Neutralizing Project Finance Risks: A Global Perspective

Last week I met Paul Allen, CEO/Project Director, Project Executive Group. Being fairly immersed in the software development world for a while, it was fascinating meeting someone equally immersed in the complexities of the oil and gas industry. I thought I understood complexity.....

He's been doing some work with Hossein Razavi, Ph.D., Sector Director, Infrastructure and Energy at the World Bank. This post describes some of the research they've done together.

So if you work for a gas or power company, and you want to do business in a developing country, you have to figure out how to protect the assets of the global corporation. But if Chevron wants to build a plant in, say, Bolivia, you don't want the country, and people you're doing business with in the country, to have access to the huge reserves of the corporation, should things all go pear-shaped.

So there's this concept of non-recourse financing, where no assets secure debt. How does this work? Is this like one of those no-money-down real estate deals I keep hearing about on late-night TV?

A project company must be formed specifically for the construction of the new power plant or whatnot, so there is no recourse back to the corporation. The assets and the cash flow of the project itself secure the debt, not the parent organization. There is no parent organization. This company has nothing to do with Chevron, okay?

Project financing allows you to deliver the keys back to the lenders if the project goes south, and all you lose is your equity. Your credit rating for the project is based entirely on who you have a contract with -- it's like you're a tiny startup that happened to get a multibillion dollar contract from a top tier firm, and everyone plays along.

So what are the big risks we're so afraid of? Well, bad organizational structures, bad regulatory systems and political instability for starters. These can lead to higher costs, loss of revenue or margin, and safety issues.

What happens if the government stops the project halfway through? What happens if the project isn't completed with acceptable quality, schedule or cost? What happens if it all works, but it's not maintainable?

There's an entire field of "financial engineering," which implies layers upon layers of guarantees and contracts, put together to protect the assets. Lenders aren't going to fund the project without adequate security documentation -- you have to prove you've neutralized project financing risks. Lenders want to be sure that costs, revenues, safety and getting the money back home are all protected. This leads to a formidable pile of documents, including agreements with the host country, operating agreements, fuel supply agreements, utility agreements, transportation agreements, and endless pro forma financials. Getting government guarantees and agreements with all the related contracts and suppliers takes a lot of time at the outset, but companies who try to short-circuit this process can pay a hefty price in a project that can't be optimized. And that only covers commercial risks!

The real nightmare is political risks. Nationalization, war and unrest, currency inconvertibility, labor permits, police harassment, government regulations.....

The answer to these is to make sure everyone has some skin in the game. Getting local investors involved will diffuse political situations. Some organizations may be tempted to screw over the host country, because you can, not realizing the amount of influence that screwed over party has to completely destroy your project. Don't even think about it.

Negotiate with the host country to ensure support before you ever get the project started. For political risks especially, you need a combination of guarantees -- offshore escrow accounts, insurance, risk guarantees by the World Bank are all good risk mitigation and guarantee instruments. It's also critical that you define force majeure very carefully -- it's amazing what can be an Act of God these days if you aren't specific enough. You should even get concession agreements with the host government. And what the heck -- force your vendors to take on the currency risk by only doing your contracts in dollars...

Normally in projects, we like to nail down organizational structure early. It's not going to change much, and it's good to know who's accountable for what. But in project financing, it's critical that the organizational structure remains flexible for as long as possible, so that you can include more local participation -- more skin in the game means less chance that your project will be disrupted.

Ultimately you may even need to fragment into multiple project vehicles, due to conflicting tax laws and accounting rules. The organization may need a holding company in a low tax country for the purpose of holding ownership interests in the project country.

Funny, in software projects I'm used to engineers chomping at the bit to start coding before the requirements are worked out. This is an entirely different, and much more painful, kind of planning. I can't imagine being this patient.