most active sector in recent quarters is the power sector. In the first quarter of 2008, project finance transaction volumes in the power sector increased by 7.2 market share points relative to other sectors (total borrowed volume of $23.4 billion).

Despite the overall downturn in credit, biomass-to-energy project financing is surging. Project lenders' and specialty consultants' use of the analysis methods discussed herein ensure that financing for biomass-to-energy ventures will continue to provide stable returns on investment, particularly in the booming Asia-Pacific region.

Thomas M. Minnich is director of Prime Capital Services Ltd. Reach him at [email protected] or (404) 425-7100.